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Become an ETF expert with this up-to-date investment guide
Want to expand your portfolio beyond stocks and mutual funds? (Of course you do, you smart investor you.) Then take a look at exchange-traded funds (ETFs)! A cross between an index fund and a stock, they're transparent, easy to trade, and tax-efficient. They're also enticing because they consist of a bundle of assets (such as an index, sector, or commodity), so diversifying your portfolio is easy. You might have even seen them offered in your 401(k) or 529 college plan.
Exchange-Traded Funds For Dummies is your primer on ETFs. It gives you an insider (the legal kind!) perspective on the investment process, starting with an overview of ETFs and how they differ from stocks and mutual funds. The book also helps you measure risk and add on to your portfolio, and offers advice on how to avoid the mistakes even professionals sometimes make. Throughout, you'll also find plenty of tips, tricks, and even sample portfolios to set you up on the right path for investment success.
With Exchange-Traded Funds For Dummies, you will:
- Find out exactly what exchange-traded funds are and why they make good investments
- Mix and match stock portfolios to diversify yours
- Go beyond stocks for maximum diversification: bonds, real estate, and commodity ETFs
- Maintain your portfolio for future growth
With the tricks of the trade in Exchange-Traded Funds For Dummies, you can easily apply the knowledge you gain to turn good investments into great ones. Happy earning!
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Veröffentlichungsjahr: 2021
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Exchange-Traded Funds For Dummies®, 3rd Edition
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Copyright © 2022 by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada
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ISBN: 978-1-119-82883-9 (pbk); ISBN 978-1-119-82884-6 (ebk); ISBN 978-1-119-82885-3 (ebk)
Exchange-Traded Funds For Dummies®
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Table of Contents
Cover
Title Page
Copyright
Introduction
Since the First Edition…
About This Book
Foolish Assumptions
Icons Used in This Book
Beyond the Book
Where to Go from Here
Part 1: The ABCs of ETFs
Chapter 1: No Longer the New Kid on the Block
In the Beginning
Fulfilling a Dream
Not Quite as Popular as the Beatles, But Getting There
Ready for Prime Time
Chapter 2: What the Heck Is an ETF, Anyway?
The Nature of the Beast
Choosing between the Classic and the New Indexes
Preferring ETFs over Individual Stocks
Distinguishing ETFs from Mutual Funds
Why the Big Boys Prefer ETFs
Why Individual Investors Are Learning to Love ETFs
Getting the Professional Edge
Passive versus Active Investing: Your Choice
Do ETFs Belong in Your Life?
Chapter 3: Getting to Know the Players
Creating an Account for Your ETFs
Introducing the Shops
Presenting the Suppliers
Familiarizing Yourself with the Indexers
Meeting the Middlemen
Meeting the Wannabe Middlemen
Part 2: Building the Stock (Equity) Side of Your Portfolio
Chapter 4: Risk Control, Diversification, and Some Other Things You Need to Know
Risk Is Not Just a Board Game
Smart Risk, Foolish Risk
How Risk Is Measured
Meet Modern Portfolio Theory
Mixing and Matching Your Stock ETFs
Chapter 5: Large Growth: Muscular Money Makers
Style Review
Big and Brawny
ETF Options Galore
Chapter 6: Large Value: Counterintuitive Cash Cows
Six Ways to Recognize Value
Looking for the Best Value Buys
Chapter 7: Small Growth: Sweet Sounding Start-ups
Getting Real about Small-Cap Investments
Your Choices for Small Growth
Smaller than Small: Meet the Micro Caps
Chapter 8: Small Value: Diminutive Dazzlers
It’s Been Quite a Ride
What About the Mid Caps?
Chapter 9: Going Global: ETFs without Borders
The Ups and Downs of Different Markets around the World
Finding Your Best Mix of Domestic and International
Not All Foreign Nations — or Stocks — Are Created Equal
Choosing the Best International ETFs for Your Portfolio
Chapter 10: Sector Investing: ETFs According to Industry
Selecting Stocks by Sector, not Style
Speculating on the Next Hot Industry
Doing Sector Investing Right
Sector Choices by the Dozen
Chapter 11: Real Estate Investment Trusts: Becoming a Virtual Landlord
Considering Five Distinguishing Characteristics of REITs
Calculating a Proper REIT Allocation
Picking REIT ETFs for Your Portfolio
Chapter 12: Dividend Funds: The Search for Steady Money
Your High-Dividend ETF Options
Promise of Riches or Smoke and Mirrors?
Part 3: Adding Bonds (Fixed Income) to Your Portfolio
Chapter 13: For Your Interest: The World of Bond ETFs
Bond Investing in the Modern Era
Tracing the Track Record of Bonds
Tapping into Bonds in Various Ways
Determining the Optimal Fixed-Income Allocation
Chapter 14: Your Basic Bonds: Treasuries, Agency Bonds, and Corporates
Tapping the Treasuries: Uncle Sam’s IOUs
Bread at $15 a Loaf? Getting Inflation Protection in a Flash
Treasuries’ Cousins: U.S. Agency Bonds (Mortgage-Backed Securities)
Banking on Business: Corporate-Bond ETFs
The Whole Shebang: Investing in the entire U.S. Bond Market
Chapter 15: Moving Beyond Basics into Municipal and Foreign Bonds
Municipals for Mostly Tax-free Income
Foreign Bonds for Fixed-Income Diversification
Emerging-Market Bonds: High Risk, High Return
Part 4: Specialized ETFs
Chapter 16: All That Glitters: Gold, Silver, and Other Commodities
Gold, Gold, Gold!
Silver: The Second Metal
Oil and Gas: Truly Volatile Commodities
(Somewhat) Safer Commodity Plays
Playing the Commodity Market Indirectly
Chapter 17: Investing for a Better World
What Are “Sustainable Investing” and “ESG”?
Which Sustainable ETFs Are Best for Your Portfolio?
Chapter 18: Going Active with ETFs
Not Exactly Setting the World on Fire
Do You Want to Get Active?
Let’s Get Practical
A Look at Some of the Most Popular Actively Managed ETFs
Time to Swap Out Your Active Mutual Funds?
Chapter 19: All-In-One ETFs: For the Ultimate Lazy Portfolio
Buying into the World’s Stock Markets in a Flash
Putting the World’s Bond Markets at Your Fingertips
Buying Stocks and Bonds in One Shot
Chapter 20: Proceed-with-Caution ETFs
Funds That (Supposedly) Thrive When the Market Takes a Dive
Funds That Double the Thrill of Investing (for Better or Worse)
Alphabet Soup: MLPs, SPACs, and IPOs
Investing in one-horse towns
Get Rich (or Not) in Crypto- or Other Currencies!
Take a Whiff of These Cannabis ETFs
Copycat ETFs
Part 5: Putting It All Together
Chapter 21: Sample ETF Portfolio Menus
So, How Much Risk Can You Handle and Still Sleep at Night?
Keys to Optimal Investing
Finding the Perfect Portfolio Fit
Chapter 22: Exercising Patience: The Key to Any Investment Success
The Tale of the Average Investor (A Tragicomedy in One Act)
The Value Line Paradox
“Investment Pornography” Everywhere
Patience Pays, Literally
Chapter 23: Exceptions to the Rule (Ain’t There Always)
Rebalancing to Keep Your Portfolio Fit
Contemplating Tactical Asset Allocation
Harvesting Tax Losses, and the IRS’s Oh-So-Tricky “Wash Rule”
Revamping Your Portfolio with Life Changes: Marriage, Divorce, and Babies
Are Options an Option for You?
Chapter 24: Using ETFs to Fund Your Fun (Retirement) Years
Aiming for Economic Self-Sufficiency
Curing the 401(k) Blues
Strategies for the Self-Employed
Ushering Your Portfolio into Retirement Readiness
Withdrawing Funds to Replace Your Paycheck
Chapter 25: Marrying ETFs and Non-ETFs to Make an Optimal Portfolio
Tinkering with an Existing Stock or Mutual Fund Portfolio
Looking Beyond the Well-Rounded ETF Portfolio
Part 6: The Part of Tens
Chapter 26: Ten FAQs about ETFs
Are ETFs Appropriate for Individual Investors?
Are ETFs Risky?
Do I Need a Financial Professional to Set Up and Monitor an ETF Portfolio?
How Much Money Do I Need to Invest in ETFs?
With Hundreds of ETFs to Choose From, Where Do I Start?
Where Is the Best Place for Me to Buy ETFs?
Is There an Especially Good or Bad Time to Buy ETFs?
Do ETFs Have Any Disadvantages?
Does It Matter Which Exchange My ETF Is Traded On?
Which ETFs Are Best in My IRA, and Which Are Best in My Taxable Account?
Chapter 27: Ten Mistakes Most Investors (Even Smart Ones) Make
Paying Too Much for an Investment
Failing to Properly Diversify
Taking on Inappropriate Risks
Selling Out When the Going Gets Tough
Paying Too Much Attention to Recent Performance
Not Saving Enough for Retirement
Having Unrealistic Expectations of Market Returns
Discounting the Damaging Effect of Inflation
Not Following the IRS’s Rules
Failing to Incorporate Investments into a Broader Financial Plan
Chapter 28: Ten Forecasts about the Future of ETFs and Personal Investing
ETF Assets Will Continue to Grow…for Better or Worse
More Players May Enter the Field, but Only a Few
Investors Will Get Suckered into Buying Packaged Products
ETF Investors Will Have No Need for Anything but ETFs
The Markets Will (Unfortunately) See Greater Correlation than in the Past
Asset Class Returns Will Revert toward Their Historic Means
Taxes Will Rise
Inflation Will Remain Tame
Private Pensions (of Sorts) May Emerge from the Rubble
Hype Will Prevail!
Part 7: Appendixes
Appendix A: Great Web Resources to Help You Invest in ETFs
Independent, ETF-Specific Websites
Websites of ETF Providers
Financial Supermarkets
Stock Exchanges
Specialty Websites
Regulatory Agencies
The People Who Create the Indexes
Good Places to Go for General Financial News, Advice, and Education
Yours Truly
Appendix B: Glossary
Index
About the Author
Connect with Dummies
End User License Agreement
List of Tables
Chapter 1
TABLE 1-1 The Six Largest ETFs by Assets
TABLE 1-2 The Six Largest ETFs by Number of Shares Traded
Chapter 2
TABLE 2-1 ETFs versus Mutual Funds versus Individual Stocks
TABLE 2-2 Rock-Bottom-Priced ETFs
TABLE 2-3 Holdings of the iShares Dow Jones U.S. Energy Sector ETF as of mid-Aug...
Chapter 3
TABLE 3-1 Providers of ETFs
TABLE 3-2 Expense Ratio Comparison
Chapter 4
TABLE 4-1 Standard Deviation of Two Hypothetical ETFs
TABLE 4-2 Recent Performance of Various Investment Styles
TABLE 4-3 Recent Performance of Various Market Sectors
Chapter 16
TABLE 16-1 Trading Gold for Hershey Bars
Chapter 23
TABLE 23-1 A Shifting Portfolio Balance
List of Illustrations
Chapter 2
FIGURE 2-1: The secret to ETFs’ tax friendliness lies in their very structure.
Chapter 4
FIGURE 4-1: The risk levels of a sampling of ETFs.
FIGURE 4-2: ETFs A and B each have high return and high volatility.
FIGURE 4-3: The perfect ETF portfolio, with high return and no volatility.
FIGURE 4-4: The style box or grid.
Chapter 5
FIGURE 5-1: The place of large-growth stocks in the grid.
FIGURE 5-2: Large-growth stocks have given investors ample returns over the dec...
Chapter 6
FIGURE 6-1: Large-value stocks occupy the northwest corner of the grid.
FIGURE 6-2: This chart shows the growth of $1 invested in a basket of large-val...
Chapter 7
FIGURE 7-1: The shaded area is the portion of the investment grid represented b...
FIGURE 7-2: Historically, the growth of a basket of small growth stocks hasn’t ...
Chapter 8
FIGURE 8-1: Small value stocks occupy the southwest corner of the investment st...
FIGURE 8-2: As you can see, small value has truly shined in the past nine decad...
Chapter 9
FIGURE 9-1: U.S. versus non-U.S. stock-market performance, 1975–2021.
Chapter 10
FIGURE 10-1: The industry sector map for the United States.
FIGURE 10-2: The industry sector map for the entire world.
FIGURE 10-3: Industry sectors, from most to least volatile.
Chapter 13
FIGURE 13-1: An illustration of how bonds protected investors during the very t...
FIGURE 13-2: When stocks slide, bonds often do very well.
Chapter 21
FIGURE 21-1: A portfolio that assumes some risk.
FIGURE 21-2: A middle-of-the-road portfolio.
FIGURE 21-3: A portfolio aimed at safety.
Chapter 22
FIGURE 22-1: The daily pricing pattern for UGH.
FIGURE 22-2: The daily pricing pattern for DUM.
Guide
Cover
Title Page
Copyright
Table of Contents
Begin Reading
Index
About the Author
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Introduction
Every month, it seems, Wall Street comes up with some newfangled investment idea. The array of financial products (replete with 164-page prospectuses) is now so dizzying that the old, lumpy mattress is starting to look like a more comfortable place to stash the cash. But there is one product that is definitely worth looking at, even though it’s been around not even 30 years. It’s something of a cross between an index mutual fund and a stock, and it’s called an exchange-traded fund, or ETF.
Just as computers and fax machines were used by big institutions before they caught on with individual consumers, so it was with ETFs. They were first embraced by institutional traders — investment banks, hedge funds, and insurance firms — because, among other things, they allow for the quick juggling of massive holdings. Big traders like that sort of thing. Personally, playing hot potato with my money is not my idea of fun. But all the same, over the past not-even 20 years, I’ve invested most of my own savings in ETFs, and I’ve suggested to many of my clients that they do the same.
I’m not alone in my appreciation of ETFs. They have grown exponentially in the past few years, and they will surely continue to grow and gain influence. While I can’t claim that my purchases and my recommendations of ETFs account for much of the growing, global $9 trillion-plus ETF market, I’m happy to be a (very) small part of it. After you’ve read this third edition of Exchange-Traded Funds For Dummies, you may decide to become part of it as well, if you haven’t already.
Since the First Edition…
Many changes have taken place in the investment world, both on Wall Street and Main Street, since the first edition of this book was published in 2007. For one thing, a much larger pot of money (dollars, euros, yen) is now invested in ETFs: $9.1 trillion as of this writing (up from a mere $800 billion in 2007). Also, when I introduce myself as the author of Exchange-Traded Funds For Dummies, I no longer get a look as if I’m speaking some strange language with a lisp. Many people today, perhaps most, are at least somewhat familiar with the term exchange-traded funds. ETFs have, after all, made a few headlines.
Out of the shadows
The rising popularity of ETFs has been a news story in and of itself. Many educated folks are now aware that ETFs are low-cost investment vehicles that can serve as building blocks for a diversified portfolio.
And that is what I concentrate on most in this third edition: how ETFs may be used by you — the individual investor — to maximize your investment returns while minimizing risk. I tried to do that same thing in the first and second editions, but, since then, without question, there have been many changes, both positive and negative. Today, you’ll find a much greater selection of ETF offerings, although not all of them are prizes.
Filling the investment voids
One very positive change in the past several years is that the “black holes” that I identified in the first edition of this book have largely been filled. That is, when I wrote the first edition, you could not buy an ETF that would give you exposure to tax-free municipal or high-yield bonds. Or international bonds. Or international REITs. All that has changed. There are now ETFs that represent all those asset classes, and many more. Building an entire well-diversified portfolio out of ETFs was not humanly possible several years ago; it is very possible today. I’ve done it numerous times!
Another very positive development: ETFs have recently been making a grand entrance into employer-sponsored 401(k) plans, where many of America’s hard-working people store the bulk of their savings. And they’ve been appearing lately in 529 College Savings Plans, too. Insurance companies have also jumped into the fray, offering ETFs in some of their annuity plans (which, unfortunately, are still often overpriced).
Creations of dubious value
Many of the newer ETFs are bad investments, pure and simple. They were introduced to take advantage of the popularity of ETFs. They are overly expensive, and they represent foolish indexes (extremely small segments of the market, or indexes constructed using highly questionable methodologies). Much of this book is designed to help you tell the good from the bad.
Many of the newer ETFs are also specifically designed for short-term trading — which you would know if you read the really small print at the bottom of the advertisements — and short-term trading usually gets small investors into big trouble.
A scary number of the newer ETFs are based on “back-tested” models: They track whatever indexes, or invest in whatever kinds of assets, have done the best in recent months or years. These ETFs (or the indexes they track) have shining short-term performance records, which induce people to buy. But past short-term performance is a very, very poor indicator of future performance.
A number of new ETFs are focused on “meme stocks” — those stocks most highlighted on social media, often ballyhooed in memes as surefire ways to get rich. I could say “Tesla” right now, but by the time you’re reading this, Tesla will be out and some other company will be in. Buying what’s most fashionable — by investing directly in the meme stocks or in an ETF filled with meme stocks — is not a wise investment move.
Morphing into new creatures
Actively managed ETFs (that might, for example, buy and sell meme stocks) have been much slower to take off than Wall Street had hoped but have made inroads since the first edition of this book.
These ETFs differ radically from the original index ETFs. Actively managed ETFs don’t track any indexes at all but instead have portfolios built and regularly traded by managers attempting to beat the indexes. Study after study has shown that active management usually doesn’t work all that well for investors, even though the managers themselves often get very rich (more in Chapter 18).
Some of the newest ETFs, called defined outcome ETFs, are everything that an ETF shouldn’t be: actively managed, expensive, and almost absurdly complex. Whereas other ETFs are cousins of mutual funds, these complicated funds are more like variable annuities.
About This Book
As with any other investment, you’re looking for a certain payoff in reading this book. In an abstract sense, the payoff will come in your achieving a thorough understanding and appreciation of a powerful financial tool called an exchange-traded fund. The more concrete payoff will come when you apply this understanding to improve your investment results.
What makes me think ETFs can help you make money?
ETFs are intelligent.
Most financial experts agree that playing with individual stocks can be hazardous to one’s wealth. Anything from an accounting scandal to the CEO’s sudden angina attack can send a single stock spiraling downward. That’s why it makes sense for the average investor to own lots of stocks — or bonds — through ETFs or mutual funds.
ETFs are cheap.
At least 250 ETFs charge annual management expenses of 0.10 percent or lower, and a few charge as little as 0.00 percent a year! In contrast, the average actively managed mutual fund charges 0.63 percent a year. Index mutual funds generally cost a tad more than their ETF cousins. Such cost differences, while appearing small on paper, can make a huge impact on your returns over time. I crunch some numbers in
Chapter 2
.
ETFs are tax-smart.
Because of the very clever way ETFs are structured, the taxes you pay on any growth are minimal. I crunch some of those numbers as well in
Chapter 2
.
ETFs are open books. Quite unlike mutual funds, an ETF’s holdings are, by and large, readily visible. If this afternoon, for example, I were to buy 100 shares of the ETF called the SPDR (pronounced “spider”) S&P 500 ETF Trust, I would know that exactly 6.37 percent of my money was invested in Apple, Inc., and 5.92 percent was invested in the Microsoft Corporation. You don’t get that kind of detail when you buy most mutual funds. Mutual fund managers, like stage magicians, are often reluctant to reveal their secrets. In the investment game, the more you know, the lower the odds that you will get sawed in half.
(News flash: Regulators are still debating just how open the portfolios of the newer actively managed ETFs will have to be. For the time being, however, most ETFs track indexes, and the components of any index are readily visible.)
And speaking of open books, if the one you’re now reading were like some (but certainly not all) mutual funds, it would be largely unintelligible and expensive. (It might be doubly expensive if you tried to resell the book within 90 days!) Luckily, this book is more like an ETF. Here’s how:
Exchange-Traded Funds For Dummies
is intelligent.
I don’t try to convince you that ETFs are your best investment choice, and I certainly don’t tell you that ETFs will make you rich. Instead, I lay out facts and figures and summarize some hard academic findings, and I let you draw your own conclusions.
Exchange-Traded Funds For Dummies
is cheap.
Hey, top-notch investment advice for only $29.99 (plus or minus any discounts, shipping, and tax)… . Where else are you going to get that kind of deal?
And
should you come to the conclusion after reading this book that ETFs belong in your portfolio, you’ll likely get your $29.99 (plus any shipping costs and tax) back — in the form of lower fees and tax efficiency — in no time at all.
Exchange-Traded Funds For Dummies
is tax-smart.
Yes, the money you spent for this book, as all other outlays you make for investment advice, may be deducted from your federal income taxes (provided you itemize your deductions). Go for it!
Exchange-Traded Funds For Dummies
is an open book.
You’ve already established that!
If you’ve ever read a For Dummies book before, you have an idea of what you’re about to embark on. This is not a book you need to read from front to back. Feel free to jump about and glean whatever information you think will be of most use. There is no quiz at the end. You don’t have to commit it all to memory.
Foolish Assumptions
I assume that most of the people reading this book know a fair amount about the financial world. I think that’s a fairly safe assumption. Why else would you have bought an entire book about exchange-traded funds?
If you think that convertible bonds are bonds with removable tops and that the futures market is a place where fortunetellers purchase crystal balls, I help you along the best I can by letting you know how to find out more about certain topics. However, you may be better off picking up and reading a copy of the basic nuts-and-bolts Investing For Dummies by Eric Tyson (published by John Wiley & Sons, Inc.). After you spend some time with that title, c’mon back to this book. You’ll be more than welcome!
Icons Used in This Book
Throughout the book, you find little globular pieces of art in the margins called icons. These cutesy but handy tools give you a heads-up that certain types of information are in the neighborhood.
Although this is a how-to book, you also find plenty of whys and wherefores. Any paragraph accompanied by this icon, however, is guaranteed pure, 100 percent, unadulterated how-to.
The world of investments offers pitfalls galore. Wherever you see the bomb icon, know that there is a risk of your losing money — maybe even Big Money — if you skip the passage.
Read twice! This icon indicates that something important is being said and is really worth putting to memory.
If you don’t really care about the difference between standard deviation and beta, or the historical correlation between U.S. value stocks and REITs, feel free to skip or skim the paragraphs with this icon.
The world of Wall Street is full of people who make money at other people’s expense. Where you see the starburst icon, I’m describing an instance where someone may try to sucker punch you and take your loot.
Beyond the Book
Aside from the information in this book, you have access to even more help and information online at Dummies.com. There, you can find information on all manner of topics.
Dummies.com is also where you’ll find the Exchange-Traded Funds For Dummies Cheat Sheet, which suggests topics to discuss with your financial professional, explains how to choose the best ETFs, and succinctly explains how ETFs differ from mutual funds.
Where to Go from Here
Where would you like to go from here? If you want, start at the beginning. If you’re interested only in stock ETFs, hey, no one says that you can’t jump right to Part 2. Bond ETFs? Go ahead and jump to Part 3. It’s entirely your call.
Part 1
The ABCs of ETFs
IN THIS PART …
Delve into the early history of ETFs and their development ever since.
Find out what makes ETFs so special, and what makes them such darned good investments.
Discover where and how ETFs are created and traded.
Chapter 1
No Longer the New Kid on the Block
IN THIS CHAPTER
Discovering the origins of ETFs
Understanding their role in the world of investing today
Getting a handle on how ETFs are administered
Finding out how ETFs are bought and sold
Tallying the phenomenal growth of ETFs
There are, no doubt, a good number of pinstriped ladies and gentlemen on and around Wall Street who froth heavily at the mouth when they hear the words exchange-traded fund. In a world of very pricey investment products and very well-paid investment-product salespeople, ETFs have been the ultimate killjoys.
Since their arrival on the investment scene in the early 1990s, some 3,300 ETFs have been created, and ETF assets have grown faster than those of any other investment product, by far. That’s a good thing. ETFs enable the average investor to avoid shelling out fat commissions or paying layers of ongoing, unnecessary fees. And they’ve saved investors oodles in taxes.
Hallelujah.
In the Beginning
When I was a lad growing up in the ’burbs of New York City, my public school educators taught me how to read, write, and learn the capitals of the 50 states. I also learned that anything and everything of any importance in this world was, ahem, invented in the United States of America. I’ve since learned that, well, this isn’t entirely true. Take ETFs. The first ETF was introduced in Canada. It was a creation of the Toronto Stock Exchange — no Wall Streeters were anywhere in sight!
I’m afraid that the story of the development of ETFs isn’t quite as exciting as, say, the story behind penicillin or modern rocketry. As one Toronto Stock Exchange insider once explained to me, “We saw it as a way of making money by generating more trading.” Thus was born the original ETF known as TIP, which stood for Toronto Index Participation Unit. It tracked an index of large Canadian companies (Bell Canada, Royal Bank of Canada, Nortel, and 32 others) known as the Toronto 35. That index was then the closest thing that Canada had to the Dow Jones Industrial Average index that exists in the United States.
Enter the traders
TIP was an instant success with large institutional stock traders, who saw that they could now trade an entire index in a flash. The Toronto Stock Exchange got what it wanted — more trading — and the world of ETFs got its start.
TIP has since morphed to track a larger index, the so-called S&P/TSX 60 Index, which — you probably guessed — tracks 60 of Canada’s largest and most liquid companies. The fund also has a different name, the iShares S&P/TSX 60 Index ETF, and it trades (in Canada) under the ticker XIU. It is now managed by BlackRock, Inc., which, upon taking over the iShares lineup of ETFs from Barclays in 2009 (part of a juicy $13.5 billion deal), has come to be the biggest player in ETFs in the world. I introduce you to BlackRock and other ETF suppliers in Chapter 3. (A completely different BlackRock-managed U.S. ETF now uses the ticker TIP, but that fund has nothing to do with the original TIP; the present-day TIP invests in U.S. Treasury Inflation-Protected Securities.)
Moving south of the border
The first ETF didn’t come to the United States for three or so years after its Canadian birth. (Oh, how my public school teachers would cringe!) On January 22, 1993, the Mother of All U.S. ETFs was born on the American Stock Exchange (which, in January 2009 — a big year for mergers and acquisitions — became part of NYSE Euronext). The first U.S.-based ETF was called the S&P Depositary Receipts Trust Series 1, commonly known as the SPDR (or Spider) S&P 500, and it traded (and still does) under the ticker symbol SPY.
The SPDR S&P 500, which tracks the S&P 500 index, an index of the 500 largest U.S. companies, was an instant darling of institutional traders. It has since branched out to become a major holding in the portfolios of many individual and institutional investors — and a favorite of favorites among day-traders.
Fulfilling a Dream
ETFs were first embraced by institutions, and they continue to be used big-time by banks and insurance companies and such. Institutions sometimes buy and hold ETFs, but they are also constantly buying and selling ETFs and options on ETFs for various purposes, some of which I touch on in Chapter 23. For us noninstitutional types, the creation and expansion of ETFs has allowed for similar juggling (usually a mistake for individuals); but more importantly, ETFs allow for the construction of portfolios possessing institutional-like sleekness and economy.
Goodbye, ridiculously high mutual fund fees
The average mutual fund investor with a $150,000 portfolio filled with actively managed funds will likely spend $945 (0.63 percent) in annual expenses, per the Investment Company Institute and Morningstar. By switching to an ETF portfolio, that investor might incur — if they incur any trading costs at all — perhaps $50 or so to set up the portfolio, and maybe $20 or so a year thereafter. But now the investor’s ongoing annual expenses will be about $270 (0.18 percent). That’s a difference, ladies and gentlemen of the jury, of big bucks. We’re looking at an overall yearly savings of $625, or more if your brokerage has eliminated trading commissions altogether, which many have. Keep in mind that your $625 or more a year will be compounded every year the money is invested.
Loads, those odious fees that some mutual funds charge when you buy or sell their shares, simply don’t exist in the world of ETFs.
Capital gains taxes, the blow that comes on April 15th to many mutual fund holders with taxable accounts, hardly exist. In fact, here’s what my predominately buy-and-hold clients with their taxable money in ETFS have paid in capital gains taxes in the past three years: $0.00.
In Chapter 2, I delve much deeper into both the cost savings and the tax efficiency of ETFs.
Hello, building blocks for a better portfolio
In terms of diversification, my own and my clients’ portfolios include large stocks; small stocks; micro cap stocks; English, French, Swiss, Japanese, and Korean stocks; intermediate-term bonds; short-term bonds; and real estate investment trusts (REITs) — all held in low-cost ETFs. I discuss diversification and how to use ETFs as building blocks for a Class A portfolio, in Parts 2 and 3.
Yes, you could use other investment vehicles, such as mutual funds, to create a well-diversified portfolio. But ETFs — at least most ETFs — make it much easier because they tend to track very specific indexes. They are, by and large, much more “pure” investments than mutual funds. An ETF that bills itself as an investment in, say, small growth stocks is going to give you an investment in small growth stocks, plain and simple. A mutual fund that bills itself as an investment vehicle for small growth stocks may include everything from cash to bonds to shares of Microsoft (no kidding, and I give other examples in the next chapter).
Will you miss the court papers?
While scandals of various sorts — hidden fees, “soft-money” arrangements, after-hours sweetheart deals, and executive kickbacks — have plagued the world of mutual funds and hedge funds, this is the number of ETF scandals that have touched my life or the lives and fortunes of my clients: 0. That’s in good part because the vast majority of ETF managers, forced to follow existing indexes, have very little leeway in their investment choices. Unlike many investment vehicles, ETFs are closely regulated by the U.S. Securities and Exchange Commission. And ETFs trade during the day, in plain view of millions of traders — not after hours, as mutual funds do, which can allow for sweetheart deals when no one is looking.
In Chapter 2, I discuss in greater detail the transparency and cleanliness of ETFs.
Not Quite as Popular as the Beatles, But Getting There
With all that ETFs have going for them, I’m not surprised that they have spread like mad. Per the Investment Company Institute, there were, at the beginning of 2000, only 80 ETFs on the U.S. market; by mid-year 2021, there were nearly 2,300 ETFs, and the total assets invested in ETFs rose from $66 billion to just about $6 trillion. Yes, trillion. That’s just in the U.S. alone. In the world, we’re looking at $9 trillion invested in ETFs.
THE LITTLE KID IS GROWING FAST: ETFs’ PHENOMENAL GROWTH
Following are a few facts and figures from the Investment Company Institute that indicate how the ETF market compares with the mutual fund market and how rapidly ETFs are gaining in popularity.
The amount of money invested in U.S.-based ETFs and mutual funds as of mid-year 2021 is as follows.
ETFs: ~ $6 trillionMutual funds: ~ $25 trillionThe total number of U.S.-based ETFs and mutual funds as of mid-year 2021 is as follows.
ETFs: ~ 2,300Mutual funds: ~ 7,600The number of U.S.-based ETFs in recent years is as follows.
2005: 2042010: 9232015: 1,5972020: 2,204Mid-2021: 2,300The total net assets invested in ETFs in recent years are as follows.
2005: $300.8 billion2010: $992.0 billion2015: $2.1 trillion2020: $5.5 trillionMid-2021: $6.0 trillionSix trillion isn’t quite the $25 trillion or so invested in mutual funds. But if current trends continue, ETFs may indeed become as popular as were John, Paul, George, and Ringo. And I would bet that the current trends will continue to gain popularity, especially among institutions and younger investors. Among my own clients, I can tell you that those under 40 tend to think of mutual funds as akin to landline telephones and disco music.
Part of ETFs’ popularity stems from the growly bearish market of the first decade of this millennium. Investors who had been riding the double-digit annual returns of the 1990s suddenly realized that their portfolios weren’t going to keep growing in leaps and bounds, and perhaps it was time to start watching investment costs. Then, as the first decade of the millennium turned into the second decade, there was also a huge awakening to the power of indexing, aka passive investing (investing in entire markets or market segments) and its superiority to so-called active investing (trying to cherry-pick stocks and time markets). Much more on that topic in Chapter 2.
Moving from Wall Street to Main Street
In the world of fashion, trendsetters — movie stars or British royals — wander out in public wearing something that most people consider ridiculous, and the next thing you know, everyone is wearing that same item. Investment trends work sort of like fashion trends, but a bit slower. It took from 1993 until, oh, 2001 or so (around the time I bought my first ETF) for this newfangled investment vehicle to really start moving. By about 2003, insiders say, the majority of ETFs were being purchased by individual investors, not institutions or investment professionals.
BlackRock, Inc., which controls more than a third of the U.S. market for ETFs, estimates that approximately 60 percent of all the trading in ETFs is done by individual investors. The other 40 percent consists of institutions and fee-only financial advisors, like me.
Fee-only, by the way, signifies that a financial advisor takes no commissions of any sort. It’s a very confusing term because fee-based is often used to mean the opposite. Check out Chapter 26, where I talk about whether and what kind of financial professional you need to build and manage an ETF portfolio.
Actually, individual investors — especially the buy-and-hold kind of investors — benefit much more from ETFs than do institutional traders. That’s because institutional traders have always enjoyed the benefits of the very best deals on investment vehicles. That hasn’t changed. For example, institutions often pay much less in management fees than do individual investors for shares in the same mutual fund. (Fund companies often refer to institutional class versus investor class shares. All that really means is “wholesale/low price” versus “retail/higher price.”) And institutions almost always bypass nefarious “loads” (high commissions to buy and sell) on mutual funds.
Keeping up with the Vanguards
It may sound like I’m pushing ETFs as not only the best thing since sliced bread but as a replacement for sliced bread. Well, not quite. As much as I like ETFs, good old mutual funds still enjoy their place in the sun. That’s especially true of inexpensive index mutual funds, such as the ones offered by Vanguard, Fidelity, and Schwab. Mutual funds, for example, are clearly the better option when you’re investing in dribs and drabs and don’t want to have to pay for each trade you make…although, starting a couple of years ago, a number of brokerage houses, including Charles Schwab, TD Ameritrade, Vanguard, and Fidelity, started to allow customers to trade ETFs for free.
One of the largest purveyors of ETFs is The Vanguard Group, the very same people who pioneered index mutual funds. In the case of Vanguard, shares in the company’s ETFs are the equivalent of shares in one of the company’s index mutual funds. In other words, they are different share classes of the same fund — the same representation of companies but a different structure and generally slightly lower management fees for the ETFs.
Because Vanguard funds allow for an apples-to-apples comparison of ETFs and index mutual funds, and because the company presumably has no great stake in which you choose, Vanguard may be a good place to turn for objective advice on which investment is better for you. But rest assured — a point that I’ll make again in this book — this ain’t rocket science. For most buy-and-hold investors, ETFs will almost always be the better choice, at least in the long run. I look more closely at the ETFs-versus-mutual-funds question when I design specific portfolios and give actual portfolio examples in Chapter 21.
THE RIPPLE EFFECT: FORCING DOWN PRICES ON OTHER INVESTMENT VEHICLES
You don’t need to invest in ETFs to profit from them. They are doing to the world of investing what Chinese labor has done to global manufacturing wages. That is, they are driving prices down. Thanks to the competition that ETFs are giving to index mutual funds (ETFs now claim more than 60 percent of all money invested in all index funds), mutual fund providers have been lowering their charges. If you look at all funds in America, the average fee has declined from 0.81 percent in 1990 to 0.49 percent today. Zeroing in on just index funds — both traditional index mutual funds and ETFs — the average cost has fallen from 0.30 percent in 1990 to 0.18 percent today.
Ready for Prime Time
Although most investors are now familiar with ETFs, mutual funds remain the investment vehicle of choice by a margin of almost 4:1. Several reasons exist for the dominance of mutual funds — at least for the moment. First, mutual funds have been around a lot longer and so got a good head start. (The first mutual fund, called the Massachusetts Investors Trust, was founded in 1929.) Second, largely as a corollary to the first reason, most company retirement plans and pension funds still use mutual funds rather than ETFs; as a participant, you have no choice but to go with mutual funds. And finally, the vast majority of ETFs, unlike mutual funds, are index funds, and index funds have only fairly recently — after a long, uphill battle — caught the eye of millions of investors.
Index mutual funds, which most closely resemble ETFs, have been in existence since 1976 when Vanguard, under visionary John Bogle, first rolled out the Index Investment Trust fund. Since that time, Vanguard and other mutual fund companies have created hundreds of index funds tracking every conceivable index. But it has taken a long time for them to catch fire. As recently as 1998, actively managed stock funds had 6.5 times the assets as index funds. By 2020, index funds finally caught up to actively managed funds, and in 2021 surpassed them. Yes, Americans now have more money invested in index funds — initially referred to by many as “Bogle’s folly” — than actively managed funds.
Why would anyone want to invest in index funds or index ETFs? After all, the financial professionals who run actively managed mutual funds spend many years and tens of thousands of dollars educating themselves at places with real ivy on the walls, like Harvard and Wharton. They know all about the economy, the stock market, business trends, and so on. Shouldn’t we cash in on their knowledge by letting them pick the best basket of investments for us?
Good question! Here’s the problem with hiring these financial whizzes, and the reason that index funds or ETFs generally kick their Ivy League butts: When these whizzes from Harvard and Wharton go to market to buy and sell stocks, they are usually buying and selling stock (not directly, but through the markets) from other whizzes who graduated from Harvard and Wharton. One whiz bets that ABC stock is going down, so he sells. His former classmate bets that ABC stock is going up, so he buys. Which whiz is right? Half the time, it’s the buyer; half the time, it’s the seller. Meanwhile, you pay for all the trading, not to mention the whiz’s handsome salary while all this buying and selling is going on.
Economists have a name for such a market; they call it “efficient.” It means, in general, that there are soooo many smart people analyzing and dissecting and studying the market that the chances are slim that any one whiz — no matter how whizzical, no matter how thick his Cambridge accent — is going to be able to beat the pack.
CAN YOU PICK NEXT YEAR’S WINNERS?
Okay, study after study shows that most actively managed mutual funds don’t do as well in the long run as the indexes. But certainly some do much better, at least for a few years. And any number of magazine articles will tell you exactly how to pick next year’s winners.
Alas, if only it were that easy. Sorry, but studies show rather conclusively that it is anything but easy. Morningstar, on a great number of occasions, has earmarked the top-performing mutual funds and mutual fund managers over a given period of time and tracked their performance moving forward. In one representative study, the top 30 mutual funds for sequential five-year periods were evaluated for their performance moving forward. In each and every five-year period, the “30 top funds,” as a group, did worse than the S&P 500 in subsequent years.
That, in a nutshell, is why actively managed mutual funds tend to lag the indexes, usually by a considerable margin. If you want to read more about why stock-pickers and market-timers almost never beat the indexes, I suggest picking up a copy of the seminal A Random Walk Down Wall Street by Princeton economist Burton G. Malkiel. The book, now in something like its 200th edition, is available in paperback from W. W. Norton & Company. There’s also a website — www.ifa.com — run by something of an indexing fanatic (hey, there are worse things to be) that is packed with articles and studies on the subject. You could spend days reading!
The proof of the pudding
One study, done in 2010 by Wharton finance professor Robert F. Stambaugh and University of Chicago finance professor Lubos Pastor, looked back over 23 years of data. The conclusion: Actively managed funds have trailed, and will likely continue to trail, their indexed counterparts (whether mutual funds or ETFs) by nearly 1 percent a year. That may not seem like a big deal, but compounded over time, 1 percent a year can be HUGE.
Let’s plug in a few numbers. An initial investment of $100,000 earning, say, 7 percent a year, would be worth $386,968 after 20 years. An initial investment of $100,000 earning 8 percent for 20 years would be worth $466,096. That’s $79,128 extra in your pocket, all things being equal, if you invest in index funds. And if that investment were held in a taxable account, the figure would likely be much higher after you account for taxes. (Taxes on actively managed funds can be considerably higher than those on index funds.)
But wait, what if you carefully pick which actively managed funds to invest in? Good luck! Every year, Standard & Poors issues what they call the SPIVA Scorecard, which shows your odds of beating the indexes by investing in actively managed funds. It’s scary (like, Stephen King–scary) reading. In 2020, 57 percent of active U.S. stock funds lagged the S&P 500 index, and that was an exceptionally good year for active funds. In 2019, 70 percent lagged the indexes; in 2018, 69 percent.
But it is over longer time periods that active funds really show their lack of spine. Again, according to the 2020 SPIVA Scorecard, only 17 percent of actively managed stock funds beat their benchmark indexes over the 10-year period prior to December 31, 2020. Actively managed bond funds tended to do even worse.
Moving to a real-ETF-world example, let’s look at that very first ETF introduced in the United States, the SPDR S&P 500 (SPY). Since its inception in January 1993, that fund has enjoyed an average annual return (as of mid-2021) of 10.4 percent — not bad, considering that it survived several very serious bear markets (2000–2002, 2008–2009, and 2020). Very few actively managed funds can match that record. (You’ll find some performance specifics in the next chapter.)
By the way, SPY, as well as it has performed, has several flaws that make it far from my first choice of ETF for most portfolios; I will divulge these flaws in Chapter 5. But despite its flaws — and I’m certainly not the only investment professional privy to them — SPY remains by far the largest ETF on the market, with total assets of $363 billion. In terms of average number of shares traded daily, nothing even comes close to SPY: 83 million shares.
The major players
In Parts 2, 3, and 4 of this book, I provide details about many of the ETFs on the market. Here, I want to introduce you to just a handful of the biggies. You will likely recognize a few of the names.
In Table 1-1, I list the six largest ETFs based on their assets, as of mid-August 2021.
In Table 1-2, I list the six largest ETFs on the market as of mid-August 2021, as calculated by the number of shares traded.
TABLE 1-1 The Six Largest ETFs by Assets
Name
Ticker
Assets (in billions of dollars)
SPDR S&P 500
SPY
$363
iShares Core S&P 500 ETF
IVV
$278
Vanguard Total Stock Market
VTI
$239
Vanguard S&P 500 ETF
VOO
$220
Invesco QQQ
QQQ
$160
VEA
IVV
$97
TABLE 1-2 The Six Largest ETFs by Number of Shares Traded
Name
Ticker
Average daily trading volume
ProShares UltraPro Short QQQ
SQQQ
96 million shares
ProShares Ultra VIX Short-Term Futures
UVXY
86 million shares
SPDR S&P 500 ETF
SPY
83 million shares
Financial Select Sector SPDR Fund
XLF
58 million shares
Invesco QQQ
QQQ
52 million shares
iShares MSCI Emerging Markets ETF
EEM
42 million shares
Twist and shout: Commercialization is tainting a good thing
Innovation is a great thing. Usually. In the world of ETFs, a few big players (BlackRock, Vanguard, State Street Global Advisors) jumped in early when the going was hot. Now, in order to get their share of the pie, a number of new players have entered the fray with some pretty wild ETFs. “Let’s invest in all companies whose CEO is named Fred!” Okay, there’s no Fred portfolio, but the way things are going, it could happen.
I tend to like my ETFs vanilla plain, maybe with a few sprinkles. I like them to follow indexes that make sense. And, above all, I like their expense ratios looooow. When ETFs first hit the market, most had expense ratios, I’d say, in the 0.20–0.40 percent range. Strangely, the growth in the market has created a big divide. The more basic ETFs, such as those that track the S&P 500, have, due to a lot of competition, come down in price. At present, there are dozens upon dozens of ETFs that carry expense ratios of 0.10 percent or less. Heck, all the competition out there has forced down mutual fund fees, as well.
Conversely, many of the newer, more complicated ETFs (and I don’t use “complicated” as a compliment), have expense ratios edging up into the ballpark of what you would pay — even what you would’ve paid several years back — for mutual funds. Approximately 140 ETFs now carry net expense ratios of 1 percent or more; 19 of these have an expense ratio of over 2 percent.
I’m not saying that all ETFs must follow traditional indexes. The ETF format allows for more variety than that. (Actually, when I think about it, some of the traditional indexes, like the Dow, are darn dumb. I explain why in Chapter 3.) But the ETF industry has lost some of its integrity over the past few years with higher expenses and some awfully silly investment schemes.
The rest of this book will help you to sidestep the greed and the silliness — to take only the best parts of ETF investing and put them to their best use.
RIP THESE ETFs
New ETFs are being born every week, but at the same time, others are dying. Over 1,000 ETFs in the past several years have been zipped up, closed down, folded, and sent to that Great Brokerage in the Sky. In 2020 alone, according to the Investment Company Institute, as 313 ETFs came into existence, 182 disappeared.
No need to shed tears for the investors, however; they are okay.
If you are holding shares in a particular ETF that closes down, you will generally be given at least several weeks’ notice. You can sell, or you can wait till the final day and receive whatever is the value of the securities held by the ETF at that point. It isn’t like holding a bond (or an exchange-traded note) that goes belly up. You may have a bit of a hassle redoing your portfolio, and you may face sudden tax consequences. If the ETF tracks a very small segment of the market, there may be a bit of investor panic that could depress prices. But you aren’t going broke.
As for the purveyors of the ETFs that have closed, I may shed only a crocodile tear or two. Most of the ETFs that have gone under are exactly the kinds of ETFs that I try to steer you away from in this book: They tracked narrow segments of the market (companies based in Oklahoma, for example); or they tracked somewhat silly and complex indexes (dividend rotation); or they were highly leveraged, exposing investors to excessive risk; or they were overpriced; or all of the above! The public simply would not buy. Bravo, public.
Here is just a small sampling from the ETF graveyard:
WisdomTree Middle East Dividend Fund (GULF)Forensic Accounting Long-Short ETF (FLAG)HealthShares Dermatology and Wound Care ETF (HRW)Goldman Sachs Human Evolution ETF (GDNA)Global X Fertilizers/Potash ETF (SOIL)Claymore/Zacks Country Rotation ETF (CRO)Claymore/Zacks Dividend Rotation ETF (IRO)Geary Oklahoma ETF (OOK)JETS DJ Islamic Market International ETF (JVS)Guggenheim Inverse 2x Select Sector Energy ETF (REC)
