Investing in ETFs For Dummies. Russell Wild

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 that 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, for reasons I make clear in Chapter 6.

Choosing between the classic and the new indexes

      Some of the ETF providers (Vanguard, iShares, Schwab) tend to use traditional indexes, such as those I mention in the previous section. Others (Invesco PowerShares, WisdomTree, Guggenheim) 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 (IVW), you’d be buying into a traditional index (large U.S. growth companies). At about $117.30 a share (at this writing), you’d plunk down $11,170 for a portfolio of stocks that would include shares of Apple, Microsoft Corp., Walt Disney, Facebook, Amazon, and Johnson & Johnson. If you wanted to know the exact breakdown, the iShares prospectus found on the iShares website (or any number of financial websites, such as http://finance.yahoo.com) would tell you specific percentages: Apple, 7.48 percent; Microsoft Corp., 4.10 percent; Walt Disney, 1.75; 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 (EWJ), with a market value of about $13.30 per share as of this writing, your $1,330 would buy you a stake in large Japanese companies such as Toyota Motor, Honda Motor, Mitsubishi, and Softbank Corp. 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 PowerShares Dynamic Large Cap Growth Portfolio (PWB), you’ll buy roughly $3,100 worth of a portfolio of stocks that mirror a very unconventional index – one created by the PowerShares family of exchange-traded funds. The large U.S. growth companies in the PowerShares index don’t include Apple, Microsoft, or Amazon, but rather companies like Schlumberger N.V., Bristol-Myers Squibb, and MasterCard Incorporated. Invesco PowerShares refers to its custom indexes as “enhanced.”

      A big controversy in the world of ETFs is whether the newfangled, customized indexes offered by companies like Invesco PowerShares make any sense. Most financial professionals are skeptical of anything that’s new. 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.

      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. More on that topic later in this chapter and throughout the 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 II of the book.

Preferring ETFs over individual stocks

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

      You may recall that in August 2010, HP CEO Mark Hurd suddenly resigned over a sex scandal. The stock plummeted, and HP shareholders lost billions. A few years before that, the always fashionable Martha Stewart was convicted of obstruction of justice and lying to investigators in an insider-trading case involving a small company called ImClone. Within hours, shares in Stewart’s namesake firm, Martha Stewart Living Omnimedia, tumbled 23 percent.

      Those sorts of things – sometimes much worse – happen every day in the world of stocks.

      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 Ghandi – or Martha Stewart.

      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, 2 or 3 percent these days) is generally considered a pretty big deal.

      

If you, like me, are not especially keen on roller coasters, then you are 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 is 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 managers of the ETFs tend to do very little trading of securities in the ETF. (The ETFs are passively managed.) Most mutual funds are actively managed.

      ✔ Although they may require you to pay small trading fees, ETFs usually wind up costing you less than mutual funds because the ongoing management fees are typically much less, and there is never a load (an entrance and/or exit fee, sometime an exorbitant one) as you find with many mutual funds.

      ✔ Because of low portfolio turnover and also the way ETFs are structured, ETFs generally declare much less in taxable capital gains than mutual funds.

Table 1-1 provides a quick look at some ways that investing in ETFs differs from investing in mutual funds and individual stocks.

Table 1-1 ETFs Versus Mutual Funds Versus Individual Stocks

      Why the Big Boys Prefer ETFs

      When ETFs were first introduced, they were primarily of interest to institutional traders – insurance companies, hedge fund people, banks – who often have investment needs considerably more complicated than yours and mine. In this section, I explain why ETFs appeal to the largest investors.

Trading in large lots

      Prior to the introduction of ETFs, a trader had no way to buy or sell instantaneously, in one fell swoop, hundreds of stocks or bonds. Because they trade both during market hours and, in some cases, after market hours, ETFs made that possible.

      Institutional investors also found other things to like about ETFs. For example, ETFs are often used to put cash to productive use quickly or to fill gaps in a portfolio by allowing immediate exposure to an industry sector or geographic region.

Savoring the versatility

      Unlike mutual funds, ETFs can also be purchased with limit, market, or stop-loss orders, taking away the uncertainty involved with placing a buy order for a mutual fund and not knowing what price you’re going to get until several hours after the market closes.

      And because many ETFs can be sold short, they provide an important means of risk management. If, for example, the stock market takes a dive, shorting ETFs – selling them now at a locked-in price with an agreement to purchase them back (cheaper, you hope) later on – may help keep a portfolio afloat. For that reason, ETFs have become a darling