Investing in ETFs For Dummies E-Book

Russell Wild

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 422

Veröffentlichungsjahr: 2023

Beschreibung

Develop ETF expertise with this straightforward guide Investing in ETFs For Dummies has all the basics you need to make calculated and profitable choices when investing in exchange-traded funds. ETFs make it possible for investors to quickly and easily gain exposure to wide swaths of the market. There are funds that are linked to popular market indices like the S&P 500, there are quirky thematic funds that allow you to invest in stuff like video game technology or breakfast commodities, and there's everything in between. This updated guide helps you sift through it all, covering the pros and cons of ETF investing and walking you through new and time-tested ETF strategies. Add some ETFs to your portfolio and profit in any market environment, thanks to this simple Dummies guide. * Figure out what ETFs are and learn the ins and outs of the ETF marketplace * Learn to research ETFs and weigh the risks so you can make informed trades * Discover the latest ETF products, providers, and strategies * Gain the confidence you need to invest in ETFs, even in a down market Investing in ETFs For Dummies is a great starting point for anyone looking to enhance their investment portfolio by participating in the nearly $2 trillion ETF market.

Leseprobe

Investing in ETFs For Dummies®, Second Edition

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Investing in ETFs For Dummies®

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Table of Contents

Cover

Title Page

Copyright

Introduction

About This Book

Foolish Assumptions

Icons Used in This Book

Where to Go from Here

Part 1: Getting Started with ETFs

Chapter 1: ETFs: No Longer the New Kid on the Block

What the Heck Is an ETF?

Why the Big Boys Prefer ETFs

Why Individual Investors Are Learning to Love ETFs

How to Get the Professional Edge

Passive versus Active Investing: Your Choice

Do ETFs Belong in Your Life?

Chapter 2: Introducing the ETF 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: Familiarizing Yourself with Different ETFs

Chapter 3: ETFs for Large Growth and Large Value

Reviewing Large-Growth Basics

Looking into Big and Brawny Stocks

Digging into Large-Cap ETF Options Galore

Checking Out Six Ways to Recognize Value

Searching for the Best Value Buys

Chapter 4: ETFs for Small Growth and Small Value

Getting Real about Small-Cap Investments

Checking Out Your Choices for Small Growth

Opting for Small Value: Diminutive Dazzlers

What about the Mid Caps?

Chapter 5: Around the World: Global and International ETFs

Studying the Ups and Downs of Markets around the World

Finding Your Best Mix of Domestic and International

Knowing That Not All Foreign Stocks Are Created Equal

Choosing the Best International ETFs for Your Portfolio

Chapter 6: Sector Investing and Different Specialized Stocks

Selecting Stocks by Sector, not Style

Surveying Sector Choices by the Dozen

Investing for a Better World

Dividend Funds: The Search for Steady Money

All-In-One ETFs: For the Ultimate Lazy Portfolio

Chapter 7: For Your Interest: Bond ETFs

Tracing the Track Record of Bonds

Tapping into Bonds in Various Ways

Determining the Optimal Fixed-Income Allocation

Your Basic Bonds: Treasurys, Agency Bonds, and Corporates

Moving Beyond Basics into Municipal and Foreign Bonds

Chapter 8: REITs, Commodities, and Active ETFs

Real Estate Investment Trusts

All That Glitters: Gold, Silver, and Other Commodities

Going Active with ETFs

Part 3: Making the Most of Your ETF Portfolio

Chapter 9: Checking Out Sample ETF Portfolio Menus

So, How Much Risk Can You Handle and Still Sleep at Night?

A Few Keys to Optimal Investing

Finding the Perfect Portfolio Fit

Aiming for Economic Self-Sufficiency in Retirement

Curing the 401(k) Blues

Chapter 10: Getting a Handle on Risk, Return, and Diversification

Risk Is Not Just a Board Game

Smart Risk, Foolish Risk

Understanding How Risk Is Measured

Meeting Modern Portfolio Theory

Mixing and Matching Your Stock ETFs

Chapter 11: Exercising Patience and Discovering Exceptions

The Tale of the Average Investor (A Tragicomedy in One Act)

Patience Pays, Literally

Exceptions to the Rule (Ain’t There Always)

Are Options an Option for You?

Part 4: The Part of Tens

Chapter 12: Ten Common Questions about ETFs

Are ETFs Appropriate for Individual Investors?

Are ETFs Risky?

Do I Need a 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 Should I Keep in Which Accounts?

Chapter 13: Ten Typical Mistakes Most Investors 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

Not Incorporating Investments into a Broader Financial Plan

Index

About the Author

Connect with Dummies

End User License Agreement

List of Tables

Chapter 1

TABLE 1-1 Comparing ETFs, Mutual Funds, and Individual Stocks

Chapter 2

TABLE 2-1 Providers of ETFs

TABLE 2-2 Expense Ratio Comparison

Chapter 9

TABLE 9-1 A Simple ETF Portfolio

Chapter 10

TABLE 10-1 Standard Deviation of Two Hypothetical ETFs

TABLE 10-2 Recent Performance of Various Investment Styles

TABLE 10-3 Recent Performance of Various Market Sectors

Chapter 11

TABLE 11-1 A Shifting Portfolio Balance

List of Illustrations

Chapter 1

FIGURE 1-1: The secret to ETFs’ tax-friendliness lies in their very structure.

Chapter 3

FIGURE 3-1: The place of large-growth stocks in the grid.

FIGURE 3-2: Large-value stocks occupy the northwest corner of the grid.

Chapter 4

FIGURE 4-1: The shaded area is the portion of the investment grid represented b...

FIGURE 4-2: Small-value stocks occupy the southwest corner of the investment st...

Chapter 9

FIGURE 9-1: A portfolio that assumes some risk.

FIGURE 9-2: A middle-of-the-road portfolio.

FIGURE 9-3: A portfolio aimed at safety.

Chapter 10

FIGURE 10-1: The risk levels of a sampling of ETFs.

FIGURE 10-2: ETFs A and B both have high return and high volatility.

FIGURE 10-3: The perfect ETF portfolio, with high return and no volatility.

FIGURE 10-4: The style box or grid.

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 (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 for ETFs. They’ve grown exponentially in the past few years, and they’ll surely continue to grow and gain influence. I can’t claim that my purchases and my recommendations of ETFs account for much of the growing but global $9 trillion-plus ETF market, but I’m happy to be a (very) small part of it. After you’ve read this book, you may decide to become part of it as well, if you haven’t already.

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 for a powerful financial tool called an ETF. 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 0.1 percent or lower, and a few charge as little as 0 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 1

.)

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 1

.)

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 and 5.92 percent was invested in Microsoft. 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’ll 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.

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.

Most of the heavy technical matter is tucked neatly into the shaded sidebars. But if any technicalities make it into the main text, I give you a heads-up with a Technical Stuff icon. That’s where you can skip over or speed-read — or choose to get dizzy. Your call!

Keep in mind that when this book was printed, some web addresses may have needed to break across two lines of text. Wherever that’s the case, rest assured that this book uses no extra characters (hyphens or other doohickeys) to indicate the break. So, when going to one of these web addresses, just type in exactly what you see in this book. Pretend that the line break doesn’t exist.

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 ETFs?

If you think that convertible bonds are bonds with removable tops and that the futures market is a place where fortune tellers 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 (Wiley). 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 committing 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 real estate investment trusts (REITs), feel free to skip or skim the paragraphs marked with this icon.

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 Chapters 3–6. Bond ETFs? Go ahead and jump to Chapter 7. Sample ETF portfolios? Head to Chapter 9. It’s entirely your call.

Part 1

Getting Started with ETFs

IN THIS PART …

Find out how exchange-traded funds (ETFs) work and how they’re different from other investment options.

Look into the pluses and minuses of ETFs to determine whether they’re a good fit for you.

Get the pieces into position for ETF investing, from starting an account to finding a brokerage house.

Understand the indexers and exchanges in the ETF world.

Chapter 1

ETFs: No Longer the New Kid on the Block

IN THIS CHAPTER

Distinguishing what makes ETFs unique

Taking a look at who’s making the most use of ETFs

Appreciating ETFs’ special attributes

Understanding that ETFs aren’t perfect

Asking whether ETFs are for you

Banking your retirement on stocks is risky enough; banking your retirement on any individual stock, or even a handful of stocks, is about as risky as wrestling crocodiles. Banking on individual bonds is less risky (maybe wrestling an adolescent crocodile), but the same general principle holds. There is safety in numbers. That’s why teenage boys and girls huddle together in corners at school dances. That’s why gnus graze in groups. That’s why smart stock and bond investors grab onto exchange-traded funds (ETFs).

In this chapter, I explain not only the safety features of ETFs but also the ways in which they differ from their cousins, mutual funds. By the time you’re done with this chapter, you should have a pretty good idea of what ETFs can do for your portfolio.

What the Heck Is an ETF?

Just as a deed shows that you have ownership of a house, and a share of common stock certifies ownership in a company, a share of an ETF represents ownership (most typically) in a basket of company stocks. To buy or sell an ETF, you place an order with a broker, generally (and preferably, for cost reasons) online, although you can also place an order by phone. The price of an ETF changes throughout the trading day (which is to say from 9:30 a.m. to 4 p.m. Eastern time), going up or down with the market value of the securities it holds. Sometimes there can be a little sway — times when the price of an ETF doesn’t exactly track the value of the securities it holds — but that situation is rarely serious, at least not with ETFs from the better purveyors.

Originally, ETFs were developed to mirror various indexes:

The SPDR S&P 500 (ticker symbol: SPY) represents stocks from the Standard & Poor’s (S&P) 500, an index of the 500 largest companies in the United States.

The DIAMONDS Trust Series 1 (ticker symbol: DIA) represents the 30 or so underlying stocks of the Dow Jones Industrial Average (DJIA) index.

The Invesco QQQ Trust Series 1 (ticker symbol: QQQ; formerly known as the Nasdaq-100 Trust Series 1) represents the 100 stocks of the Nasdaq-100 Index.

Since ETFs were first introduced, many others, tracking all kinds of things, including some rather strange things that I dare not even call investments, have emerged.

The component companies in an ETF’s portfolio usually represent a certain index or segment of the market, such as large U.S. value stocks, small-growth stocks, or micro-cap stocks. (If you’re not 100 percent clear on the difference between value and growth, or what a micro cap is, rest assured that I define these and other key terms in Part 2.)

Sometimes, the stock market is broken up into industry sectors, such as technology, industrials, and consumer discretionary. ETFs exist that mirror each sector.

Regardless of what securities an ETF represents, and regardless of what index those securities are a part of, your fortunes as an ETF holder are tied, either directly or in some leveraged fashion, to the value of the underlying securities. If the price of Microsoft stock, U.S. Treasury bonds, gold bullion, or British pound futures goes up, so does the value of your ETF. If the price of gold tumbles, your portfolio (if you hold a gold ETF) may lose some glitter. If Microsoft stock pays a dividend, you’re due a certain amount of that dividend — unless you happen to have bought into a leveraged or inverse ETF.

Some ETFs allow for leveraging, so that if the underlying security rises in value, your ETF shares rise doubly or triply. If the security falls in value, well, you lose according to the same multiple. Other ETFs allow you not only to leverage but also to reverse leverage, so you stand to make money if the underlying security falls in value (and, of course, lose if the underlying security increases in value). I’m not a big fan of leveraged and inverse ETFs.

Choosing between the classic and the new indexes

Some of the ETF providers (Vanguard, iShares, Charles Schwab) tend to use traditional indexes, such as those I mention in the previous section. Others (Dimensional, WisdomTree) tend to develop their own indexes.

For example, if you were to buy 100 shares of an ETF called the iShares S&P 500 Growth Index Fund (ticker symbol: IVW), you’d be buying into a traditional index (large U.S. growth companies). At about $70 a share (at the time of this writing), you’d plunk down $7,000 for a portfolio of stocks that would include shares of Apple, Microsoft, Amazon, Facebook, Alphabet (Google), and Tesla. If you wanted to know the exact breakdown, the iShares prospectus found on the iShares website (or any number of financial websites, such as https://finance.yahoo.com) would tell you specific percentages: Apple, 11.3 percent; Microsoft, 10.3 percent; Amazon, 7.8 percent; and so on.

Many ETFs represent shares in companies that form foreign indexes. If, for example, you were to own 100 shares of the iShares MSCI Japan Index Fund (ticker symbol: EWJ), with a market value of about $69 per share as of this writing, your $6,900 would buy you a stake in large Japanese companies such as Toyota Motor, SoftBank Group, Sony Group, Keyence, and Mitsubishi UFJ Financial Group. (Chapter 5 is devoted entirely to international ETFs.)

Both IVW and EWJ mirror standard indexes: IVW mirrors the S&P 500 Growth Index, and EWJ mirrors the MSCI Japan Index. If, however, you purchase 100 shares of the Invesco Dynamic Large Cap Growth ETF (ticker symbol: PWB), you’ll buy roughly $7,100 worth of a portfolio of stocks that mirror a very unconventional index — one created by the Invesco family of ETFs. The large U.S. growth companies in the PowerShares index that have the heaviest weightings include Facebook and Alphabet, but also NVIDIA and Texas Instruments. Invesco PowerShares refers to its custom indexes as Intellidex indexes.

A big controversy in the world of ETFs is whether the newfangled, customized indexes offered by companies like Invesco make any sense. Most financial professionals are skeptical of anything that’s new. We’re a conservative lot. Those of us who have been around for a while have seen too many “exciting” new investment ideas crash and burn. But I, for one, try to keep an open mind. For now, let me continue with my introduction to ETFs, but rest assured that I address this controversy (in Chapter 2 and throughout the rest of this book).

Another big controversy is whether you may be better off with an even newer style of ETFs — those that follow no indexes at all but rather are “actively” managed. I prefer index investing to active investing, but that’s not to say that active investing, carefully pursued, has no role to play. (You can find more on that topic later in this chapter and throughout this book.)

Other ETFs — a distinct but growing minority — represent holdings in assets other than stocks, most notably, bonds and commodities (gold, silver, oil, and such). And then there are exchange-traded notes (ETNs), which allow you to venture even further into the world of alternative investments — or speculations — such as currency futures. (I discuss these products in Part 2.)

Preferring ETFs over individual stocks

Okay, why buy a basket of stocks rather than an individual stock? Quick answer: You’ll sleep better.

A company I’ll call ABC Pharmaceutical sees its stock shoot up by 68 percent because the firm just earned an important patent for a new diet pill; a month later, the stock falls by 84 percent because a study in the New England Journal of Medicine found that the new diet pill causes people to hallucinate and think they’re Genghis Khan.

Compared to the world of individual stocks, the stock market as a whole is as smooth as a morning lake. Heck, a daily rise or fall in the Dow of more than a percent or two (well, maybe 2 percent or 3 percent these days) is generally considered a pretty big deal.

If you, like me, are not especially keen on roller coasters, you’re advised to put your nest egg into not one stock, not two, but many. If you have a few million sitting around, hey, you’ll have no problem diversifying — maybe individual stocks are for you. But for most of us commoners, the only way to effectively diversify is with ETFs or mutual funds.

Distinguishing ETFs from mutual funds

So, what’s the difference between an ETF and a mutual fund? After all, mutual funds also represent baskets of stocks or bonds. The two, however, are not twins. They’re not even siblings. Cousins are more like it. Here are some of the big differences between ETFs and mutual funds:

ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their prices change throughout the trading day. Mutual-fund orders can be made during the day, but the actual trading doesn’t occur until after the markets close.

ETFs tend to represent indexes — market segments — and the managers of the ETFs tend to do very little trading of securities in the ETF. (The ETFs are

passively

managed.) Most mutual funds are actively managed.

Although they may require you to pay small trading fees, ETFs usually wind up costing you much less than mutual funds because the ongoing management fees are typically much lower, and there is never a

load

(an entrance and/or exit fee, sometimes an exorbitant one), as you find with many mutual funds.

Because of low portfolio turnover and also the way ETFs are structured, ETFs generally declare much less in taxable capital gains than mutual funds do.

Table 1-1 provides a quick look at some ways that investing in ETFs differs from investing in mutual funds and individual stocks.

TABLE 1-1 Comparing ETFs, Mutual Funds, and Individual Stocks

ETFs

Mutual Funds

Individual Stocks

Are they priced, bought, and sold throughout the day?

Yes

No

Yes

Do they offer some investment diversification?

Yes

Yes

No

Is there a minimum investment?

No

Yes

No

Are they purchased through a broker or online brokerage?

Yes

Yes

Yes

Do you pay a fee or commission to make a trade?

Rarely

Sometimes

Rarely

Can that fee or commission be more than a few dollars?

No

Yes

No

Can you buy/sell options?

Sometimes

No

Sometimes

Are they indexed (passively managed)?

Typically

Atypically

No

Can you make money or lose money?

Yes

Yes

You bet

Why the Big Boys Prefer ETFs

When ETFs were first introduced, they were primarily of interest to institutional traders — insurance companies, hedge-fund people, banks — whose investment needs are often considerably more complicated than yours and mine. In this section, I explain why ETFs appeal to the largest investors.

Trading in large lots

Prior to the introduction of ETFs, a trader had no easy way to buy or sell instantaneously, in one fell swoop, hundreds of stocks or bonds. Because ETFs trade both during market hours and, in some cases, after market hours, they made that possible.

Institutional investors also found other things to like about ETFs. For example, ETFs are often used to put cash to productive use quickly or to fill gaps in a portfolio by allowing immediate exposure to an industry sector or geographic region.

Savoring the versatility

Unlike mutual funds, ETFs can also be purchased with limit, market, or stop-loss orders, taking away the uncertainty involved with placing a buy order for a mutual fund and not knowing what price you’re going to get until several hours after the market closes. See the nearby sidebar “Your basic trading choices (for ETFs or stocks)” if you’re not certain what limit, market, and stop-loss orders are.

And because many ETFs can be sold short, they provide an important means of risk management. If, for example, the stock market takes a dive, then shorting ETFs — selling them now at a locked-in price with an agreement to purchase them back (cheaper, you hope) later on — may help keep a portfolio afloat. For that reason, ETFs have become a darling of hedge-fund managers who offer the promise of investments that won’t tank should the stock market tank.

YOUR BASIC TRADING CHOICES (FOR ETFs OR STOCKS)

Buying and selling an ETF is just like buying and selling a stock; there really is no difference. Although you can trade in all sorts of ways, the vast majority of trades fall into the following categories:

Market order: This is as simple as it gets. You place an order with your broker or online to buy, say, 100 shares of a certain ETF. Your order goes to the stock exchange, and you get the best available price.Limit order: More exact than a market order, you place an order to buy, say, 100 shares of an ETF at $23 a share. That’s the maximum price you’ll pay. If no sellers are willing to sell at $23 a share, your order won’t go through. If you place a limit order to sell at $23, you’ll get your sale if someone is willing to pay that price. If not, there will be no sale. You can specify whether an order is good for the day or until canceled (if you don’t mind waiting to see if the market moves in your favor).Stop-loss (or stop) order: Designed to protect you should the price of your ETF or stock take a tumble, a stop-loss order automatically becomes a market order if and when the price falls below a certain point (say, 10 percent below the current price). Stop-loss orders are used to limit investors’ exposure to a falling market, but they can (and often do) backfire, especially in very turbulent markets. Proceed with caution.Short sale: You sell shares of an ETF that you’ve borrowed from the broker. If the price of the ETF then falls, you can buy replacement shares at a lower price and pocket the difference. If, however, the price rises, you’re stuck holding a security that is worth less than its market price, so you pay the difference, which can sometimes be huge.

For more information on different kinds of trading options, see the U.S. Securities and Exchange Commission (SEC) discussion at www.sec.gov/investor/alerts/trading101basics.pdf.

Why Individual Investors Are Learning to Love ETFs

Clients I’ve worked with are often amazed that I can put them into a financial product that will cost them a fraction in expenses compared to what they’re currently paying. Low costs are probably what I love the most about ETFs. But I also love their tax-efficiency, transparency (you know what you’re buying), and — now in their third decade of existence — good track record of success.

The cost advantage: How low can you go?

In the world of actively managed mutual funds (which is to say, most mutual funds), the average annual management fee, according to the Investment Company Institute and Morningstar, is 0.63 percent of the account balance. That may not sound like a lot, but don’t be misled. A well-balanced portfolio with both stocks and bonds may return, say, 5 percent over time. In that case, paying 0.63 percent to a third party means that you’ve just lowered your total investment returns by one-eighth. In a bad year, when your investments earn, say, 0.63 percent, you’ve just lowered your investment returns to zero. And in a very bad year … you don’t need me to do the math.

Active ETFs, although cheaper than active mutual funds, aren’t all that much cheaper, averaging 0.51 percent a year (although a few are considerably higher than that).

I’m astounded at what some funds charge. Whereas the average active fund charges between 0.51 percent (for ETFs) and 0.63 percent (for mutual funds), I’ve seen charges five times that amount. Crazy. Investing in such a fund is tossing money to the wind. Yet people do it. The chances of your winding up ahead after paying such high fees are next to nil. Paying a load (an entrance and/or exit fee) that can total as much as 6 percent is just as nutty. Yet people do it.

In the world of index funds, the expenses are much lower, with index mutual funds averaging 0.06 percent and ETFs averaging 0.17 percent, although many of the more traditional index ETFs cost no more than 0.06 percent a year in management fees, and as more competition has entered the market, even that price now seems high. A handful are now under 0.03 percent. And one purveyor, BNY Mellon, has actually introduced two ETFs with no fees.

No fees?

How can no fees make sense?

The multibillion-dollar BNY Mellon Bank didn’t enter the ETF game until 2020, and it took the price-cutting war to a new level. The bank issued two ETFs with an expense ratio of zero. How can the company do that and expect to make money? It doesn’t. “It’s a courtesy to investors, and we’re hoping that they’ll look at our other ETFs,” says a BNY Mellon official. Indeed, it got me looking at the BNY Mellon lineup, and I showcase a few of their other ETF offerings later in this book, all of which are very reasonably priced. However, there may be no more freebies in the pipeline, and to date, no other ETF purveyors have dropped their prices to zero, although a number of index mutual-fund purveyors have.

Keep in mind that price is just one of the characteristics — albeit a very important one — that you’ll be looking at in deciding how to pick “best in class” when choosing an ETF.

Numerous studies have shown that low-cost funds have a huge advantage over higher-cost funds. One study by Morningstar looked at stock returns over a five-year period. In almost every category of stock mutual fund, low-cost funds beat the pants off high-cost funds. Do you think that by paying high fees you’re getting better fund management? Hardly. The Morningstar study found, for example, that among mutual funds that hold large-blend stocks (blend meaning a combination of value and growth — an S&P 500 fund would be a blend fund, for example), the annualized gain was 8.75 percent for those funds in the costliest quartile of funds; the gain for the least-costly quartile was 9.89 percent.

Why ETFs are cheaper

The management companies that bring us ETFs, such as BlackRock and Invesco, are presumably not doing so for their health. No, they’re making a good profit. One reason they can offer ETFs so cheaply compared to mutual funds is that their expenses are much less. When you buy an ETF, you go through a brokerage house, not BlackRock or Invesco. That brokerage house (for example, Fidelity) does all the necessary paperwork and bookkeeping on the purchase. If you have any questions about your money, you’ll likely call Fidelity, not BlackRock. So, unlike a mutual-fund company, which must maintain telephone operators, bookkeepers, and a mailroom, the providers of ETFs can operate almost entirely in cyberspace.

ETFs that are linked to indexes have to pay some kind of fee to S&P Dow Jones Indices or MSCI or whoever created the index. But that fee is nothing compared to the exorbitant salaries that mutual funds pay their dart throwers, er, stock pickers, er, market analysts.

An unfair race

Active mutual funds (the vast majority of mutual funds are active) really don’t have much chance of beating passive index funds — whether mutual funds or ETFs — over the long run, at least not as a group. (There are individual exceptions, but it’s virtually impossible to identify them before the fact.) Someone once described the contest as a race in which the active mutual funds are “running with lead boots.” Why? In addition to the management fees that eat up a substantial part of any gains, there are also the trading costs. Yes, when mutual funds trade stocks or bonds, they pay a spread and a small cut to the stock exchange, just like you and I do. That cost is passed on to you, and it’s on top of the annual management fees previously discussed.

An actively managed fund’s annual turnover costs will vary, but one study several years ago found that they were typically running at about 0.8 percent. And active mutual-fund managers must constantly keep some cash on hand for all those trades. Having cash on hand costs money, too: The opportunity cost, like the turnover costs, can vary greatly from fund to fund, but a fund that keeps 20 percent of its assets in cash — and there are many that do — is going to see significant cash drag. After all, only 80 percent of its assets are really working for you.

So, you take the 0.63 percent average management fee, and the perhaps 0.8 percent hidden trading costs, and the cash drag or opportunity cost, and you can see where running with lead boots comes in. Add taxes to the equation, and although some actively managed mutual funds may do better than ETFs for a few years, over the long haul, I wouldn’t bank on many of them coming out ahead.

Uncle Sam’s loss, your gain

Alas, unless your money is in a tax-advantaged retirement account, making money in the markets means that you have to fork something over to Uncle Sam at year’s end. That’s true, of course, whether you invest in individual securities or funds. But before there were ETFs, individual securities had a big advantage over funds in that you were required to pay capital gains taxes only when you actually enjoyed a capital gain. With mutual funds, that isn’t so. The fund itself may realize a capital gain by selling off an appreciated stock. You pay the capital gains tax regardless of whether you sell anything and regardless of whether the share price of the mutual fund increased or decreased since the time you bought it.

There have been times (pick a bad year for the market — 2000, 2008 …) when many mutual-fund investors lost a considerable amount in the market, yet had to pay capital gains taxes at the end of the year. Talk about adding insult to injury! One study found that over the course of time, taxes have wiped out approximately two full percentage points in returns for investors in the highest tax brackets.

In the world of ETFs, such losses are very unlikely to happen. Because most ETFs are index based, they generally have little turnover to create capital gains. Perhaps even more important, ETFs are structured in a way that largely insulates shareholders from capital gains that result when mutual funds are forced to sell in order to free up cash to pay off shareholders who cash in their chips.

The structure of ETFs makes them different from mutual funds. Actually, ETFs are legally structured in three different ways: as exchange-traded open-end mutual funds, as exchange-traded unit investment trusts, and as exchange-traded grantor trusts. The differences are subtle, and I elaborate on them somewhat in Chapter 2. For now, I want to focus on one seminal difference between ETFs and mutual funds, which boils down to an extremely clever setup whereby ETF shares, which represent stock holdings, can be traded without any actual trading of stocks.

Think of the poker player who plays hand after hand, but thanks to the miracle of little plastic chips, they don’t have to touch any cash.

In the world of ETFs, you don’t have croupiers, but you have market makers. Market makers are people who work at the stock exchanges and create (like magic!) ETF shares. Each ETF share represents a portion of a portfolio of stocks, sort of like poker chips represent a pile of cash. As an ETF grows, so does the number of shares. Concurrently (once a day), new stocks are added to a portfolio that mirrors the ETF. Figure 1-1 may help you envision the structure of ETFs and what makes them such tax wonders.

When an ETF investor sells shares, those shares are bought by a market maker who turns around and sells them to another ETF investor. By contrast, with mutual funds, if one person sells, the mutual fund must sell off shares of the underlying stock to pay off the shareholder. If stocks sold in the mutual fund are being sold for more than the original purchase price, the shareholders left behind are stuck paying a capital gains tax. In some years, that amount can be substantial.

© John Wiley & Sons, Inc.

FIGURE 1-1: The secret to ETFs’ tax-friendliness lies in their very structure.

In the world of ETFs, no such thing has happened or is likely to happen, at least not with the vast majority of ETFs, which are index funds. Because index funds trade infrequently, and because of ETFs’ poker-chip structure, ETF investors rarely see a bill from Uncle Sam for any capital gains tax. That’s not a guarantee that there will never be capital gains on any index ETF, but if there ever are, they’re sure to be minor.

The actively managed ETFs — currently a small fraction of the ETF market, but almost certain to grow — may present a somewhat different story. They’re going to be, no doubt, less tax-friendly than index ETFs but more tax-friendly than actively managed mutual funds. Exactly where will they fall on the spectrum? It may take another few years before we really know.

Tax-efficient does not mean tax-free. Although you won’t pay capital gains taxes, you will pay taxes on any dividends issued by your stock ETFs, and stock ETFs are just as likely to issue dividends as are mutual funds. In addition, if you sell your ETFs and they’re in a taxable account, you have to pay capital gains tax (15 percent for most folks; 20 percent for those who make big bucks) if the ETFs have appreciated in value since the time you bought them. But hey, at least you get to decide when to take a gain, and when you do, it’s an actual gain.

ETFs that invest in taxable bonds and throw off taxable-bond interest are not likely to be very much more tax-friendly than taxable-bond mutual funds.

ETFs that invest in actual commodities, holding real silver or gold, tax you at the “collectible” rate of 28 percent. And ETFs that tap into derivatives (such as commodity futures) and currencies sometimes bring with them very complex (and costly) tax issues.

Taxes on earnings — be they dividends or interest or money made on currency swaps — aren’t an issue if your money is held in a tax-advantaged account, such as a Roth individual retirement account (IRA). I love Roth IRAs! Find more on that topic when I get into retirement accounts in Chapter 9.

What you see is what you get

A key to building a successful portfolio, right up there with low costs and tax-efficiency, is diversification, a subject I discuss more in Chapter 10. You can’t diversify optimally unless you know exactly what’s in your portfolio. In a rather infamous example, when tech stocks (some more than others) started to go belly-up in 2000, holders of Janus mutual funds got clobbered. That’s because they learned after the fact that their three or four Janus mutual funds, which gave the illusion of diversification, were actually holding many of the same stocks.

Style drift: An epidemic

With a mutual fund, you often have little idea of what stocks the fund manager is holding. In fact, you may not even know what kinds of stocks they’re holding — or even if they’re holding stocks! I’m talking here about style drift, which occurs when a mutual-fund manager advertises their fund as aggressive, but over time it becomes conservative, and vice versa. I’m talking about mutual-fund managers who say they love large value but invest in large growth or small value.

One classic case of style drift cost investors in the popular Fidelity Magellan Fund a bundle. The year was 1996, and then fund manager Jeffrey Vinik reduced the stock holdings in his “stock” mutual fund to 70 percent. He had 30 percent of the fund’s assets in either bonds or short-term securities. He was betting that the market was going to sour, and he was planning to fully invest in stocks after that happened. He was dead wrong. Instead, the market continued to soar, bonds took a dive, Fidelity Magellan seriously underperformed, and Vinik was out.

One study by the Association of Investment Management concluded that a full 40 percent of actively managed mutual funds are not what they say they are. Some funds bounce around in style so much that you, as an investor, have scant idea of where your money is actually invested.

ETFs are the cure

When you buy an index ETF, you get complete transparency. You know exactly what you’re buying. No matter what the ETF, you can see in the prospectus or on the ETF provider’s website (or on any number of independent financial websites) a complete picture of the ETF’s holdings. See, for example, https://etfdb.com or https://finance.yahoo.com. If I go to either website and type IYE (the ticker symbol for the iShares Dow Jones U.S. Energy Sector ETF) in the search box, I can see in an instant what my holdings are.

You simply can’t get that information on most actively managed mutual funds. Or, if you can, the information is both stale and subject to change without notice.

Transparency also discourages dishonesty

The scandals that have rocked the mutual-fund world over the years have left the world of ETFs untouched. There’s not a whole lot of manipulation that a fund manager can do when their picks are tied to an index. And because ETFs trade throughout the day, with the price flashing across thousands of computer screens worldwide, there is no room to take advantage of the “stale” pricing that occurs after the markets close and mutual-fund orders are settled. All in all, ETF investors are much less likely ever to get bamboozled than are investors in active mutual funds.

How to Get the Professional Edge

I don’t know about you, but when I, on rare occasions, go bowling and bowl a strike, I feel as if a miracle of biblical proportions has occurred. And then I turn on the television, stumble upon a professional bowling tournament, and see people for whom not bowling a strike is a rare occurrence. The difference between amateur and professional bowlers is huge. The difference between investment amateurs and investment professionals can be just as huge. But you can close much of that gap with ETFs.

By investment professionals, I’m not talking about stockbrokers or variable-annuity salespeople (or my barber, who always has a stock recommendation for me); I’m talking about the managers of foundations, endowments, and pension funds with $1 billion or more in invested assets. By amateurs, I’m talking about the average U.S. investor with a few assorted and sundry mutual funds in their 401(k).