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Jelly Roll Capital Equity Research |
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Market Analysis, Education, and Wall Street-Quality Stock Reports |
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The Basics on Exchange-Traded Funds (ETFs) |
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One frequent question people handling their own investments have is about the proper use of Exchange-Traded Funds (ETFs) in their portfolio. An ETF is a versatile financial instrument that is essentially a group of stocks that trade as a single stock. ETFs may track an index, commodity, or simply a group of stocks that have some similarity — there are ETFs that track the S&P 500, Dow Jones Industrials, crude oil prices, gold futures, technology stocks, small caps, Japanese stocks, etc. Why add them to your portfolio? Here are a few reasons:
-Diversification. For investors with a limited amount of capital, proper use of ETFs can provide a solid level of diversification in only one trade. Simply buying a broad market ETF (such as SPY or DIA) can provide an investor a fractional stake in many of the world’s best companies. SPY, for example, contains 500 different companies and allows the investor to keep pace with the S&P 500 benchmark index with the exception of… -Fees and Expenses. Compared to mutual funds, ETFs usually have relatively low fees. To use SPY as an example again, the expense ratio is a tiny 0.1% compared to the normal mutual fund, which has an average expense ratio around 1% — 10x that of the ETF. The larger the ETF, the lower the expense ratio will tend to be, so a well-known product such as SPY or DIA will have a lower cost than a niche ETF like the Taiwan Index (EWT), although the expense ratio of the ETF is still normally lower than that of an actively managed mutual fund focusing on the same stocks. One area to be watchful of is brokerage commissions, however, because constantly trading in and out of ETFs can eliminate any savings from the lower expense ratio. -Trading. ETFs trade all day, just like any single stock, so investors have much more liquidity in ETFs than they do in mutual funds, which only trade once at the end of the day. Although the constant trading isn’t a huge benefit to buy-and-hold investors, the feature makes ETFs appealing to traders and other short-term speculators.
An example of how to use ETFs: My personal opinion is that ETFs are excellent for beginning investors because it minimizes many of the problems they can have with limited capital, diversification, and stockpicking know how. A hypothetical investor with $5,000 to start can choose from several “core” portfolio options such as SPY, VTI (for the Vanguard Total Stock Market index), or ISI (for the S&P 1500). This core holding could have anywhere from 50% to 100% of the investor’s capital, although for our example we will choose 60% or $3,000. This core holding is going to be several hundred of the stock market’s largest companies, so the investor may want to add exposure to small cap stocks (typically stocks with a market cap of less than $1 billion). This can be done through an ETF such as IJR (iShares S&P Small Cap 600) or VB (Vanguard Small Caps), and we will allocate 20% of the portfolio or $1,000 to this sector. The remaining part of the portfolio can be a “wildcard” pick for the investor. This is their chance to make a bet on a specific sector without having to worry about individual stocks. A solid pick here might be, for example, EEM (iShares MSCI Emerging Markets index) or ADRD (BLDRS Developed Market 100). This would diversify some of the risk of being invested solely in America, and foreign investment will become increasingly important in a globalized world as markets become more independent. Our hypothetical investor could also choose to go in another direction with the remaining capital, and tilt the portfolio to appreciate more heavily if a specific sector goes up. This could be accomplished through buying XLV if the investor likes Healthcare stocks, or XLE if the investor favored Energy.
The bottom line on ETFs is that the increased offerings from various companies will drive down expense ratios, while allowing investors broader access to various financial instruments that help tailor portfolios to personal preferences. The growth of ETFs is a great benefit to investors, and their range of usefulness means that everyone should be aware of how ETFs can help both active traders and passive portfolio management.
For a more in-depth examination of how to trade ETFs, read |