Chapter 5
IN THIS CHAPTER
Distinguishing ETFs and mutual funds
Picking a bullish or bearish ETF
Getting the basics of indexes
When it comes to stock investing, there’s more than one way to do it. Buying stocks directly is good; sometimes, buying stocks indirectly is equally good (or even better) — especially if you’re risk-averse. Buying a great stock is every stock investor’s dream, but sometimes you face investing environments that make finding a winning stock a hazardous pursuit. For 2020–2021, prudent stock investors should definitely consider adding exchange-traded funds to their wealth-building arsenal.
An exchange-traded fund (ETF) is basically a mutual fund that invests in a fixed basket of securities but with a few twists. In this chapter, I show you how ETFs are similar to (and different from) mutual funds (MFs), I provide some pointers on picking ETFs, and I note the fundamentals of stock indexes (which are connected to ETFs).
For many folks and for many years, the only choice besides investing directly in stocks was to invest indirectly through mutual funds (MFs). After all, why buy a single stock for roughly the same few thousand dollars that you can buy a mutual fund for and get benefits such as professional management and diversification?
For small investors, mutual fund investing isn’t a bad way to go. Investors participate by pooling their money with others and get professional money management in an affordable manner. But MFs have their downsides too. Mutual fund fees, which include management fees and sales charges (referred to as loads), eat into gains, and investors have no choice about investments after they’re in a mutual fund. Whatever the fund manager buys, sells, or holds onto is pretty much what the investors in the fund have to tolerate. Investment choice is limited to either being in the fund … or out.
But now, with the advent of ETFs, investors have greater choices than ever, a scenario that sets the stage for the inevitable comparison between MFs and ETFs. The following sections go over the differences and similarities between ETFs and MFs.
Simply stated, in a mutual fund, securities such as stocks and bonds are constantly bought, sold, and held (in other words, the fund is actively managed). An ETF holds similar securities, but the portfolio typically isn’t actively managed. Instead, an ETF usually holds a fixed basket of securities that may reflect an index or a particular industry or sector (see Chapter 13). An index is a method of measuring the value of a segment of the general stock market. It’s a tool used by money managers and investors to compare the performance of a particular stock to a widely accepted standard; see the later section “Taking Note of Indexes” for more details.
For example, an ETF that tries to reflect the S&P 500 will attempt to hold a securities portfolio that mirrors the composition of the S&P 500 as closely as possible. Here’s another example: A water utilities ETF may hold the top 35 or 40 publicly held water companies. (You get the picture.)
Here are some other advantages: You can put various buy/sell brokerage orders on ETFs (see Chapter 17), and many ETFs are optionable (meaning you may be able to buy/sell put and call options on them; I discuss some strategies with options in Chapters 23 and 24). MFs typically aren’t optionable. I cover put and call options extensively in my book High-Level Investing For Dummies (Wiley).
In addition, many ETFs are marginable (meaning that you can borrow against them with some limitations in your brokerage account). MFs usually aren’t marginable when purchased directly (although it is possible if they’re within the confines of a stock brokerage account). To find out more about margin, check out Chapter 17.
Even though ETFs and mutual funds have some major differences, they do share a few similarities:
Buying a stock is an investment in a particular company, but an ETF is an opportunity to invest in a block of stocks. In the same way a few mouse clicks can buy you a stock at a stock brokerage website, those same clicks can buy you virtually an entire industry or sector (or at least the top-tier stocks anyway).
For investors who are comfortable with their own choices and do their due diligence, a winning stock is a better (albeit more aggressive) way to go. For those investors who want to make their own choices but aren’t that confident about picking winning stocks, an ETF is definitely a better way to go.
You had to figure that choosing an ETF wasn’t going to be a coin flip. There are considerations that you should be aware of, some of which are tied more to your personal outlook and preferences than to the underlying portfolio of the ETF. I give you the info you need on bullish and bearish ETFs in the following sections.
You may wake up one day and say, “I think that the stock market will do very well going forward from today,” and that’s just fine if you think so. Maybe your research on the general economy, financial outlook, and political considerations makes you feel happier than a starving man on a cruise ship. But you just don’t know (or don’t care to research) which stocks would best benefit from the good market moves yet to come. No problem!
In the following sections, I cover ETF strategies for bullish scenarios, but fortunately, ETF strategies for bearish scenarios exist too. I cover those later in this chapter.
Why not invest in ETFs that mirror a general major market index such as the S&P 500? ETFs such as SPY construct their portfolios to track the composition of the S&P 500 as closely as possible. As they say, why try to beat the market when you can match it? It’s a great way to go when the market is having a good rally. (See the later section “Taking Note of Indexes” for the basics on indexes.)
When the S&P 500 was battered in late 2008 and early 2009, the ETF for the S&P 500, of course, mirrored that performance and hit the bottom in March 2009. But from that moment on and into 2015, the S&P 500 (and the ETFs that tracked it) did extraordinarily well. It paid to buck the bearish sentiment of early 2009. Of course, it did take some contrarian gumption to do so, but at least you had the benefit of the full S&P 500 stock portfolio, which at least had more diversification than a single stock or a single subsection of the market. Of course, as the S&P 500 entered the bull market of 2009–2015, bullish ETFs that mirrored the S&P 500 did very well while the ETFs that were inverse to the S&P 500 (betting on a bearish move) declined in the same period.
Some ETFs cover industries such as food and beverage, water, energy, and other things that people will keep buying no matter how good or bad the economy is. Without needing a crystal ball or having an iron-will contrarian attitude, a stock investor can simply put money into stocks — or in this case, ETFs — tied to human need. Such ETFs may even do better than ETFs tied to major market indexes (see the preceding section).
Here’s an example: At the end of 2007 (mere months before the great 2008–2009 market crash), what would have happened if you had invested 50 percent of your money in an ETF that represented the S&P 500 and 50 percent in an ETF that was in consumer staples (such as food and beverage stocks)? I did such a comparison, and it was quite revealing to note that by the end of 2015, the consumer staples ETF (for the record I used one with the securities symbol PBJ) actually beat out the S&P 500 ETF by more than 45 percent (not including dividends). Very interesting!
ETFs don’t necessarily have to be tied to a specific industry or sector; they can be tied to a specific type or subcategory of stock. All things being equal, what basic categories of stocks do you think would better weather bad times: stocks with no dividends or stocks that pay dividends? (I guess the question answers itself, pretty much like, “What tastes better: apple pie or barbed wire?”) Although some sectors are known for being good dividend payers, such as utilities (and there are some good ETFs that cover this industry), some ETFs cover stocks that meet specific criteria.
You can find ETFs that include high-dividend income stocks (typically 3.5 percent or higher) as well as ETFs that include stocks of companies that don’t necessarily pay high dividends but do have a long track record of dividend increases that meet or exceed the rate of inflation.
For more information on dividend investing strategies (and other income ideas), head over to Chapter 9.
Most ETFs are bullish in nature because they invest in a portfolio of securities that they expect to go up in due course. But some ETFs have a bearish focus. Bearish ETFs (also called short ETFs) maintain a portfolio of securities and strategies that are designed to go the opposite way of the underlying or targeted securities. In other words, this type of ETF goes up when the underlying securities go down (and vice versa). Bearish ETFs employ securities such as put options (and similar derivatives) and/or employ strategies such as “going short” (see Chapter 17).
Take the S&P 500, for example. If you were bullish on that index, you might choose an ETF such as SPY. However, if you were bearish on that index and wanted to seek gains by betting that it would go down, you could choose an ETF such as SH.
You can take two approaches on bearish ETFs:
For stock investors, ETFs that are bullish or bearish are ultimately tied to major market indexes. You should take a quick look at indexes to better understand them (and the ETFs tied to them).
Whenever you hear the media commentary or the scuttlebutt at the local watering hole about “how the market is doing,” it typically refers to a market proxy such as an index. You’ll usually hear them mention “the Dow” or perhaps “the S&P 500.” There are certainly other major market indexes, and there are many lesser, yet popular, measurements, such as the Dow Jones Transportation Average. Indexes and averages tend to be used interchangeably, but they’re distinctly different entities of measurement.
Most people use these indexes basically as standards of market performance to see whether they’re doing better or worse than a yardstick for comparison purposes. They want to know continuously whether their stocks, ETFs, MFs, or overall portfolios are performing well.
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