Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part I. The Essentials of Stock Investing

Chapter 5. Stock Investing through Exchange-Traded Funds

IN THIS CHAPTER

Seeing similarities and differences in ETFs and mutual funds

Picking a bullish or bearish ETF

Getting the basics of indexes

When it comes to stock investing, there’s more than one way to do it. Buying stocks directly is good; sometimes, buying stocks indirectly is equally good (or even better) — especially if you’re risk-averse. Buying a great stock is every stock investor’s dream, but sometimes you face investing environments that make finding a winning stock a hazardous pursuit. For 2016-17, prudent stock investors should definitely consider adding exchange-traded funds to their wealth-building arsenal.

An exchange-traded fund (ETF) is basically a mutual fund that invests in a fixed basket of securities but with a few twists. In this chapter, I show you how ETFs are similar to (and different from) mutual funds (MFs), I provide some pointers on picking ETFs, and I note the fundamentals of stock indexes (which are connected to ETFs).

Comparing Exchange-Traded Funds and Mutual Funds

For many folks and for many years, the only choice besides investing directly in stocks was to invest indirectly through MFs. After all, why buy a single stock for roughly the same few thousand dollars that you can buy a mutual fund for and get benefits such as professional management and diversification?

For small investors, mutual fund investing isn’t a bad way to go. Investors participate by pooling their money with others and get professional money management in an affordable manner. But MFs have their downsides too. Mutual fund fees, which include management fees and sales charges (referred to as loads), eat into gains, and investors have no choice about investments after they’re in a mutual fund. Whatever the fund manager buys, sells, or holds on to is pretty much what the investors in the fund have to tolerate. Investment choice is limited to either being in the fund … or out.

But now, with the advent of ETFs, investors have greater choices than ever, a scenario that sets the stage for the inevitable comparison between MFs and ETFs. The following sections go over the differences and similarities between ETFs and MFs.

The differences

Simply stated, in a mutual fund, securities such as stocks and bonds are constantly bought, sold, and held (in other words, the fund is actively managed). An ETF holds similar securities, but the portfolio typically isn’t actively managed. Instead, an ETF usually holds a fixed basket of securities that may reflect an index or a particular industry or sector (see Chapter 13). An index is a method of measuring the value of a segment of the general stock market. It’s a tool used by money managers and investors to compare the performance of a particular stock to a widely accepted standard; see the later section “Taking Note of Indexes” for more details.

For example, an ETF that tries to reflect the S&P 500 will attempt to hold a securities portfolio that mirrors the composition of the S&P 500 as closely as possible. Here’s another example: A water utilities ETF may hold the top 35 or 40 publicly held water companies. (You get the picture.)

Where ETFs are markedly different from MFs (and where they’re really advantageous, in my opinion) is that they can be bought and sold like stocks. In addition, you can do with ETFs what you can generally do with stocks (but can’t usually do with MFs): You can buy in share allotments, such as 1, 50, or 100 shares or more. MFs, on the other hand, are usually bought in dollar amounts, such as 1,000 or 5,000 dollars’ worth. The dollar amount you can initially invest is set by the manager of the individual mutual fund.

Here are some other advantages: You can put various buy/sell brokerage orders on ETFs (see Chapter 17), and many ETFs are optionable (meaning you may be able to buy/sell put and call options on them; I discuss some of these options in Chapters 23 and 24). MFs typically aren’t optionable.

In addition, many ETFs are marginable (meaning that you can borrow against them with some limitations in your brokerage account). MFs usually aren’t marginable (although it is possible if they’re within the confines of a stock brokerage account). To find out more about margin, check out Chapter 17.

Sometimes an investor can readily see the great potential of a given industry or sector but is hard-pressed to get that single really good stock that can take advantage of the profit possibilities of that particular segment of the market. The great thing about an ETF is that you can make that investment very easily, knowing that if you’re unsure about it, you can put in place strategies that protect you from the downside (such as stop-loss orders or trailing stops). That way you can sleep easier!

The similarities

Even though ETFs and mutual funds have some major differences, they do share a few similarities:

· First and foremost, ETFs and MFs are similar in that they aren’t direct investments; they’re “conduits” of investing, which means that they act like a connection between the investor and the investments.

· Both ETFs and MFs basically pool the money of investors and the pool becomes the “fund,” which in turn invests in a portfolio of investments.

· Both ETFs and MFs offer the great advantage of diversification (although they accomplish it in different ways).

· Investors don’t have any choice about what makes up the portfolio of either the ETF or the MF. The ETF has a fixed basket of securities (the money manager overseeing the portfolio makes those choices), and, of course, investors can’t control the choices made in a mutual fund.

For those investors who want more active assistance in making choices and running a portfolio, the MF may very well be the way to go. For those who are more comfortable making their own choices in terms of the particular index or industry/sector they want to invest in, the ETF may be a better venue.

Choosing an Exchange-Traded Fund

Buying a stock is an investment in a particular company, but an ETF is an opportunity to invest in a block of stocks. In the same way a few mouse clicks can buy you a stock at a stock brokerage website, those same clicks can buy you virtually an entire industry or sector (or at least the top-tier stocks anyway).

For investors who are comfortable with their own choices and do their due diligence, a winning stock is a better (albeit more aggressive) way to go. For those investors who want to make their own choices but aren’t that confident about picking winning stocks, an ETF is definitely a better way to go.

You had to figure that choosing an ETF wasn’t going to be a coin flip. There are considerations that you should be aware of, some of which are tied more to your personal outlook and preferences than to the underlying portfolio of the ETF. I give you the info you need on bullish and bearish ETFs in the following sections.

Picking a winning industry or sector is easier than finding a great company to invest in. Therefore, ETF investing goes hand in hand with the guidance offered in Chapter 13.

Bullish ETFs

You may wake up one day and say, “I think that the stock market will do very well going forward from today,” and that’s just fine if you think so. Maybe your research on the general economy, financial outlook, and political considerations makes you feel happier than a starving man on a cruise ship. But you just don’t know (or don’t care to research) which stocks would best benefit from the good market moves yet to come. No problem!

In the following sections, I cover ETF strategies for bullish scenarios, but fortunately, ETF strategies for bearish scenarios exist too. I cover those later in this chapter.

Major market index ETFs

Why not invest in ETFs that mirror a general major market index such as the S&P 500? ETFs such as SPY construct their portfolios to track the composition of the S&P 500 as closely as possible. As they say, why try to beat the market when you can match it? It’s a great way to go when the market is having a good rally. (See the later section “Taking Note of Indexes” for the basics on indexes.)

When the S&P 500 was battered in late 2008/early 2009, the ETF for the S&P 500, of course, mirrored that performance and hit the bottom in March 2009. But from that moment on and into 2015, the S&P 500 (and the ETFs that tracked it) did extraordinarily well. It paid to buck the bearish sentiment of early 2009. Of course, it did take some contrarian gumption to do so, but at least you had the benefit of the full S&P 500 stock portfolio, which at least had more diversification than a single stock or a single subsection of the market. Of course, as the S&P 500 entered the bull market of 2009-2015, bullish ETFs that mirrored the S&P 500 did very well while the ETFs that were inverse to the S&P 500 (betting on a bearish move) declined in the same period.

ETFs related to human need

Some ETFs cover industries such as food and beverage, water, energy, and other things that people will keep buying no matter how good or bad the economy is. Without needing a crystal ball or having an iron-will contrarian attitude, a stock investor can simply put money into stocks — or in this case, ETFs — tied to human need. Such ETFs may even do better than ETFs tied to major market indexes (see the preceding section).

Here’s an example: At the end of 2007 (mere months before the great 2008-2009 market crash), what would have happened if you had invested 50 percent of your money in an ETF that represented the S&P 500 and 50 percent in an ETF that was in consumer staples (such as food and beverage stocks)? I did such a comparison, and it was quite revealing to note that by the end of 2015, the consumer staples ETF (for the record I used PBJ) actually beat out the S&P 500 ETF by more than 45 percent (not including dividends). Very interesting!

ETFs that include dividend-paying stocks

ETFs don’t necessarily have to be tied to a specific industry or sector; they can be tied to a specific type or subcategory of stock. All things being equal, what basic categories of stocks do you think would better weather bad times: stocks with no dividends or stocks that pay dividends? (I guess the question answers itself, pretty much like, “What tastes better: apple pie or barbed wire?”) Although some sectors are known for being good dividend payers, such as utilities (and there are some good ETFs that cover this industry), some ETFs cover stocks that meet specific criteria.

You can find ETFs that include high-dividend income stocks (typically 4 percent or higher) as well as ETFs that include stocks of companies that don’t necessarily pay high dividends but do have a long track record of dividend increases that meet or exceed the rate of inflation.

Given these types of dividend-paying ETFs, it becomes clear which is good for what type of stock investor:

· If I were a stock investor who was currently retired, I’d choose the high-dividend stock ETF. Dividend-paying stock ETFs are generally more stable than those stock ETFs that don’t pay dividends, and dividends are important for retirement income.

· If I were in “pre-retirement” (some years away from retirement but clearly planning for it), I’d choose the ETF with the stocks that had a strong record of growing the dividend payout. That way, those same dividend-paying stocks would grow in the short term and provide better income down the road during retirement.

For more information on dividend investing strategies, head over to Chapter 9.

Keep in mind that dividend-paying stocks generally fall within the criteria of human need investing because those companies tend to be large and stable, with good cash flows, giving them the ongoing wherewithal to pay good dividends.

To find out more about ETFs in general and to get more details on the ETFs I mention in this chapter (SPY, PBJ, and SH), go to websites such as www.etfdb.com and www.etfguide.com. Many of the resources in Appendix A also cover ETFs.

Bearish ETFs

Most ETFs are bullish in nature because they invest in a portfolio of securities that they expect to go up in due course. But some ETFs have a bearish focus. Bearish ETFs (also called short ETFs) maintain a portfolio of securities and strategies that are designed to go the opposite way of the underlying or targeted securities. In other words, this type of ETF goes up when the underlying securities go down (and vice versa). Bearish ETFs employ securities such as put options (and similar derivatives) and/or employ strategies such as “going short” (see Chapter 17).

Take the S&P 500, for example. If you were bullish on that index, you might choose an ETF such as SPY. However, if you were bearish on that index and wanted to seek gains by betting that it would go down, you could choose an ETF such as SH.

You can take two approaches on bearish ETFs:

· Hoping for a downfall: If you’re speculating on a pending market crash, a bearish ETF is a good consideration. In this approach, you’re actually seeking to make a profit based on your expectations. Those folks who aggressively went into bearish ETFs during early or mid 2008 made some spectacular profits during the tumultuous downfall during late 2008 and early 2009.

· Hedging against a downfall: A more conservative approach is to use bearish ETFs to a more moderate extent, primarily as a form of hedging, whereby the bearish ETF acts like a form of insurance in the unwelcome event of a significant market pullback or crash. I say “unwelcome” because you’re not really hoping for a crash; you’re just trying to protect yourself with a modest form of diversification. In this context, diversification means that you have a mix of both bullish positions and, to a smaller extent, bearish positions.

Taking Note of Indexes

For stock investors, ETFs that are bullish or bearish are ultimately tied to major market indexes. You should take a quick look at indexes to better understand them (and the ETFs tied to them).

Whenever you hear the media commentary or the scuttlebutt at the local watering hole about “how the market is doing,” it typically refers to a market proxy such as an index. You’ll usually hear them mention “the Dow” or perhaps “the S&P 500.” There are certainly other major market indexes, and there are many lesser, yet popular, measurements, such as the Dow Jones Transportation Average. Indexes and averages tend to be used interchangeably, but they’re distinctly different entities of measurement.

Most people use these indexes basically as standards of market performance to see whether they’re doing better or worse than a yardstick for comparison purposes. They want to know continuously whether their stocks, ETFs, MFs, or overall portfolios are performing well.

Appendix A gives you resources to help you gain a fuller understanding of indexes. You can also find great resources online, such as indexes.dowjones.com, that give you the history and composition of indexes. For your purposes, these are the main ones to keep an eye on:

· Dow Jones Industrial Average (DJIA): This is the most widely watched index (technically it’s not an index, but it’s utilized as one). It tracks 30 widely owned, large cap stocks, and it’s occasionally re-balanced to drop (and replace) a stock that’s not keeping up.

· Nasdaq Composite: This covers a cross section of stocks from Nasdaq. It’s generally considered a mix of stocks that are high-growth (riskier) companies with an over-representation of technology stocks.

· S&P 500 index: This index tracks 500 leading, publicly traded companies considered to be widely held. The publishing firm Standard & Poor’s created this index (I bet you could’ve guessed that).

· Wilshire 5000: This index is considered the widest sampling of stocks across the general stock market and, therefore, a more accurate measure of stock market movement.

If you don’t want to go nuts trying to “beat the market,” consider an ETF that closely correlates to any of the indexes mentioned in the preceding list. Sometimes it’s better to join ’em than to beat ’em. The resources in Appendix A can help you find an index you believe is suitable for you. You can find ETFs that track or mirror the preceding indexes at sites such as www.etfdb.com.

INTERNATIONAL INVESTING MADE EASY

Interested in investing in stocks on the international scene? Does Europe, China, or India interest you? Perhaps Singapore or Australia appeal to you, but finding a good stock seems a little daunting. Why not do it in a safer way through ETFs? Many ETFs invest in a cross-section of the major stocks in a given country. So why buy an individual stock when you can get the top 40 or 50 stocks in that country’s stock market? In this chapter, you discover the advantages of ETFs, so including a batch of international stocks in your portfolio is easier than ever. To find major international ETFs, go to www.etfdb.com and use the country's name in your keyword search. Just remember to do your homework on that country (geopolitical risks and so on) with the help of CIA World Fact Book (www.ciaworldfactbook.us) and the Financial Times (www.ft.com). You can find other resources in Appendix A. Of course, if you get skittish about holding such ETFs, you can minimize the risks, such as with stop-loss orders, which I cover in Chapter 17.