If you have a savings account or certificate of deposit (CD), you're probably not making much more than 1% each year from interest. That's better than spending the money, but in order for it to truly to grow in value, it has to perform better than the rate of inflation. According to the U.S. Bureau of Labor Statistics, the 2012 average inflation rate was 2.1%. Most financial planners use 3.0% as the historical average.
Investing in exchange traded funds (ETFs) is the hottest trend since the mutual fund. There are 1,445 U.S.-listed exchange traded products with a total trading volume of $1.2 trillion monthly. A 2011 Charles Schwab study found that 44% of investors planned to expand the use of ETFs in their portfolios.
Within these 1,400-plus product offerings, there are many easy-to-understand ETFs that have the potential to outperform inflation. To yield better results, you have to take on more risk, but some ETFs offer much lower risk than individual stocks. For investors with a longer-term time horizon, these ETFs can build long-term savings better than a savings account or CD.
Index ETFs follow a large market index. Investors use these funds as core holdings along with bond ETFs, which are explained later in this article. When developing an investment portfolio, it is important to take a balanced approach. Some financial planners recommend that the younger you are, the more weight stock market index ETFs should have in your portfolio.
Here are three index ETFs to take a closer look at:
SPDR S&P 500
The SPDR S&P 500 (NYSE: SPY) is an index fund that mirrors the performance of the S&P 500. It is the largest ETF in the world, as well as the oldest. The fund's fees are only 0.09% - far below the category average of 0.35%. Over the last five years, this fund has quadrupled the performance of most savings accounts each year: SPY yields 2.1%.
iShares Russell 2000 Value Index
If you want to capture the performance of smaller companies, you need the iShares Russell 2000 Value Index ETF (NYSE: IWM). With an expense ratio of 0.2%, its cost is still below the industry average, and this fund is a favorite among small cap investors.
IWM yields 2%.
Vanguard Total Stock Market ETF
If you want the broadest representation of the U.S. stock market, consider the Vanguard Total Stock Market ETF (NYSE: VTI). The fund follows an index that invests in a sample of stocks from the New York Stock Exchange and the NASDAQ. Like any Vanguard product, it is inexpensive, with an expense ratio of just 0.05%. VTI yields 2.1%.
Bond ETFs allow you to invest in the safety of bonds without the risk of holding one or two individual bonds. These funds invest in hundreds or thousands of bonds at the same time, making your money relatively safe. Don't expect to see big price gains in these ETFs. It's the dividend yield that should interest you. The older you are, the more your investment dollars should be in bonds.
Here are two bond ETFs to consider:
iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG)
This fund gives investors exposure to the higher-yielding corporate bonds on the market. It has a yield of more than 5% and an expense ratio of 0.5%.
iShares iBoxx $ Investment Grade Corporate Bond ETF
Higher yields come with higher risk. To capture the returns of higher-rated bonds, look at the iShares iBoxx $ Investment Grade Corp Bond Fund (NYSE: LQD). This ETF not only gives you the safety of investing in a large basket of bonds, but all are highly rated with little chance of default. The expense ratio is only 0.15%, and the yield is 3.1%.
Sector ETFs are riskier than the index ETFs discussed previously. Investors use these securities to add more weight in an area of the economy that they believe may outperform the rest of the economy in coming years.
You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.
If you are interested, consider these two:
Financial Select Sector SPDR
With an average trading volume of 51.5 million shares, the Financial Select Sector SPDR (NYSE: XLF) is the most popular sector ETF.
The fund invests in a basket of stocks that represent the financial sector.
The largest holdings in the fund are Wells Fargo (NYSE: WFC) and JP Morgan Chase (NYSE: JPM). Expenses are a respectable 0.18%. The fund yields 1.7%.
STRONG>PowerShares QQQ Trust Series 1
Although not technically a sector ETF, the PowerShares QQQ (NASDAQ: QQQ) is the ETF of choice for investors who want to capture the performance of the technology sector. Of the fund's assets, 63%, including all of the top 10 holdings, are invested in technology stocks. The fund has an expense ratio of 0.2%. This fund has no yield.
The Bottom Line
Keeping money in a savings account might feel safe, but its value is eroding due to inflation. That might change in future years as interest rates rise, but for now, a relatively safe way to put your money to work is through ETFs.
Use this article as a guide to start learning more. Take a look at each fund's website and learn all you can about each security you are interested in adding to your portfolio.
You should be able to talk to your friends or family about the details of the fund before investing real money. If you can't do that, you're not ready to invest.