Chapter 1

ETFs: No Longer the New Kid on the Block

IN THIS CHAPTER

Distinguishing what makes ETFs unique

Taking a look at who’s making the most use of ETFs

Appreciating ETFs’ special attributes

Understanding that ETFs aren’t perfect

Asking whether ETFs are for you

Banking your retirement on stocks is risky enough; banking your retirement on any individual stock, or even a handful of stocks, is about as risky as wrestling crocodiles. Banking on individual bonds is less risky (maybe wrestling an adolescent crocodile), but the same general principle holds. There is safety in numbers. That’s why teenage boys and girls huddle together in corners at school dances. That’s why gnus graze in groups. That’s why smart stock and bond investors grab onto exchange-traded funds (ETFs).

In this chapter, I explain not only the safety features of ETFs but also the ways in which they differ from their cousins, mutual funds. By the time you’re done with this chapter, you should have a pretty good idea of what ETFs can do for your portfolio.

What the Heck Is an ETF?

Just as a deed shows that you have ownership of a house, and a share of common stock certifies ownership in a company, a share of an ETF represents ownership (most typically) in a basket of company stocks. To buy or sell an ETF, you place an order with a broker, generally (and preferably, for cost reasons) online, although you can also place an order by phone. The price of an ETF changes throughout the trading day (which is to say from 9:30 a.m. to 4 p.m. Eastern time), going up or down with the market value of the securities it holds. Sometimes there can be a little sway — times when the price of an ETF doesn’t exactly track the value of the securities it holds — but that situation is rarely serious, at least not with ETFs from the better purveyors.

Originally, ETFs were developed to mirror various indexes:

• The SPDR S&P 500 (ticker symbol: SPY) represents stocks from the Standard & Poor’s (S&P) 500, an index of the 500 largest companies in the United States.
• The DIAMONDS Trust Series 1 (ticker symbol: DIA) represents the 30 or so underlying stocks of the Dow Jones Industrial Average (DJIA) index.
• The Invesco QQQ Trust Series 1 (ticker symbol: QQQ; formerly known as the Nasdaq-100 Trust Series 1) represents the 100 stocks of the Nasdaq-100 Index.

Since ETFs were first introduced, many others, tracking all kinds of things, including some rather strange things that I dare not even call investments, have emerged.

The component companies in an ETF’s portfolio usually represent a certain index or segment of the market, such as large U.S. value stocks, small-growth stocks, or micro-cap stocks. (If you’re not 100 percent clear on the difference between value and growth, or what a micro cap is, rest assured that I define these and other key terms in Part 2.)

Sometimes, the stock market is broken up into industry sectors, such as technology, industrials, and consumer discretionary. ETFs exist that mirror each sector.

Regardless of what securities an ETF represents, and regardless of what index those securities are a part of, your fortunes as an ETF holder are tied, either directly or in some leveraged fashion, to the value of the underlying securities. If the price of Microsoft stock, U.S. Treasury bonds, gold bullion, or British pound futures goes up, so does the value of your ETF. If the price of gold tumbles, your portfolio (if you hold a gold ETF) may lose some glitter. If Microsoft stock pays a dividend, you’re due a certain amount of that dividend — unless you happen to have bought into a leveraged or inverse ETF.

Some ETFs allow for leveraging, so that if the underlying security rises in value, your ETF shares rise doubly or triply. If the security falls in value, well, you lose according to the same multiple. Other ETFs allow you not only to leverage but also to reverse leverage, so you stand to make money if the underlying security falls in value (and, of course, lose if the underlying security increases in value). I’m not a big fan of leveraged and inverse ETFs.

Choosing between the classic and the new indexes

Some of the ETF providers (Vanguard, iShares, Charles Schwab) tend to use traditional indexes, such as those I mention in the previous section. Others (Dimensional, WisdomTree) tend to develop their own indexes.

For example, if you were to buy 100 shares of an ETF called the iShares S&P 500 Growth Index Fund (ticker symbol: IVW), you’d be buying into a traditional index (large U.S. growth companies). At about $70 a share (at the time of this writing), you’d plunk down $7,000 for a portfolio of stocks that would include shares of Apple, Microsoft, Amazon, Facebook, Alphabet (Google), and Tesla. If you wanted to know the exact breakdown, the iShares prospectus found on the iShares website (or any number of financial websites, such as https://finance.yahoo.com) would tell you specific percentages: Apple, 11.3 percent; Microsoft, 10.3 percent; Amazon, 7.8 percent; and so on.

Many ETFs represent shares in companies that form foreign indexes. If, for example, you were to own 100 shares of the iShares MSCI Japan Index Fund (ticker symbol: EWJ), with a market value of about $69 per share as of this writing, your $6,900 would buy you a stake in large Japanese companies such as Toyota Motor, SoftBank Group, Sony Group, Keyence, and Mitsubishi UFJ Financial Group. (Chapter 5 is devoted entirely to international ETFs.)

Both IVW and EWJ mirror standard indexes: IVW mirrors the S&P 500 Growth Index, and EWJ mirrors the MSCI Japan Index. If, however, you purchase 100 shares of the Invesco Dynamic Large Cap Growth ETF (ticker symbol: PWB), you’ll buy roughly $7,100 worth of a portfolio of stocks that mirror a very unconventional index — one created by the Invesco family of ETFs. The large U.S. growth companies in the PowerShares index that have the heaviest weightings include Facebook and Alphabet, but also NVIDIA and Texas Instruments. Invesco PowerShares refers to its custom indexes as Intellidex indexes.

A big controversy in the world of ETFs is whether the newfangled, customized indexes offered by companies like Invesco make any sense. Most financial professionals are skeptical of anything that’s new. We’re a conservative lot. Those of us who have been around for a while have seen too many “exciting” new investment ideas crash and burn. But I, for one, try to keep an open mind. For now, let me continue with my introduction to ETFs, but rest assured that I address this controversy (in Chapter 2 and throughout the rest of this book).

Another big controversy is whether you may be better off with an even newer style of ETFs — those that follow no indexes at all but rather are “actively” managed. I prefer index investing to active investing, but that’s not to say that active investing, carefully pursued, has no role to play. (You can find more on that topic later in this chapter and throughout this book.)

Other ETFs — a distinct but growing minority — represent holdings in assets other than stocks, most notably, bonds and commodities (gold, silver, oil, and such). And then there are exchange-traded notes (ETNs), which allow you to venture even further into the world of alternative investments — or speculations — such as currency futures. (I discuss these products in Part 2.)

Preferring ETFs over individual stocks

Okay, why buy a basket of stocks rather than an individual stock? Quick answer: You’ll sleep better.

A company I’ll call ABC Pharmaceutical sees its stock shoot up by 68 percent because the firm just earned an important patent for a new diet pill; a month later, the stock falls by 84 percent because a study in the New England Journal of Medicine found that the new diet pill causes people to hallucinate and think they’re Genghis Khan.

Compared to the world of individual stocks, the stock market as a whole is as smooth as a morning lake. Heck, a daily rise or fall in the Dow of more than a percent or two (well, maybe 2 percent or 3 percent these days) is generally considered a pretty big deal.

If you, like me, are not especially keen on roller coasters, you’re advised to put your nest egg into not one stock, not two, but many. If you have a few million sitting around, hey, you’ll have no problem diversifying — maybe individual stocks are for you. But for most of us commoners, the only way to effectively diversify is with ETFs or mutual funds.

Distinguishing ETFs from mutual funds

So, what’s the difference between an ETF and a mutual fund? After all, mutual funds also represent baskets of stocks or bonds. The two, however, are not twins. They’re not even siblings. Cousins are more like it. Here are some of the big differences between ETFs and mutual funds:

• ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their prices change throughout the trading day. Mutual-fund orders can be made during the day, but the actual trading doesn’t occur until after the markets close.
• ETFs tend to represent indexes — market segments — and the...