IN THIS CHAPTER

Assessing risk

Considering professional help

Figuring out which ETFs make sense for you

Oh, it’s been fun writing a book about exchange-traded funds! When someone asks me what I’m working on, and I say, “The third edition of Exchange-Traded Funds For Dummies,” sometimes their eyes glaze over, and then, if the topic isn’t immediately steered in a new direction, I’m inevitably asked what the heck an exchange-traded fund is. And so I explain (essentially quoting, from memory, a few lines from this book’s Introduction). The next question I’m asked is invariably one of the following.

Are ETFs Appropriate for Individual Investors?

You bet they are. Although the name exchange-traded funds sounds highly technical and maybe a little bit scary, ETFs — at least the ones I tend to recommend in this book — are essentially friendly index mutual funds with a few spicy perks. They are more than appropriate for individual investors. In fact, given the low expense ratios and high tax efficiency of most ETFs, as well as the ease with which you can use them to construct a diversified portfolio, these babies can be the perfect building blocks for just about any individual investor’s portfolio.

Are ETFs Risky?

That all depends.

Some ETFs are way riskier than others. It’s a question of what kind of ETF we’re talking about. Many ETFs track stock indexes, and some of those stock indexes can be extremely volatile, such as individual sectors of the U.S. economy (technology, energy, defense and aerospace, and so on) or the stock markets of emerging-market nations. Other ETFs track broader segments of the U.S. stock market, such as the S&P 500. Those can be volatile, too, but less so.

But other ETFs track bond indexes. Those tend to be considerably less volatile (and less potentially rewarding) than stock ETFs. One ETF (ticker symbol SHY) tracks short-term Treasury bonds, and as such is only a little bit more volatile than a money market fund.

Many of the newer-generation ETFs are leveraged, using borrowed money or financial derivatives to increase volatility (and potential performance). Those leveraged ETFs can be so wildly volatile that you are taking on risk of Las Vegas proportions.

When putting together a portfolio, a diversity of investments can temper risk. Although it seems freakily paradoxical, you can sometimes add a risky ETF to a portfolio (such as an ETF that tracks the stocks of foreign small companies) and lower your overall risk! How so? If the value of your newly added ETF tends to rise as your other investments fall, that addition will lower the volatility of your entire portfolio. (Financial professionals refer to this strange but sweet phenomenon as Modern Portfolio Theory.)

Do I Need a Financial Professional to Set Up and Monitor an ETF Portfolio?

Do you need an auto mechanic to service your car? I don’t know. It depends on both your particular skills and your inclination to spend a Sunday afternoon getting greasy under the hood. Setting up a decent ETF portfolio, with the aid of this book, is very doable. You can certainly monitor such a portfolio, as well. A professional, however, has special education, tools, and (I hope) objectivity to help you understand investment risk and construct a portfolio that fits you like a glove, or at least a sock. A financial planner can also help you properly estimate your retirement needs and plan your savings accordingly.

Do be aware that many investment “advisors” out there are nothing more than salespeople in disguise. Don’t be at all surprised if you bump into a few who express their disgust of ETFs! ETFs make no money for those salespeople, who make their living hawking expensive (often inferior) investment products. Your best bet for good advice is to find a fee-only (takes no commissions) financial planner. If you are more or less a do-it-yourselfer but simply want a little guidance, try to find a fee-only planner who will work with you on an hourly basis.

If you hire a fee-only advisor who takes your assets under management, know that the standard 1-percent-of-assets-under-management fee has gone largely by the wayside. You shouldn’t have to pay that much if you are only getting portfolio management. If your advisor also helps you with other financial matters, that’s a different story. But do consider an hourly advisor first.

How Much Money Do I Need to Invest in ETFs?

You can buy as little as one share of any ETF, and many ETF shares sell for under $30. Heck, some brokerage houses now allow for the purchase of fractional shares on the more common ETFs, so you could theoretically start an ETF portfolio with pennies.

You will need a brokerage house to purchase ETFs, and some brokerage houses do have minimums. But there are plenty of brokerage houses that do not have minimums, including Schwab and Fidelity. Vanguard has no minimum, but you will pay an annual service fee of $20 for any account that holds less than $10,000, although you can waive the service fee if you agree to get all your documents electronically.

With Hundreds of ETFs to Choose From, Where Do I Start?

The answer depends on your objective. If you are looking to round out an existing portfolio of stocks or mutual funds, your ETF should complement that. Your goal is always to have a well-diversified collection of investments. If you are starting to build a portfolio, you want to make sure to include stocks and bonds and to diversify within those two broad asset classes.

There is not much in the world of stocks and bonds that can’t be satisfied with ETFs. Try to have both U.S. and international stock ETFs. And within the U.S. stock arena, aim to have large-cap and small-cap, value and growth stocks. (I explain these terms in Chapters 5 through 8.) You can also diversify your stock ETFs by industry sector: consumer staples, energy, financials, and so on. (See Chapter 10 for a discussion of sector diversification.)

On the bond side of your portfolio, you want both government-issued bonds and corporate bonds, and if you’re in a higher tax bracket, you may want municipal bonds as well. For more conservative portfolios in which bonds play a major role, foreign bonds may offer added diversification. There are many ETFs that will give you exposure to all of these kinds of bonds. (For a full discussion, see Part 3.)

Although most ETFs are somewhat reasonably priced, some are more reasonably priced than others. If you are going to pay 0.40 percent a year in operating expenses for a certain ETF, you should have a good reason for doing so. Many ETFs are available for under 0.20 percent, and some for even less than 0.05 percent. A handful are free!

Where Is the Best Place for Me to Buy ETFs?

I suggest setting up an account with a financial supermarket such as Fidelity, Vanguard, Charles Schwab, or TD Ameritrade. Each of these allows you to hold ETFs, along with other investments — such as mutual funds or individual stocks and bonds — in one account. (You probably don’t need or want individual securities. I’m just saying…)

Different financial supermarkets offer different services and charge different prices depending on how much you have to invest, how often you trade, and whether you do everything online or by phone. You need to do some shopping around to find the brokerage house that works best for you. I provide more suggestions for shopping financial supermarkets in Chapter 3, where you’ll also find contact information. Their websites are listed in Appendix A.

Is There an Especially Good or Bad Time to Buy ETFs?

Well, the stock market is open for business between 9:30 a.m. and 4:00 p.m., Monday through Friday. That’s NYC time. It’s generally best to trade your ETFs between 9:45 a.m. and 3:45 p.m. Avoid the opening and closing bells; there is often added volatility at those times.

Other than that, nope, there really is no particular good or bad time. It isn’t like airline tickets (which many people say you should shop for on Tuesdays, and never on Fridays).

And how about a day after the market is up as opposed to down? Studies show rather conclusively that the stock and bond markets (or any segment of the stock or bond markets) are just about as likely to go up after a good day as they are after a bad day (or week, month, year, or any other piece of the calendar). Trying to time the market tends to be a fool’s game — or, just as often, a game that some like to play with other people’s money.

Do ETFs Have Any Disadvantages?

Because most ETFs follow an index, you probably won’t see your ETF (or any of your index mutual funds) winding up number one on Wise Money magazine’s list of Top Funds for the Year. (But you probably won’t find any of your ETFs at the bottom of such a list, either.)

But perhaps the biggest disadvantage of ETFs is something that many consider an advantage. ETFs, unlike mutual funds, trade in a flash. If at, say, 2:34 on a Wednesday afternoon, you want to sell your entire portfolio, then you can have it done by 2:35. This is not a technical disadvantage — unless you have a trigger finger and are apt to make rash financial decisions. Yes, there are some people who sell out their stock ETFs after every downward blip in the market. If this is you, you’d be better off with mutual funds…or perhaps cash under your mattress!

Does It Matter Which Exchange My ETF Is Traded On?

No. Most ETFs are traded on the NYSE Arca (Archipelago) exchange, but plenty of others are traded on the NASDAQ. It doesn’t matter in the slightest to you, the individual investor. The cost of your trade is determined by the brokerage house you use, and most brokerage houses are now charging zero for ETFs. The spread (the difference between the price a buyer pays and the price the seller receives) is determined in large part by the share volume of the ETF being traded. Regardless of the exchange, if the volume is small (such as would be the case for, say, the Global X Nigeria ETF), you may want to place a limit order rather than a market order. I explain the different kinds of orders in a sidebar in Chapter 2.

Which ETFs Are Best in My IRA, and Which Are Best in My Taxable Account?

Generally, investments that generate income — whether interest, dividends, or capital gains — are best kept in a tax-advantaged retirement account, such as your IRA or 401(k) plan. That would include any bond, REIT, or high-dividend-paying ETF. You’ll eventually need to pay income tax on any money you withdraw from those accounts, but it is generally better to pay later than sooner. In the case of a Roth IRA, which is often the best case of all, you will never have to pay taxes on the earnings, the principal, what is in the account, or what you withdraw. Try to put your ETFs that have the greatest potential for growth — REIT ETFs are great candidates — into your Roth IRA.

Because retirement accounts generally penalize you if you take money out before age 59½, anyone younger than that would want to keep all emergency money in a non-retirement account.