I know, I know. Most of us know what ETFs or Exchange Traded Funds are. But you will be surprised how many people don’t know how ETFs work. For most investors, a portfolio of passive ETFs is the safest way to invest in the stock market for the long term. Why is this? Because fund managers operate ETFs. We pay a small annual fee so that they select and rebalance the funds according to the market dynamics.
An ETF is essentially a basket of stocks or assets that provide exposure to a broader sector or index. The first ETFs were established in Canada back in 1990 by institutional investors. The first US-domiciled ETF was SPY, the State Street SPDR ETF that tracks the S&P 500 index. According to a recent Statista report, more than 8,550 ETFs trade globally. They have become an overwhelmingly popular investment asset for casual investors.
The Difference Between an ETF and a Mutual Fund
You might be thinking that an ETF sounds suspiciously like a mutual fund. In actuality, the two are very similar. Mutual funds tend to have much higher management fees, as they are typically actively managed assets. ETFs are designed to be passively managed. Since there is less work for fund managers, there are understandably lower fees.
Mutual funds also do not trade on the stock market per se. Instead, they trade through their providers, usually big banks or other financial institutions. ETFs trade directly on stock exchanges like the NYSEARCA and even the NASDAQ. This means they can be traded multiple times daily, and you can even trade options for them. It also means ETFs have the flexibility of stocks but provide exposure to a much wider selection of assets.
It doesn’t hurt to own both if you’re looking for a diversified portfolio. In the long run, ETFs are proving to be the better asset simply because the fees are much lower, which will help you sustain your gains in the future. Mutual funds have their benefits. You don’t need to buy whole shares like you do with ETFs. Instead, you can add a lump sum and buy units. Still, with fractional share investing, this has largely been removed as a benefit for mutual funds!
What to Look for in an ETF
This is key! There are several things you’ll want to look at with ETFs. For example, one gold ETF might not be the same as the next. ETFs that track things like the S&P 500 will have the same components, but for other more specialized ETFs, it is up to the fund managers which assets are included.
What is the MER?
The MER and the management fees go hand in hand. MER stands for Management Expense Ratio and is an annual fee charged to the ETF shareholder. An MER is calculated as a percentage per $10,000 invested. For example, an MER of 0.10% is fairly standard. So this means for every $10,000 invested into the ETF, the investor will be charged $10.00 per year.
Finding a lower MER is key to locking in long-term gains for your ETF investments. Take two S&P 500 ETFs: SPY and VOO. SPY is the one that everyone knows. It was the first ETF in the US, with an inception date in 1993. But it has an MER of 0.0945%. Not bad right? VOO has an MER of 0.03%, so for two ETFs with the same constituents, why wouldn’t you choose VOO with a third of the fees over your investment?
This is why shopping around for low MERs is a good strategy for ETFs. Certain funds may offset a higher MER with a higher distribution yield (read as a dividend). Fine, this could even things out, but you may be investing in the ETF in an account that taxes you on dividends. In this case, I’ll take the lower MER any day!
Regarding ETFs, distributions are just another way of saying dividends. Yes, ETFs pay distributions, some of which can be quite high! So while you might receive more in dividends if you own each stock, you would also need to put up more in initial capital. Nevertheless, ETF distributions can be a great source of continuous income for your portfolio. Some ETFs hold high dividend-paying stocks and will pay a monthly distribution.
Choosing a high distribution isn’t always the best. First, you’ll want to examine the distribution history and the 12-month trailing yield. This will give you an idea of how sustainable a distribution is. There are also high-distribution ETFs that hold covered calls or other investment vehicles. These can be great for short-term income but not long-term capital growth.
One of the most important things to look for is the holdings itself. You can buy ten different ETFs that track the US stock market. The odds are that most will hold some combination of Apple, Microsoft, Alphabet, Amazon, and Tesla. These are great stocks, but you’re not diversifying if all your ETFs hold the same stocks.
Look carefully at the holdings, especially the top ten or so weighted allocations. You’ll want to ensure you diversify your portfolio and hold different stocks from different sectors. Also, check that the ETF holds stocks you believe in. Don’t blindly trust a fund manager because many ETFs don’t have positive returns. As always, research the stocks and ensure they jive with your investment thesis and strategy!
How to Build an ETF Portfolio
Ideally, you’ll want to hold about 5-10 core ETFs, but there is always room for more. I’m against putting all your eggs into one basket, especially for casual investors. People like Warren Buffett can do this, but he can also afford to make a few mistakes. The goal for ETF investing is long-term capital gains, with passive and defensive positions for a bull or bear market.
Balancing some high-growth ETFs like the QQQ, which covers the NASDAQ 100 index, with some blue-chip ETFs like the Dow 30 or a gold ETF is key. You don’t want all growth, but you don’t want all value stocks. This also depends on where you are in your investing career. Those closer to retirement will likely want security and might want to invest in dividend-yielding ETFs. Younger investors will want long-term growth and might opt to invest in more growth-oriented names.
Sector ETFs are great, and I recommend having at least one index ETF, preferably VOO. Since its inception in 1957, the S&P 500 has had an average annual return of about 10.5%. That seems like a pretty good foundation for your portfolio! Sector ETFs like gold, semiconductors, or international markets are also great. For example, Vanguard has the Total International Stock Market ETF, which is EX-US, meaning it doesn’t hold any US stocks. It also offers the All World Ex-US ETF as well. These are great to hedge against the US stock market. Again this goes back to having all of your eggs in one basket.
Don’t be afraid of some high-growth, riskier ETFs as well. Look at ones like the Innovation ETFs from Ark Invest or even biotech or medical technology ETFs. These might not be doing well right now, but just like the stocks, they could be in for mega returns ten or twenty years from now!
Is ETF Investing Right For Me?
The answer to this is yes! No matter how much of a day trader you are, there is always room for ETFs in any portfolio. Even the highest leveraged crypto traders hold passive ETFs in their retirement portfolios. It’s an easy way to have stable income and growth over decades.
So if you are a day trader, swing trader, or even an options trader, that’s perfectly fine. Assuming that you are making gains, there is never any harm in skimming some profits and putting those into a more stable investment like ETFs. For 99% of investors, having a passively managed portfolio of diversified ETFs is the safest way to protect your money while allowing it to grow. BullishBears wants to help you with all types of trading and investing. More than anything, we love to educate you on the different ways to invest in the stock market. So while I love to write about high-growth stocks and options trading, there is also a lot of merit in learning about passive ETF investing!