ETF Basics

by Dual Income No Kids on August 12, 2009 · 0 comments

Despite the amount of attention Exchange-Traded Funds (ETFs) have received over the last few years a lot of people are still not completely aware of their benefits. In a way, ETFs can be thought of as a hybridization of individual stocks and mutual funds. ETFs are traded on stock exchanges like regular stocks, but instead of representing a unit of value of a company, they track the value of a set of assets. Unlike mutual funds, whose Net Asset Value (NAV) is calculated at the end of each trading day, the value of the ETF, which approximately follows the underlying net value of the assets it tracks, fluctuates throughout the course of the trading day. The most popular ETFs are index trackers – such as securities that track the Dow Jones Industrial Average, S&P 500, NASDAQ, etc… ETFs can be more specific; emerging markets index trackers are popular due to their better-than-average growth potential. Real Estate Investment Trusts (REITs) were also popular and offered a decent profit before the recent mortgage crisis.

ETF Benefits

ETFs offer many benefits over a standard mutual fund. The most significant, as far as our wallets are concerned, are the cost differences. ETFs are traded on the market, and as such, are subject to brokerage commission fees. While mutual funds might not necessarily have an associated brokerage fee (although there might be an “entrance” fee), the real cost savings come into play when the discussion turns to the total expense ratios of each respective investment. Due to higher operating costs, mutual funds often have a much higher expense ratio than ETFs. The expense ratio of mutual funds varies from fund to fund, but generally they fall around 2%, and can reach as high as 3% or higher. Conversely, the expense ratio of ETFs generally fall below 1%. With a long-term investment, that seemingly minuscule different can really add up, and with mutual funds, can really eat into your profits over time. An advantage ETFs have over regular stocks is risk tolerance. Whereas a stock for a given company could fluctuate in value greatly over any period of time, ETFs experience more more gradual growth (or decline, whatever the case may be). Obviously your asset allocation is highly dependent on your own risk tolerance level, but it’s never a bad idea to have a couple ETFs in your portfolio for diversification and stability purposes. The selection of ETFs are as broad and far-reaching as most mutual fund offerings, so it’s not hard to find a set of funds that meet your desired fund characteristics.

ETFs aren’t the only, low-risk, moderate-reward investment vehicles out there. Warren Buffet, one of the great financial luminaries of our time, actually prefers low-cost index funds to ETFs. To quote:

“The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you’ll be buying into a wonderful industry, which in effect is all of American industry. If you buy it over time, you won’t buy at the bottom, but you won’t buy it all at the top either. If you have 2% a year of your funds being eaten up by fees you’re going to have a hard time matching an index fund in my view. People ought to sit back and relax and keep accumulating over time. I have nothing against ETFs, but I really think an index fund that just charges a few basis points for management is pretty hard to beat. You put it away, you have nobody encouraging you to trade it next week or next month … your broker isn’t going to be on you.”

Buffet and ETFs

But after reading his quote, most of the same reasons he gives for advocating index funds can also be applied to ETFs, with the edge given to index funds because you’re not going to have a broker calling you advising that you move your money around frequently, and you can avoid the psychological impact of watching the value of your ETF fluctuate throughout the day and concentrate more on long-term building of wealth. Warren Buffet has long been an advocate for the buy-and-hold long term investing philosophy, and it’s hard to argue with a man who’s net worth is roughly $60 billion.

My Experience with ETFs

When I first started investing I was more of a stock market cowboy than an informed investor. I liked picking individual stocks, researching companies and buying a few shared here in a there in a company that I thought would be successful. I occasionally crossed the line separating investing and gambling. I honestly didn’t do too bad (didn’t do that great either), but my limited profits were often eaten up by brokerage commissions and taxes. Discovering ETFs allowed me to diversify my portfolio while still achieving a respectable rate of return. Also, having a portfolio that features safer investment vehicles like ETFs has allowed me to allocated a smaller portion of my money that I can have a little bit of fun with. It’s with that money that I can take leaps of faith on companies that could make me a decent amount of money or lose my entire investment. It’s comforting though, to know that I have a solid foundation built upon ETFs to rely on if my other investments don’t pan out. The principles that make ETFs work are also sound general investing advice. Buy and hold. Invest for the long term. Allocate your portfolio based on your individual risk tolerance level. Don’t give in to the emotional highs and lows of following the stock market. Get the best bang for your buck by picking solid funds with the lowest possible expense ratios. I don’t always adhere to those rules as strictly as I should, but when I have, good things have always happened.



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