ETFs- The Best of Both Worlds

Since my first days of investing, I’ve had dozens of people (friends, family, colleagues, acquaintances, etc.) as me a simple question, ‘How do I invest my money?’ It’s a simple question, but an extremely loaded one. Investing is not something I think anyone should take lightly. Some people open up a trading account and invest in whatever comes to mind. Others participate in structured investment programs like 401K’s and employee stock purchase plans with little to no understanding in what they’re investing in. Both strategies, although sometimes successful, can cause major problems down the road. As I try to tell everyone, investing is something that should be taken seriously and requires time and understanding. This is your hard earned money (or at least somebody’s hard earned money), throwing it investments that are not fully understood is a dangerous proposition. Now this post isn’t meant to be an instruction manual on how to invest. Actually, that series of posts is on its way. Instead I wanted to talk about a specific tool that I recommend all relatively new investors utilize.

The ETF Concept

ETF’s (short for ‘Exchange Traded Funds’) is an investment tool that any average investor can buy into as an alternative to stocks or mutual funds. They are basically a collection of some asset like stocks, commodities, or

Bonds, broken up into little pieces and sold to investors. You might realize that this sounds somewhat like a mutual fund, and you’d be right. But there are some very important differences between ETF’s and mutual funds which make ETF’s an attractive option. Let’s go ahead and list some advantages and disadvantages:

Advantages of ETF’s Over Other Types of Investments

1. Instant Diversification – Instead of buying into a single stock, an ETF is a collection of assets (a common example is stocks). Therefore, by buying an ETF, you avoid buying a single asset and leveraging yourself out to it, thereby increasing risk. An ETF, like a mutual fund, will allow you to minimize the risks associated with buying a single stock (aka diversifiable risk) and gets you instantly diversified.
2. They Trade Like Stocks – When you buy a stock, you put in an order and the order goes through once the market is open (assuming you don’t have specific conditional orders). This generally isn’t true for mutual funds, where you have to wait a few business days for transactions to occur. ETF’s trade like stocks. You can buy and sell them instantly during market hours – thereby giving you the flexibility for more fluid trading.
3. Ability to Buy More Unique Assets – There is a large variety of ETF’s out there. There are simple ones that buy stocks of a specific industry or company size. But there’s also some more exotic ETF’s that give investors the ability to buy things like Commodities, Bonds, Real Estate, etc. There are some serious risks with these more exotic ETF’s and I’d advise you to tread carefully here.
4. Lower Costs – Because ETF’s are passively managed (i.e. the process of selecting stocks as highly automated and is based on the type of ETF you’re buying), they generally have lower fees to own them when compared to actively managed mutual funds. These costs generally run between .5% to 2%.

Disadvantages of ETF’s

1. Passive Management – Yes, they may be cheaper than mutual funds of the same category, but this advantage also has a downside. Because ETF’s are just a basket of stocks, you don’t have active managers that try to lean the fund towards the better stocks in the category. For example, if you buy an ETF that invests in stocks of financial companies (XLF), it will simply be a basket of financial stocks weighted based on the size of the company (the bigger the company, the more weighted the ETF will be towards that company). An actively managed mutual fund that invests in financial company stocks could be smarter and try to adjust its weighting based on the stronger financial companies. However, better performance from actively managed funds is obviously never guaranteed and their higher costs can often offset the benefit.

A simple ETF example is the S&P 500 ETF called the ‘Spyder’ and ticker symbol SPY. This ETF is a basket of stocks that are included in the S&P 500 index (in other words, the 500 biggest publicly traded companies). The ETF tracks very closely to the S&P 500 – so buying the ETF is like buying a piece of the S&P 500 index. Below I’ve included some details of the SPY and relevant information along with a link to the comparison graph between it and the S&P 500 itself.

Summary Details on the SPY

Comparison Chart Between the SPY and the S&P 500 since Jan 2009. Notice the almost exact correlation:

Why Should I Invest with ETF’s?

The reason is pretty simple. Most investors, especially newer ones, generally don’t know enough about individual companies in order to invest completely in them. However, the investor may understand the motivations for investing in that category (whether it be industry, region of the world, asset class, etc.) that it’s still a good idea to invest in them. Usually there’s an ETF for that category that the investor can get into at a relatively low cost.

How Do I Invest in ETF’s?

Like a mentioned before, one of the beauties of ETF’s is that they trade like stocks. This means that they have ticker symbols, and can be bought through normal investing channels like an online broker. Using the SPY example above, you can simply put an order in to buy a given number of shares of the SPY and you’ll instantly have exposure to those stocks.

What Other Kinds of ETF’s Are There?

Also like I mentioned before, there’s tons of options out there for ETF’s. There’s even one that inversely tracks the market (SH). This means that these ETF’s go up when the market goes down. If you think the economy is going to get worse, then this might be a good option for you. If that’s not enough, there’s even an ETF that has a double inverse correlation to the market. This means that if the market goes down 1%, the ETF will go up 2%. If you’re really sure the market will go down, this is an interesting option.

Comparison Chart Between Proshares Short S&P 500 (SH) and S&P 500. Notice 1-1 inverse correlation

Comparison Chart Between Proshares UltraShort S&P 500 (SDS) and S&P 500. Notice approx 2-1 inverse correlation

My point here is that there’s an option for everyone, regardless of what you want to invest in. There are some major ETF companies that create and manage the ETF’s. These include Barclays, and Morgan Stanley. To see your options in the ETF world, I suggest either going to their websites, or simply googling it. A search I did for “Africa Stock ETF’ returned 189,000 results and one of the top ones was the Africa ETF from Market Vectors (AFK)

The Bottom Line

As you can see, ETF’s provide a great alternative for investors that want to either want cheap and easy diversification in their portfolios or want to invest in more exotic assets. I highly recommend you new investors out there look into these because they you’ll be able to gain exposure to areas you’re interested even if you may not fully understand the individual companies. As you learn more, you can then look into getting into more specific companies.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.