What the Heck is an ETF? More on Understanding Funds

When I first started this blog several months ago, I added a snappy little glossary definition of ETF's, figuring that I would not be able to get many of you excited about them as a topic. But the other night I got a question from a reader about these increasingly popular investment vehicles, so I have decided it's time to give you the fully story (or at least the slightly-longer-but-not-too-tedious story)—

Let's start with my original glossary definition:

An investment fund that tracks a list of stocks, bonds, commodities or other investments. Investors own shares of the fund, rather than directly owning the investments within it. Unlike mutual funds, ETF's trade like a stock such that the price changes throughout the day.

The best known ETF's are index funds and are popular for their low costs.

If you really want to wrap your head around ETF's, you need to understand how funds in general work. A fund is a like a shared pot for which the fund manager buys a selection of investments. Those investments are usually stocks or bonds, but there are other investments they can choose from as well. Once the fund manager has created that "pot", she will buy and sell investments according to whatever strategy she has laid out at the beginning—think of that strategy as the fund's "recipe." The recipe can be pretty precise: "I'll only buy stock from companies that make things out of timber." It can be broader: "I'll look for the most undervalued stocks in the U.S. market." Or it can be blended: "I'll always keep 70% U.S. stocks and 30% U.S. bonds."

Regardless of the fund manager's strategy, all of the money for these purchases comes from people like you who buy shares in the fund. And this raises the question of how you buy "into" the fund...and how you get your money out. This is where the type of fund you buy—ETF or mutual fund—makes a difference. If you want to purchase or sell one share of a mutual fund, you will always find the price of a share from the fund's Net Asset Value (NAV for short). That number is a simple calculation of how much the fund's current investments are worth, and it's only calculated once a day—at the end of the trading day. Simple!

An Exchange Traded Fund (or ETF) doesn't make things so easy. Just as stock prices slide up and down over the course of a trading day as people bid and sell them, an ETF price slides around constantly depending on how much traders in the market are willing to pay for a share in it at that moment. If everyone is betting that the fund manager is doing well, the price of a share in the ETF will go up (and vice versa).

Should you buy ETF's?

As you can see from my glossary entry, ETF's have been a particularly popular form of "pot" for a fund manager wanting to create an index fund, where the "recipe" is to have a little bit of everything on a given list (say, all companies on the S&P 500, or all U.S. oil companies). With index funds, a computer does most of the work calculating buys and sells, and the fund manager generally can charge you, the fund owner, a little less as a result. Lower fund management fees is always a good thing.

And there is one other thing you should know about ETF's vs. Mutual Funds—the taxes are different. If you own a share of a mutual fund, you and the rest of the fund's owners will share the fund's tax bill at the end of the year. These are called contribution taxes, and they come from the capital gains taxes created when the manager sells an investment in the fund for more than she paid for it. As with any investment, you will also pay a capital gains tax on your shares when and if you sell them for more than you originally paid.

On the hand, the IRS treats ETF's like a big, funny looking stock. As with the mutual fund (and other investments) you pay capital gains taxes when you sell your shares. But the IRS ignores the fact that the ETF has all of that other buying and selling going on inside it, which means no contribution taxes for you. A lot of investors and fund managers choose ETF's over mutual funds for this tax efficiency.

Have more questions about ETF's or other investments? Post something to me in the comments box below!

Have you diversified your account...or just made it really complicated?

"Diversify!" we say, and most of the individual investors I've seen seem have listened. For years brokers, financial planners and online experts have been saying that you need to have a healthy blend of different stocks, bonds and funds to invest successfully. Unfortunately, we do not seem to have done such a good job of explaining how many investments there are in a "healthy blend." I know this because I continue to see new clients walk in with respectable little investment accounts broken up into enough funds to choke a stockbroker. So how many investments do you really need?

Let's start with this fact—the whole reason that mutual funds were invented was to make diversification easy. The fund itself is meant to be an instant portfolio, a mix of different stocks or bonds that you can buy all at once instead of in a hundred different purchases. So, the easy answer to "how many funds do I need?" is often just, "one."

But, of course, there are different kinds of diversification. Buying a little Apple, a little Expedia and a little Home Depot stock will give you some diversification in that, if one goes down, the others might not. But Apple, Expedia and Home Depot stocks all have something in common—they are are all U.S.-based companies with large market capitalization (called "large cap" stocks, it means they have more than $10 billion invested in them). And we've noticed that stock markets being what they are, when people sell off one U.S. large cap stock, they often sell off a lot of others like it.

Because of this, we have a second kind of diversification—you don't just mix the stocks themselves, but also the kind of stocks...or bonds, or REIT's or other investments. This earlier post on asset allocation talks about the different asset classes we use for this kind of diversification. As much as we in the investment industry like to complicate things, most investment accounts don't need more than five or six funds to be fully diversified. Many accounts don't even need that many. A single target date fund is an easy way to hit the basics, and a simple trio of U.S. stock fund, bond fund and non-U.S. stock funds is an easy and very respectable solution for a basic investment account.

So what is the problem with being over-diversified?

The biggest problem with having too many investments in your account (aside from the mile-long quarterly statements) is that you are likely to fall into a common trap—un-diversifying your account. By this I mean that too many investors put their money into such a complex array of funds that they don't realize how many of those investments are actually the same. It's no wonder when we look at the fund names. I mean, really, what is an "advantage" fund supposed to be? How about a "blended style fund"? A "new perspective growth fund"? It's no wonder people end up choosing randomly and hoping for the best. But more often than not, this ends in a portfolio that looks diverse from afar but turns out to be a lot of different funds all holding basically the same stocks (most often, the U.S. large cap list). If you aren't going to consult with a financial planner, the only solution to this is to do your homework on what those funds really are.

There is one more kind of diversification.

So far, I've talked about simple diversification and asset allocation, but there is one more, really important type of diversification. And that's a diversification that takes into account what is outside your investment accounts. If you work for Software Company X, and more than 50% of your investment account is in similar tech companies, you should probably think about the effect a downturn in the industry might have on your finances. Likewise, if you've got most of your savings tied up in a small business venture with your cousin or a real estate venture with your best friend from college, think twice about going heavy on similar investments in your account. Your investment account is part of a much larger strategy for creating income and protecting savings. It needs to work alongside all the other resources in your life. And that might mean fewer investments in the account to balance out whatever you have going on outside the account.

Simple and Growing.

Sometimes diversification is a process, especially if you have a small account but are regularly adding to it. Don't be afraid to start with one or two asset classes that are selling at a lower price right now and then add in, say, a mid-cap stock fund or an international stock fund later. Just be sure you know the asset classes or investments types you want to have and try to limit yourself to one fund for each of them as you grow, even if that means starting with a single fund. In the end, the greatest challenge in investing isn't that complicated—make sure you have a good strategy and stick with it as you build. Investing can be difficult but that doesn't mean it has to be complicated.

What To Do When The Stock Market Drops

Just in case you've been reading any of the ominous predictions about our lazy "bull" market or about the panic in China's market, I thought it was a good time to talk about when you should be making changes in your investment account. The short answer to "what should I do when the market drops" is easy—not much. But there are some reasons to do some trading in your account. Here are some things that go wrong in investment accounts—and how often you should check on your accounts to fix them:

1. Lazy cash. You've set up your investment accounts, bought your first stocks or funds and started adding regularly to your account. Great! But if you don't make some kind of arrangement for your new deposits to get invested, all of that money you are adding to the account might as well be stuffed under your mattress. If possible, automate your account to invest new deposits and check quarterly. Otherwise schedule a review monthly or quarterly (depending on how much you are adding) to invest the new cash;
2. Out-of-Whack Allocations. You've created a fantastic portfolio model for your investments and bought all the right percentages of large cap stocks, bonds, small cap stocks, etc..., and now you can sit back and let it work. Except that, as it works, some of your assets will be doing better than others. Over time, this means that one of or two of your asset classes will be growing larger and faster than others. At some point, you will need to rebalance. Notice that this mean buying the kinds of investment that did worse in the market. This is not a mistake—markets frequently cycle so that the investment on the bottom this year is likely to be on top a year or two from now. Check a minimum of once a year up to four times a year to be sure that you are still within range of the portfolio model you originally designed;
3. Change of plans. Sometimes it's your plans that change; other times, it will be a fund manager or company. If you are invested directly in stocks, this may be a case of your chosen small-cap company being bought out by a large multinational. If you are in funds, you may find that the original investment objectives of the fund has changed from investing in a good mix of stocks and bonds to primarily bonds (if you were counting on this fund for your bond allocation, you need to come up with a substitute). At your once a year check, take a look at the investments in your account ("positions") AND click on the name of funds to review their holdings.

And here is the #1 reason not to make changes in your investment account: stock market headlines. Why? Because you came up with a plan for how you want to manage your investments, and if that plan did not account for the ups and downs of every stock market, then it really wasn't a plan to begin with. Don't get thrown off by people trying to create more readers.

How To Open An Investment Account

So you are ready to open your first investment account! Believe it or not, this is the easiest step in your plan to start investing, and you have a few choices. Here is a quick look at your options and the pro's and con's of each:

1. Full Service Advisor

This is your best option if your goal is to tackle your finances as a whole and not just your investments. Advisors handle the investing for you, but they also can handle everything from budgeting questions and debt strategies to retirement concerns and emergency funds as questions come up over time. Note, though, that "Financial Advisor" can mean a lot of things—RIA's, CFP's, and Brokers all have different roles and requirements (click on the terms for a quick look at their meanings).

A lot of what you are paying for with a full service advisor is the personalized financial and investing advice. If you just want someone to keep an eye on your investments, and you don't have a particularly large amount to invest, you might consider option two...

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 2. Automated Advisor

Often referred to as Robo-Advisors, these are online platforms that give you a bare minimum of investment help for a low charge. They are fairly new to the market but all offer you an easy way to allocate your money in different investments once you've signed up and answered the basic questions. Some (like ours) hold the money with a designated custodian and do the rebalancing and re-allocating for you over time. Others give you limited access to advisor to help you follow your plan in your own accounts. If you really want to go it alone, try option 3 or 4...

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3. Brokerage Account/Discount Broker

These are the "stock accounts" we've all heard about. Once upon a time, they were the domain of the wealthy, but discount brokers like eTrade and Scottrade have made brokerage accounts available to just about anyone. Online brokers usually give you access to a long list of stocks, ETF's, Mutual Funds, and other publicly traded investments, but no advice on what to buy or sell. You pay them a commission, usually called a "transaction fee" for each trade you make.

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4. Fund Company Account

Let's say you have set out your investment strategy and realized that you plan to only invest in ETF's and mutual funds that are all from the same company. If that's the case, you may be able to open an online account directly with the fund company. Investing directly with a fund company can help you avoid transaction charges and account minimums and keep your investing simple.

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How To Choose An Investment

There is a vast sea of investment information out there— so much information, in fact, that it can be tough to know where to look. This post is going to tell you about the few key pieces of information you need to check before buying an ETF/Index or Mutual Fund and were to find that information on the internet. Let's start with some  screen shots from BlackRock's iShares S&P 500 Index, a popular ETF that has received a lot of attention in recent years.* Here's the header at the top of fund's web page—I've add the yellow comments to help things along:

  Investment Objective

Ignore the price quotes with the pretty green and red arrows and look for the "Investment Objective." This tells us the goal of the fund, and it means you can immediately rule out funds that don't fit into your strategy regardless of where the arrows are pointing.

In this case, we are looking at a true index fund—the whole purpose of it is to invest in all or most of the large capitalization companies that make up the S&P 500. If you are trying to find a way to invest in a broad range of large U.S. companies, this might be right for you. But there are all sorts of other objectives out there. You will find funds trying to track small U.S. or international companies, track only energy companies, blend stocks and bonds, minimize taxes, minimize risk (i.e. "low volatility" funds) or even maximize risk in the search for higher returns. Just make sure the goal of the fund matches your goal as an investor.

And before you actually make a purchase, be sure to download and read that prospectus—fund companies are required by law to provide it to you.

Performance and Benchmarks

Assuming the objective matches yours, your next glance should be at performance. Online fund charts now often provide you up to the minute information on the fund's price, and the chart is almost always set to show you only the last year (and often, only the last day). A fund's past success never means that you can count on it to perform in the future, but the fund's performance over the past year is especially useless. Click on the 10 year (10Y) option to see how the fund has done over a much longer timeframe. And crucially, compare your fund's performance to its benchmark.

What is the benchmark? The benchmark will be the market index that best matches up with the fund's investment objective. If the fund tracks bonds, it will be a bond index; if it tracks technology companies, it should be a technology index. The benchmark gives us a better idea of how well the fund is doing at what is designed for.

 Fees: What are you paying?

Investors routinely miss this little statistic (I couldn't even find it on Google Finance or Yahoo Finance's page for IVV), but this one is a big part of your decision. The Expense Ratio will be a percentage, and it tells you how much of the money you put into the fund will go to paying for fund management fees every year. To find out what you personally will be paying every year to own the fund, multiply the percentage by the amount you plan to invest.

In this case, I've chosen to show you one of the least expensive funds out there—you won't find many this cheap. Mutual funds on average range between 1 and 2%, while Index Funds average somewhere around .5% (it takes more work to manage a collection of stocks than have your computer track an index!).

You will find plenty of cases where two funds with similar holdings and objectives vary wildly in price, so make sure you aren't losing you money to management fees right off the bat.

Holdings and Risk

Now let's look at the bottom of the fund profile page:

If the fund has been clear and accurate with it's objectives, the holdings list at the bottom should not come as a surprise, but you should always take a quick glance at what you are buying. Does it overlap a lot with another fund you own? That's a warning sign that you may be paying for two funds where you only need one.

Now note the "Standard Deviation." This number will be a percentage, and it is meant as a quick indicator of how volatile the investment is likely to be—how much it's price will go up and down. Here we see that IVV's standard deviation is 9.58%, which is not coincidentally about the same deviation as the S&P 500 Index. Don't worry too much about how this number is calculated, just know that 9.58% puts IVV in the middle of the pack (deviation-wise) for publicly traded funds. At the riskier end are things like emerging markets, which might have standard deviations around 20% and "low" or "managed" volatility funds, which might have standard deviations of only 3% to 4%.

Standard Deviation is not the only indicator we use to determine whether an investment is risky (other common measures of riskiness include alpha, beta, Sharpe ratio, and R-Squared), but it does give the average investor some warning about how much an investment's price is likely to swing up and down.

One More Factor To Consider

If you are looking at a mutual fund, rather than an ETF, you may have to contend with minimum investments, especially if you are buying within another investment company. Check the sidebars of your fund profile to see if there is a minimum. And if you do see one, but like the fund, check the fund company's own website to see if it available directly through them without minimums.

*note that this does not constitute an investment recommendation for any of you out there—just an investment example.