Exchange-traded funds (ETFs) have grown wildly popular in the past few years, and for good reason. They are more liquid than mutual funds and generally cheaper as well. But most of all, ETFs are popular because they can be whatever you want them to be.
Want a shotgun blast to the broad stock market? Done - there are literally dozens of ETFs that faithfully represent the S&P 500, Russell 3000 or Wilshire Total Stock Market indexes.
Would you rather have a laser to hit a specific industry, foreign country, commodity or investing theme? No problem - there's plenty of selection to go around. And just like individual stocks, ETFs can be bought and sold during the trading day for just a standard commission fee. (To learn more about the differences between the two vehicles, check out Mutual Fund or ETF: Which is Right For You?)
Below are five classes of ETFs that every investor should become familiar with. You may want just one ETF to fill a hole in your otherwise diversified portfolio, or you may wish to construct an entire portfolio out of just ETFs. There are plenty of money managers that make a living suggesting that clients do just that. I leave the asset allocation decisions to you; for now, here's a good launching pad for future research.
#1 - Broad Stock Market ETFs
As mentioned above, there are scores of ETFs that passively invest in broad indexes like the S&P 500 or the Wilshire 3000. Changes to the holdings in these ETFs are only made when the underlying index changes. Investors should have no problem finding a broad market ETF with an expense ratio less than 40 basis points, and should beware of any domestic-focused fund that has higher annual fees.
Broad market ETFs are steady, diversified and can be a cornerstone of a well-balanced portfolio.
#2 - Dividend & Bond ETFs
As with the stock funds, there are many ETFs that passively follow bond indexes, which have notoriously been hard for individual investors to represent on their own. Popular indexes like the Barclays Aggregate and Lehman Aggregate Bond indexes have ETFs modeled after them, with a focus on U.S. Treasury securities.
There are somewhat lesser known index-based ETFs that run the gamut of government bonds, corporate bonds (both investment grade and high yield) and municipal bonds.
Two of the larger players in this arena are the iShares Barclays Aggregate Bond Fund (AGG) and the iShares IBoxx Investment Grade Bond Fund (LQD).
I've also included dividend-based ETFs in this class because of their focus on consistent fixed income. While the dividend rates of individual companies are of course subject to change, many diversified funds can deliver consistent yields above that of prevailing 10-year Treasury rates (3-5%).
On the dividend side, check out the iShares Dow Jones Select Dividend Index Fund (DVY) or the PowerShares Dividend Achievers Fund (PFM).
#3 - Foreign ETFs
If a country has a developed enough economy for you to have ever read about it in the Wall Street Journal, chances are it has one or more ETFs that focus solely on that nation. These ETFs can be especially useful to retail investors because most of us can't access foreign stocks directly through brokerage accounts unless they have an ADR listed on a U.S. exchange.
Expense ratios tend to be higher for this class because of the increased costs to access foreign markets, so don't be surprised to see expense ratios in the range of 0.75% - 1.25%.
Also, remember that the economies of developing nations can be much more volatile than what we see at home, so it's best to cap your allocations toward these ETFs at 5% of your portfolio, per country. But all evidence points to the fact that emerging economies like China, Brazil and India are set to outpace the U.S. in terms of growth for many years.
It's definitely worthwhile for retail investors to get some exposure to foreign-based stocks, whether through a singular country ETF or a broad international ETF. (Think beyond your borders to reduce the impact of local market downturns. Read Finding Fortune In Foreign-Stock ETFs.)
#4 - Quantitative ETFs
These may sound daunting at first, but "quantitative" is just a fancy way of saying that an ETF has some underlying rules or strategy that is followed religiously to pick its holdings. One common strategy is to equal weight stocks, as opposed to the market cap weightings found in the S&P 500, for example.
Another strategy is to use financial metrics like earnings, revenues, cash flow and dividend yield to filter specific stocks for inclusion in the fund.
Keep in mind that some of the ETFs in this arena employ an active investing strategy more akin to mutual funds. In other words, people are making decisions as opposed to blindly following and index created by a third party. (To learn more about active vs. passive investing, check out Active Vs. Passive Investing In ETFs.)
For a starting point, check out the PowerShares Dynamic Market Fund (PWC) or the WisdomTree LargeCap Dividend Fund (DLN).
#5 - Theme-based ETFs
It's in this area that we have seen some of the biggest growth in the ETF space in recent years. Commodity-based ETFs allow direct access to everything from gold and silver to steel, crude oil and agricultural commodities. This landscape is a bit of a 'Wild West' of smaller indexes and strategies, and it can't be guaranteed that the performance of a given ETF will directly track the performance of the underlying commodity.
There are also ETFs that focus on some up and coming investing trends like socially-conscious investing and clean technology. Because there are relatively few companies focused on these emerging trends, most ETFs in this area have fewer holdings and can thus be more volatile. (Corporations that reduce their environmental footprint anticipate large long-term gains. Check out Five Companies Leading The Green Charge.)
Exchange-traded funds are certainly here to stay; that much I can say for sure. But there will be many changes to the industry in coming years, as some types of funds (such as leveraged ETFs) may see increased scrutiny or go by the wayside, while other classes of funds may see hundreds of new participants. The ETFs will follow the trends, and pop up to fill the demands of investors.
At the end of the day, investors have the ultimate power; the ease with which you can move in and out of ETFs makes them a compelling alternative to mutual funds. Do your homework and stick with the larger players in the field, and chances are you'll be able to find exactly what you're looking for in an ETF - and likely some investing ideas you hadn't even considered.
(ETNs offer yet another way to track an index. Find out what they have to offer, and what's at stake. Check out Exchange Traded Notes - An Alternative To ETFs.)
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