One of the hottest investing options out there right now is the ETF. It has taken the industry by storm,especially in the last few years. They have become the go-to choice for the beginners as well as seasoned investors looking for a no-frills way to get a good return without a lot of effort.
In 2007 Warren Buffett gave this advice to individual investors who don’t have the time to research individual companies. He suggested that cheap index funds were the best way to invest in the stock market.
The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you’ll be buying into a wonderful industry, which in effect is all of the American Industry.
If you buy it over time, you won’t buy at the bottom, but you won’t buy it all at the top either. Warren Buffett
What is an ETF?
An Exchange Traded Fund or ETF is a marketable security that tracks and index, a commodity, bonds, or a basket of assets like an index fund.
The ETF differs from a mutual fund in that it trades on the stock exchange like an individual stock. The price of an ETF will fluctuate up and down during the course of a day. ETFs typically have higher liquidity than mutual funds and much lower fees, which makes them an attractive investment for investors, particularly ones that are newer to investing or those looking for lower fees.
Because it trades like a stock, it’s price will fluctuate during the day, unlike the mutual fund that is calculated at the end of the day.
One advantage of an ETF is that you get the advantage of an index fund in regards to the diversification, plus an ability to short sell, buy on a margin or buy a single share (there are no minimum requirements for deposits).
Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. Just like buying any common stock, when you buy or sell an ETF with your broker you will pay a commission for that trade.
Some examples of widely traded ETFs
- One of the most widely known and traded ETFs tracks the S&P 500 Index and is called the Spider(SPDR), and trades under the ticker SPY.
- The IWM tracks the Russell 2000 Index
- The QQQ tracks the Nasdaq 100, and the DIA tracks the Dow Jones Industrial Average.
- Sector ETFs exist that track individual industries such as oil companies(OIH), energy companies(XLE), financial industries (XLF), RIETS (IYR), the biotech sector (BBH).
- Commodity ETFs exist to track commodity prices including crude oil (USO), gold (GLD), silver (SLV), and natural gas (UNG) among others.
- ETFs that track foreign stock market indices exist for most developed and many emerging markets, as well as other ETFs which track currency movements worldwide.
What is the difference between ETFs and Index Funds?
ETFs are considered more flexible and easier to use than Index funds. ETFs are traded similarly to common stocks and are priced throughout the day. Index funds are more similar to mutual funds as they are priced at the end of the day. You can also buy ETFs in smaller batches and are much less hassle than index funds.
Cost are different too. With Index funds, the transactional costs are less than ETFs. However, costs for taxes and management fees are lower for ETFs.
Most retail passive investors choose Index funds because of the lower cost comparison between the two. Likewise, most passive institutional investors choose ETFs.
You can choose an ETF that matches an Index, such as Wilshire 5000 Total Market Index.
What are the fees for an ETF?
Total estimated ETF costs during one year
|Description of costs and assumptions||Long-term, buy-and-hold investor||Active investor|
|Average trades per year ($10,000 per trade)||2 (1 roundtrip)||60 (30 roundtrips)|
|Commissions ($9 per trade)||$18||$540|
|Bid/ask spreads (0.25% average per roundtrip)||$25||$750|
|Operating expenses (0.3% per year on $10,000 balance)||$30 (ETF held every day in the year)||$15 (ETF held for half of the days in the year)|
|Changes in discounts/premiums||$0||$0|
Source: Schwab Center for Financial Research
As you can see the costs can depend greatly on how much you buy and sell. The transaction costs can really add up if you are in and out of the stock(EFT) during the course of the year.
Let’s break this down a little bit. So, transaction fees are the commission that your broker will charge you to buy or sell an ETF. Every time you buy or sell this charge is incurred. My broker, TradeKing, charges $4.95 a trade. So much lower than our friends at Charles Schwab.
Next, we will talk about bid/ask spreads. The bid/ask price is the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept to sell it. These bid/ask spreads are baked into every ETF and are incurred during every buy or sell transaction.
The last fees we will discuss are the management fees. These are typically the lowest fees and are set as a yearly expense for the investor. This is particularly important to buy-and-hold investors as this function helps drive down the fees of an ETF. If you buy the stock for 25 years, you only pay the transaction, bid/ask spreads for one round trip. And the management fees would be every year. As you can see from the chart this helps drive down the costs of investing in an ETF as opposed to buying and selling constantly.
Investing Strategies with ETFs
There are four major strategies that we will take a look at.
- Core Holdings-You can use a few low-cost ETFs as a basis for your core holdings for your portfolio. This can be a great start for asset class diversification.
- Asset Allocation-This is where an ETF can shine. You can easily build an asset allocation into your portfolio by utilizing ETFs. You can even use ETFs that have several asset classes included in their allocations. This is a great way to incorporate passive investing into your strategy. As long as you rebalance the portfolio from time to time, ETFs can be a great way to diversify across several asset classes.
- Diversification-Another area of excellence for the ETF. These allow investors to diversify across all major asset classes, U.S. equity, foreign equity, and fixed income, but they can also diversify into allocations that have little in common with the major asset classes. Such as commodities, real estate, small caps, and others.
Hedging-This use of EFTs can help you hedge against a drop in the market by purchasing inverse ETFs or leveraged inverse ETFs. These rise when the market falls. If you are worried about inflation, you can hedge against it by investing in commodities or inflation-protected bond ETFs. There are multiple ways you can use ETFs to hedge against just about any scenario you can dream up.
How to choose an ETF
According to Morningstar, there are over 1900 ETFs in the US market as of October 2016. The combined assets of these funds are over $2 trillion.
- Level of Assets-To be viable an ETF should have a minimum level of assets. A common threshold is $10 million. The more assets the more interest level by other traders, which helps with liquidity and wider spreads.
- Trading Activity-An investor needs to make sure the ETF is trading sufficiently for them to consider it as an investment. This is another excellent indicator of liquidity of a particular ETF.
- Underlying Asset or Index-Strongly consider the underlying asset or index of the ETF, this will be based on your investing strategy and what kind of asset allocation you are looking for. Also, consider more widely followed, broad indexes as opposed to more obscure, less widely followed indexes.
- Low Fees-Look for ETFs that have low fees as this will allow you to diversify your asset allocation and keep your costs down so that you have more money in your pocket.
EFTs in your IRA
Mutual funds have been the bread and butter of 401ks for a while now as well as IRAs for investors. Since 1993 when ETFs were first created there has been a shift to ETFs. Among the many reasons if the lower fees than a mutual fund.
We have already discussed how the fees affect your returns and what you should look out for. After all, a mutual fund is unlikely to beat the market over the long haul. So why pay for those extra fees when you have other options.
Keep in mind to look at those fees closely to make sure they are indeed lower. Not every single ETF is going to be lower than a mutual fund so it is critically important that you take the time to check it out.
Next thing to keep in mind is that if you pick an ETF that follows an index then it is going to match that index exactly. This is important because as that index goes up, your ETF rises and vice-versa.
The latest and greatest in passive investing is the ETF, they are perfect for this style of investing because they have lower fees. This is because they don’t utilize a team to investigate and trade in those stocks. If the index is being matched then it is quite simple to manage. This helps bring the fees or cost of the ETF down. But again is important to do your homework and make sure that the fees are what you are looking for.
Remember that diversifying is one way to help mitigate risk in your investment portfolio. Broad-based ETFs are a great way to accomplish this but it is important to look for those types of ETFs and make sure the fees are in line.
The top providers of ETFs
BlackRock’s iShares ETFs-with over 500 funds and $650 billion, BlackRock is far and away the largest provider of ETFs. iShares is most renowned for builiding it’s ETFs around leading global indexes, such as Barclay’s Capital, Dow Jones, Morningstar, and Standard & Poors. Currently, these funds average the highest dividend yield of any provider.
Vanguard ETFs-currently the second largest provider of ETFs in the world. Vanguard is thought of as the “Walmart of investing” with its low-cost focus. Its FTSE Emerging Markets ETF (VWO) is huge with over $60 billion in assets and tremendous trading volume, with 19 million trades in the last three years.
State Street Global Advisors’ SPDR ETFs-This firm was started in 1792 and they offer more than 100 ETFs. Most of these are SPDR funds. The SPDR S&P 500 ETF (SPY) is the oldest and largest ETF, with nearly $125 million in assets. SPY is the most actively traded fund in the world.
ETFs have become such a staple in the investing world, and for good reason. They offer such a wide array of options of where to invest your money.
There are many terrific ETFs that can help you lessen your risk in your portfolio and help you diversify across many different asset classes. They have also started to creep into IRAs or 401k plans as another tool for investors to utilize.
The two major advantages to ETFs are the low-cost aspect. Typically the fees will be lower than mutual funds, which will allow your money to go farther. Another aspect is the ease of asset allocation. Instead of having to find individual investments to meet your asset allocation designs, you can find one or tow ETFs that will fit the bill.
The great thing about this diversification is that also helps lower your costs because you simply have fewer investments to buy. As you now each investment comes with a transaction cost.
I think we discussed how ETFs can be a great vehicle for you in many different ways and how you should try to take advantage of them.
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As always, thank you for taking the time to read this post.