The beginning investor, or what the finance world calls the “retail investor,” has a lot of homework to do. Stocks? Bonds? Mutual Funds? And once the asset class decision is figured out, the decision of which specific asset to choose as an investment vehicle immediately rears its devious head. While most “experts” generally tell beginning investors to pick stocks as investment vehicles, most “experts” are probably active traders. The active trader is heavily involved in the research and trading of personally owned stocks, and other asset classes. The passive trader is someone who works 9 to 5 in a field other than finance. While the passive trader still devotes time to investment homework, she can not possibly match the active trader in breadth, depth or analytical knowledge of one stock.
There are people hired by various banks and financial institutions to sleep, breathe and eat just a handful of stocks.
The knowledge and time deficit exhibited by the passive trader is a fantastic reason why investing in ETFs should be explored. Here are five reasons why index funds should be considered as part of your portfolio.
- Investment, Meet Diversification. Diversification is not just the opportunity to make more money by spreading the pennies. Diversification is an insurance policy that you will not lose all of your pennies. ETFs meet the diversification criteria because the goal of an ETF is broad market, albeit concentrated, exposure. Take a look at the iShares Russell 2000 Growth ETF. The ETF is focused on identifying growth companies, that operate in America and can be acquired at a reasonable price. Look at the breakdown of sector concentration.
- Actively Managed, but Not Managed Actively
Most ETFs follow a very simple strategy: invest in the market. The EFT manager simply creates a fund that follows an entire index, like the S&P 500. An example of this would be the SPDR S&P 500 ETF (SPY). When the S&P 500 moves up, on average, SPY moves up. When the S&P 500 moves down, on average, SPY moves down. The manager will re-balance the fund every so often to keep the ETF diverse, but also maximize profits. If Apple is soaring, then the manager may purchase more Apple stock (AAPL) while decreasing positions in others. For this management, you may pay a fee.
Now, the iShares Russell 2000 Growth ETF is more actively managed. The managers and analysts look for domestic growth stocks and take small(ish) positions in each stock for a well balanced portfolio.
- Less Homework
The big reason why many “experts” find a certain disdain for ETFs (and other managed funds) is because of the fees. Yes, you will pay a fee in order to take part in these funds. But, if the fund performs well – which is very easy to check on a regular basis – I think the fee, which may take the form of increased commission at the time of purchase, is well worth knowing that someone with more knowledge and analytical power is watching over your investments. ETFs make money through fees, and the way the acquire more fees is to bring in additional investors.
A Word of Warning
ETF investing does not come without caution. Remember, they are simply funds that follow multiple stocks – some more than others. Some ETFs are very narrow, and very focused, on growth. A focus on growth is always accompanied by increased risk. An ETF like SPY that holds 99 stocks is interested in balance. Within your ETF investment portfolio, you should still aim to diversify. Don’t park all of your money into one ETF. And don’t park your money into too many. Why? Because, within the world of funds, it is easy to have a portfolio with redundancies. This happens when too many of your ETFs contain too many of the same holdings.
Now, in some cases, that’s fine. If you purchase two growth oriented ETFs, they both may contain a stock that is poised to gain. But when you purchase those growth oriented ETFs, then a technology EFT, then a healthcare ETF, and, finally, something like SPY, you may have the same stocks being a primary driver of the EFT if the stock spans multiple sectors. Though you have a very diverse portfolio, the assets within those funds expose you to additional risks.
ETFs are awesome because they are very transparent. At any given time, you can go to the ETF website, or some other financial application, and see which stocks the ETF holds, at what percentage, and how those stocks are moving.
Please note that ETFs are a long term commitment. Because the commission structure is greater than a typical stock, ETFs should not be traded in the short run.