Exchange-traded funds (ETFs) are one of Wall Street's best innovations: They allow individual investors to buy and hold a whole portfolio of stocks or bonds, and pay very low expenses to do so. ETFs get their name from the fact they trade on stock exchanges, in contrast to shares in other funds, like mutual funds, which are purchased directly from the companies that manage them.
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All about the index
The vast majority of exchange-traded funds are designed to track an "underlying index" of investments. Unlike actively managed mutual funds, most ETFs do not employ costly stock pickers or investment analysts. Instead, they simply construct their portfolios so that the portfolio matches an index of stocks or bonds.
The largest ETF in existence is the SPDR S&P 500 ETF(NYSEMKT: SPY) which tracks the S&P 500 index. The S&P 500 index, by design, holds the 500 largest companies on American exchanges (more or less; valuations do fluctuate, after all). Its constituents make up approximately 80% of the U.S. stock market's value, which makes the S&P 500 a fair "benchmark" for the overall performance of U.S. stocks.
ETFs have a huge cost advantage on other funds. Image source: Getty Images.
Over time, the S&P 500 and the ETFs that track it have outperformed the vast majority of large-cap stock funds. This outperformance has everything to do with fees. A recent study by the Investment Company Institute found that stock index funds like ETFs have an average annual expense ratio of 0.09% vs. 0.82% for the average actively managed fund.
Those lower expenses are a tremendous advantage for investors. The S&P 500 has produced a long-term annual return of approximately 9%, but investors who pay 1% a year in fees to get that performance end up with much less money than investors who pay just 0.1% in fees.
Source: Calculations by author.
How to pick an ETF
Picking an ETF is just like picking a mutual fund, or any other type of investment. The typical rules apply: You should look for ETFs that are diversified, transparent in their strategy, and inexpensive to hold.
Many people do very well by using ETFs as the basic building blocks of their portfolios. With just a few funds, you can diversify your holdings across thousands of stocks in different sectors (energy or banking, for example) of various sizes (small cap stocks to large cap stocks).
The S&P 500 is by far one of the most popular indexes for ETFs to be based upon, but there are thousands more. Generally, indexes are categorized by the underlying stocks' market capitalization, or market values. Here are some popular ways stocks are sliced and diced into ETFs:
Total stock market
Vanguard popularized the concept of the total stock market index fund. The Vanguard Total Stock Market ETF (NYSEMKT: VTI) holds virtually every stock on the U.S. stock exchanges, from companies worth hundreds of billions of dollars down to companies with a value of just $3 million, and thus includes more than 3,500 individual stocks.
These ETFs hold only the largest companies in the market. The S&P 500 is the most popular large-cap index, whose components make up roughly 80% of the value of the U.S. stock market. Other popular indexes include the Russell 1000, which includes the 1,000 largest stocks of the Russell 3000 index. Stocks in the Russell 1000 collectively make up about 92% of the total value of the U.S. stock market. The SPDR Russell 1000 ETF (NYSEMKT: ONEK) is the least expensive ETF for this particular index.
The S&P MidCap 400 index is the index for mid-cap stocks. Its compenents are selected by committee; the index simply requires that stocks have a market capitalization between $1.6 billion and $6.8 billion. The iShares Core S&P Mid-Cap ETF (NYSEMKT: IJH) is the least expensive of funds that track this index.
There are two popular indexes for small-cap stocks. The first is the CRSP U.S. Small Cap Index, which holds stocks that are in the bottom 85% to 98% of U.S. stocks by market value. The Vanguard Small Cap ETF (NYSEMKT: VB) is based on this index. The Russell 2000 is another popular small-cap index. It tracks the bottom 2000 stocks of the Russell 3000 index. The iShares Russell 2000 ETF (NYSEMKT: IWM) is the largest ETF tracking this particular index.
Being smart with ETFs
Because exchange-traded funds are bought and sold just like stocks, investing in them requires investors pay a little more attention to the actual process of buying or selling.
The first thing you should know is that you'll have to pay a commission to buy and sell an ETF just as you would a stock. Some brokers have commission-free ETFs, or a list of ETFs that you can trade without paying a commission. Using a broker with a good list of commission-free ETFs would be a good way to reduce your transaction costs.
Secondly, investors should pick ETFs that have higher daily trading volumes, which will limit the risk that they'll have to pay a premium to buy the ETF. While there is no one-size-fits-all rule, in general, exchange-traded funds with about 500,000 shares of average daily trading volume are liquid enough for retail investors to buy and sell without "moving the market," so to speak.
Investors who keep their transaction costs low when buying ETFs unlock the full power of the advantages that ETFs have to offer -- above-average fund returns thanks to lower-than-average expenses.
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