Introduction

Every month, it seems, Wall Street comes up with some newfangled investment idea. The array of financial products (replete with 164-page prospectuses) is now so dizzying that the old, lumpy mattress is starting to look like a more comfortable place to stash the cash. But there is one product that is definitely worth looking at, even though it’s been around not even 30 years. It’s something of a cross between an index mutual fund and a stock, and it’s called an exchange-traded fund, or ETF.

Just as computers and fax machines were used by big institutions before they caught on with individual consumers, so it was with ETFs. They were first embraced by institutional traders — investment banks, hedge funds, and insurance firms — because, among other things, they allow for the quick juggling of massive holdings. Big traders like that sort of thing. Personally, playing hot potato with my money is not my idea of fun. But all the same, over the past not-even 20 years, I’ve invested most of my own savings in ETFs, and I’ve suggested to many of my clients that they do the same.

I’m not alone in my appreciation of ETFs. They have grown exponentially in the past few years, and they will surely continue to grow and gain influence. While I can’t claim that my purchases and my recommendations of ETFs account for much of the growing, global $9 trillion-plus ETF market, I’m happy to be a (very) small part of it. After you’ve read this third edition of Exchange-Traded Funds For Dummies, you may decide to become part of it as well, if you haven’t already.

Since the First Edition…

Many changes have taken place in the investment world, both on Wall Street and Main Street, since the first edition of this book was published in 2007. For one thing, a much larger pot of money (dollars, euros, yen) is now invested in ETFs: $9.1 trillion as of this writing (up from a mere $800 billion in 2007). Also, when I introduce myself as the author of Exchange-Traded Funds For Dummies, I no longer get a look as if I’m speaking some strange language with a lisp. Many people today, perhaps most, are at least somewhat familiar with the term exchange-traded funds. ETFs have, after all, made a few headlines.

Out of the shadows

The rising popularity of ETFs has been a news story in and of itself. Many educated folks are now aware that ETFs are low-cost investment vehicles that can serve as building blocks for a diversified portfolio.

And that is what I concentrate on most in this third edition: how ETFs may be used by you — the individual investor — to maximize your investment returns while minimizing risk. I tried to do that same thing in the first and second editions, but, since then, without question, there have been many changes, both positive and negative. Today, you’ll find a much greater selection of ETF offerings, although not all of them are prizes.

Filling the investment voids

One very positive change in the past several years is that the “black holes” that I identified in the first edition of this book have largely been filled. That is, when I wrote the first edition, you could not buy an ETF that would give you exposure to tax-free municipal or high-yield bonds. Or international bonds. Or international REITs. All that has changed. There are now ETFs that represent all those asset classes, and many more. Building an entire well-diversified portfolio out of ETFs was not humanly possible several years ago; it is very possible today. I’ve done it numerous times!

Another very positive development: ETFs have recently been making a grand entrance into employer-sponsored 401(k) plans, where many of America’s hard-working people store the bulk of their savings. And they’ve been appearing lately in 529 College Savings Plans, too. Insurance companies have also jumped into the fray, offering ETFs in some of their annuity plans (which, unfortunately, are still often overpriced).

Creations of dubious value

Many of the newer ETFs are bad investments, pure and simple. They were introduced to take advantage of the popularity of ETFs. They are overly expensive, and they represent foolish indexes (extremely small segments of the market, or indexes constructed using highly questionable methodologies). Much of this book is designed to help you tell the good from the bad.

Many of the newer ETFs are also specifically designed for short-term trading — which you would know if you read the really small print at the bottom of the advertisements — and short-term trading usually gets small investors into big trouble.

A scary number of the newer ETFs are based on “back-tested” models: They track whatever indexes, or invest in whatever kinds of assets, have done the best in recent months or years. These ETFs (or the indexes they track) have shining short-term performance records, which induce people to buy. But past short-term performance is a very, very poor indicator of future performance.

A number of new ETFs are focused on “meme stocks” — those stocks most highlighted on social media, often ballyhooed in memes as surefire ways to get rich. I could say “Tesla” right now, but by the time you’re reading this, Tesla will be out and some other company will be in. Buying what’s most fashionable — by investing directly in the meme stocks or in an ETF filled with meme stocks — is not a wise investment move.

Morphing into new creatures

Actively managed ETFs (that might, for example, buy and sell meme stocks) have been much slower to take off than Wall Street had hoped but have made inroads since the first edition of this book.

These ETFs differ radically from the original index ETFs. Actively managed ETFs don’t track any indexes at all but instead have portfolios built and regularly traded by managers attempting to beat the indexes. Study after study has shown that active management usually doesn’t work all that well for investors, even though the managers themselves often get very rich (more in Chapter 18).

Some of the newest ETFs, called defined outcome ETFs, are everything that an ETF shouldn’t be: actively managed, expensive, and almost absurdly complex. Whereas other ETFs are cousins of mutual funds, these complicated funds are more like variable annuities.

About This Book

As with any other investment, you’re looking for a certain payoff in reading this book. In an abstract sense, the payoff will come in your achieving a thorough understanding and appreciation of a powerful financial tool called an exchange-traded fund. The more concrete payoff will come when you apply this understanding to improve your investment results.

What makes me think ETFs can help you make money?

• ETFs are intelligent. Most financial experts agree that playing with individual stocks can be hazardous to one’s wealth. Anything from an accounting scandal to the CEO’s sudden angina attack can send a single stock spiraling downward. That’s why it makes sense for the average investor to own lots of stocks — or bonds — through ETFs or mutual funds.
• ETFs are cheap. At least 250 ETFs charge annual management expenses of 0.10 percent or lower, and a few charge as little as 0.00 percent a year! In contrast, the average actively managed mutual fund charges 0.63 percent a year. Index mutual funds generally cost a tad more than their ETF cousins. Such cost differences, while appearing small on paper, can make a huge impact on your returns over time. I crunch some numbers in Chapter 2.
• ETFs are tax-smart. Because of the very clever way ETFs are structured, the taxes you pay on any growth are minimal. I crunch some of those numbers as well in Chapter 2.

• ETFs are open books. Quite unlike mutual funds, an ETF’s holdings are, by and large, readily visible. If this afternoon, for example, I were to buy 100 shares of the ETF called the SPDR (pronounced “spider”) S&P 500 ETF Trust, I would know that exactly 6.37 percent of my money was invested in Apple, Inc., and 5.92 percent was invested in the Microsoft Corporation. You don’t get that kind of detail when you buy most mutual funds. Mutual fund managers, like stage magicians, are often reluctant to reveal their secrets. In the investment game, the more you know, the lower the odds that you will get sawed in half.

  (News flash: Regulators are still debating just how open the portfolios of the newer actively managed ETFs will have to be. For the time being, however, most ETFs track indexes, and the components of any index are readily visible.)

And speaking of open books, if the one you’re now reading were like some (but certainly not all) mutual funds, it would be largely unintelligible and expensive. (It might be doubly expensive if you tried to resell the book within 90 days!) Luckily, this book is more like an ETF. Here’s how:

• Exchange-Traded Funds For Dummies is intelligent. I don’t try to convince you that ETFs are your best investment choice, and I certainly don’t tell you that ETFs will make you rich. Instead, I lay out facts and figures and summarize some hard academic findings, and I let you draw your own conclusions.
• Exchange-Traded Funds For Dummies is cheap....