What are ETFs and How To Invest with ETFs

Exchange Traded Funds (ETFs) are a great way for investors to diversify their money from their regular brokerage account.  (The alternative would be to have a separate account with a mutual fund company.)  This allows you to have a single IRA account, for example, and invest both in individual stocks and index mutual fund-like assets.  ETFs are also a way to invest in specific sectors of the market since there are ETFs that track most market segments.  Finally, ETFs tend to have lower fees than all managed mutual funds and even most index mutual funds.  Since the fees you pay can greatly affect your outcome, ETFs are a smart way to invest for long periods of time.

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The first ETF that existed was the Standard and Poor’s Depository Receipts (SPDR)s, which went by the name “Spiders.”  This ETF invested in all of the companies that were in the S&P 500 index, which is a group of 500 of the biggest and most dominant companies in the United States.  By purchasing shares of Spiders, investors could invest in all of these companies and track the performance of the S&P 500 index.  Given that less than half professional mutual fund managers beat the S&P 500 over long periods of time even before fees are taken out, this was not a bad way to invest.

With the huge success of Spiders, the Small-Cap Spiders and Mid-Cap Spiders were soon created.  These tracked small company stocks and mid-sized company stocks, respectively.  Today, with investments in just Spiders and Small-cap Spiders, an investor could create a well-diversified portfolio of US stocks with very low fees.

After Spiders, other ETFs started to be created.  The DIAs (or “Diamonds”) were created that track the Dow Jones Industrial Average.  Then, sector ETFs were created that invested in all of the companies within a certain sector of the market.  For example, there are ETFs that track healthcare, utilities, retail, transportation, and basic materials.  This allows you to pick specific sectors of the market you think will do well.  For example, early in a bull market technology stocks might pick up as businesses start to upgrade their business accounting systems.  As things really start humming, basic materials might start to do well.  During down periods, consumer staples would be the place to be since these are things consumers need to buy no matter what.

Finally, there are also ETFs that are designed to go opposite the market.  These are called “Short ETFs.”  You might buy these ETFs if you think the market is about to take a tumble since as the market falls these ETFs will rise in price.  This would also be a good way to protect a portfolio if you just wanted to lock in your gains and sell during a later year to delay or reduce taxes.  Note that there are also ETFs called “Ultra Short ETFs” that are designed to go up two or even three times as fast as the market goes down, but these are poorly designed.  If the market zig-zags on its way down you can actually lose money investing in these due to the way they are designed to match double the daily change in the Index rather than the long-term value change.

Buying ETFs is just as easy as buying shares of stock.  You simply pick out the ETF and then buy it through your regular brokerage account just as if you were buying an individual stock.  Each ETF will have its price listed on the stock exchange (usually the American Stock Exchange) alongside the individual stocks.  Each ETF will also have a ticker symbol just like an individual stocks (Diamonds, for example, have the symbol DIA.)

So what is the best way to use ETFs in your investing?  In general you want to have a portion of your portfolio diversified (invested in a lot of different things).  When you first start investing you may want to just invest in a few individual stocks (assuming you have a separate retirement account that is invested in mutual funds).  As you start to build wealth, however, you’ll want to shift a portion to ETFs to reduce the risk of a significant loss.

Because large stocks and small stocks tend to do well at different times, holding relatively equal portions of each is a good idea. Also, smaller companies tend to do better over long periods of time while large companies tend to be more stable, so holding a greater percentage in small-cap stocks when you are young and then shifting to a larger percentage of large-cap stocks when you’re nearing retirement is wise.

So, you might put 70% into the Small-Cap Spiders and 30% into the regular Spiders when you were starting to invest at 20 and then shift to 70% regular Spiders (or maybe 35% Spiders and 35% Diamonds) and 30% Small-Cap Spiders when you were 60. You would also build up a portfolio of fixed-income assets like bonds and high yielding investments like dividend paying stocks and REITs as you approached retirement. A portfolio for someone who was 60 might therefore be 50% bonds and dividend paying stocks, 35% Spiders, and 15% Small-Cap Spiders.

For example, you might start out by purchasing shares in 3-5 stocks that you consider to be the “best of breed” in each of 3-5 different sectors.  You might then decide to purchase an ETF (a Small-Cap Spider would be a good choice if you are young and have a long time to invest).  You might have somewhere between 10% and 20% of your investments in the ETF with the remainder in your individual stock selections.

You would keep investing, building the positions up to the 500-1000 share range and adding to the ETF to keep it in proportion until you had maybe $100,000 in your portfolio.  If you had a stock that did well, you might now have  one stock position worth $30,000 to $40,000, others in the $15,000-$25,000 range, and then maybe $20,000 in your Small-Cap ETF.

At that point you might want to cut back on the large position, maybe selling half, and buy into the Large Cap Spider or a combination of Spiders and Diamonds.  You would keep investing regularly from your paycheck and keep shifting funds from your individual investments as they grew too large to withstand a loss of the whole position.  This would continue until you were well into your forties and hopefully had a portfolio worth over a million dollars with maybe $500,000-$750,000 in ETFs.

In general it is not worth using the sector ETFs because it is very difficult to determine which sector will be hot in the future.  You will usually end up buying in when it has already been bought up, causing the price to be high, and then miss out on another sector that is doing well.  It is also usually not worth buying the short ETFs, even if you think the market is going to swoon, because rallies often last a lot longer than you think they will.  The one exception is if you just want to lock in your gains but not sell because you want to delay the taxes.  In that case you might buy into a short ETF to offset any movements in the long ETFs you own and then accept the fact that your portfolio value will not grow until you close the short position.

ETFs can be a great way to diversify in a regular brokerage account.  They are also much cheaper than mutual funds, adding to your long-term gains.  They belong in the portfolio of virtually any investor.

Contact me at VTSIoriginal@yahoo.com or leave a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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