Exchange- Traded Funds FOR DUMMIES - 2ND EDITION - by Russell Wild, MBA About the Author Russell Wild is a NAPFA-certified financial advisor and principal of Global Portfolios, an investment advisory firm based in Allentown, Pennsylvania. He is one of only a handful of wealth managers in the nation who is both feeonly (takes no commissions) and welcomes clients of both substantial and modest means. He calls his firm Global Portfolios to reflect his ardent belief in international diversification — using exchange-traded funds to build welldiversified, low-expense, tax-efficient portfolios. Wild, in addition to the fun he has with his financial calculator, is also an accomplished writer who helps readers understand and make wise choices about their money. His articles have appeared in many national publications, including AARP The Magazine, Consumer Reports, Details, Maxim, Men’s Health, Men’s Journal, Cosmopolitan, Reader’s Digest, and Real Simple. He writes a regular finance column for The Saturday Evening Post. And he has also contributed to numerous professional journals, such as Financial Planning, Financial Advisor, and the NAPFA Advisor. The author or coauthor of two dozen nonfiction books, Wild’s last work (prior to the one you’re holding in your hand) was One Year to an Organized Financial Life, coauthored with professional organizer Regina Leeds, published by Da Capo Press. He also wrote two other Dummies titles in addition to this one: Bond Investing For Dummies and Index Investing For Dummies. No stranger to the mass media, Wild has shared his wit and wisdom on such shows as Oprah, The View, CBS Morning News, and Good Day New York, and in hundreds of radio interviews. Wild holds a Master of Business Administration (MBA) degree with a concentration in finance from The Thunderbird School of Global Management, in Glendale, Arizona (consistently ranked the #1 school for international business by both U.S. News and World Report and The Wall Street Journal); a Bachelor of Science (BS) degree in business/economics magna cum laude from American University in Washington, D.C.; and a graduate certificate in personal financial planning from Moravian College in Bethlehem, Pennsylvania (America’s sixth-oldest college). A member of the National Association of Personal Financial Advisors (NAPFA) since 2002, Wild is also a long-time member and past president of the American Society of Journalists and Authors (ASJA). The author grew up on Long Island and now lives in Allentown, Pennsylvania. His son Clayton attends George Washington University in Washington, D.C. His daughter Adrienne is in high school. His dog Norman, a standard poodle, protects their home from killer squirrels. His website is www.global portfolios.net. Dedication To the small investor, who has been bamboozled, bullied, and beaten up long enough. Author’s Acknowledgments Although I’ve written many books, the first edition of this book was my first Dummies book, and writing a first Dummies book is a bit like learning to ride a bicycle — on a very windy day. If it weren’t for Joan Friedman, project editor, who kept a steady hand on the back of my seat, I would surely have fallen off a curb and been run over by a pickup truck flying a Confederate flag. Joan, hands down, is one of the best editors I’ve ever worked with. She’s a very nice person, too. For those reasons, I was absolutely thrilled when I learned that Joan would be project editor on this second edition, as well. If there’s ever a third edition . Joan? Other nice people that I’d also like to tip my bicycle helmet to include Marilyn Allen of Allen O’Shea Literary Agency (she calls me “babe,” just like agents do in movies; I love that) and Stacy Kennedy, acquisitions editor at Wiley. If these two gals hadn’t gotten together, I wouldn’t have had a bicycle to ride. Thanks, too, to Paul Justice, CFA, editor of Morningstar’s ETFInvestor newsletter. Paul, who knows a heck of a lot about ETFs, was the official technical editor on this book, and he checked every chapter to make certain that this remained strictly a work of nonfiction. Fellow fee-only financial advisor and good friend Neil Stoloff then double checked. You da man, Neil. I’d like to thank Morningstar — all the folks there aside from Paul — for extreme generosity in providing fund industry data and analysis. Additional good data came from the various ETF providers, such as Vanguard, State Street, BlackRock, and T. Rowe Price, as well as a few non-ETF providers, such as Dimensional and the U.S. Treasury. Thanks, all. I’d also like to thank Donald Bowles, my old professor of economics at American University, for showing me that supply and demand curves can be fun. Sorry we lost touch, but I haven’t forgotten you. And finally, I’d like to thank my old man, attorney Lawrence R. Wild, both my most beloved and most difficult client, who, if he told me once, told me a thousand times: ‘Rich or poor, it’s good to have money. It took me years, Dad, to discover the profound wisdom in that statement. Contents at a Glance Introduction . 1 Part I: The ABCs of ETFs . 9 Chapter 1: The (Sort of Still) New Kid on the Block .11 Chapter 2: What the Heck Is an ETF, Anyway? .23 Chapter 3: Getting to Know the Players 45 Part II: Building the Stock (Equity) Side of Your Portfolio 69 Chapter 4: Risk Control, Diversification, and Some Other Things You Need to Know 71 Chapter 5: Large Growth: Muscular Money Makers .91 Chapter 6: Large Value: Counterintuitive Cash Cows 103 Chapter 7: Small Growth: Sweet Sounding Start-ups .111 Chapter 8: Small Value: Diminutive Dazzlers 121 Chapter 9: Going Global: ETFs without Borders .127 Chapter 10: Sector Investing: ETFs According to Industry .147 Chapter 11: Specialized Stock ETFs .165 Part III: Adding Bonds, REITs, and Other ETFs to Your Portfolio . 183 Chapter 12: For Your Interest: The World of Bond ETFs .185 Chapter 13: Real Estate Investment Trusts (REITs): Becoming a Virtual Landlord 211 Chapter 14: All That Glitters: Gold, Silver, and Other Commodities .219 Chapter 15: Working Non-ETFs and Active ETFs into Your Investment Mix 235 Part IV: Putting It All Together 249 Chapter 16: Sample ETF Portfolio Menus 251 Chapter 17: Exercising Patience: The Key to Any Investment Success .271 Chapter 18: Exceptions to the Rule (Ain’t There Always) .285 Chapter 19: Using ETFs to Fund Your Golden Years 303 Part V: The Part of Tens 321 Chapter 20: Ten FAQs about ETFs 323 Chapter 21: Ten Mistakes Most Investors (Even Smart Ones) Make .329 Chapter 22: Ten Forecasts about the Future of ETFs and Personal Investing 333 Part VI: Appendixes 339 Appendix A: Great Web Resources to Help You Invest in ETFs .341 Appendix B: Glossary .347 Index . 353 Table of Contents Introduction 1 Since the First Edition .1 Out of the shadows .2 Filling the investment voids 2 Creations of dubious value 2 Morphing into new creatures 3 About This Book .3 Conventions Used in This Book 5 What You’re Not to Read .5 Foolish Assumptions 6 How This Book Is Organized .6 Part I: The ABCs of ETFs 6 Part II: Building the Stock (Equity) Side of Your Portfolio 6 Part III: Adding Bonds, REITs, and Other ETFs to Your Portfolio .7 Part IV: Putting It All Together 7 Part V: The Part of Tens .7 Part VI: Appendixes 7 Icons Used in This Book 7 Where to Go from Here 8 Part I: The ABCs of ETFs 9 Chapter 1: The (Sort of Still) New Kid on the Block . 11 In the Beginning 11 Enter the traders .12 Moving south of the border .12 Fulfilling a Dream 13 Goodbye, ridiculously high mutual fund fees .13 Hello, building blocks for a better portfolio 14 Will you miss the court papers? .14 Not Quite as Popular as the Beatles, But Getting There .15 Moving from Wall Street to Main Street .16 Keeping up with the Vanguards 16 Ready for Prime Time 18 The proof of the pudding .19 The major players .20 Twist and shout: Commercialization is tainting a good thing 21 Chapter 2: What the Heck Is an ETF, Anyway? 23 The Nature of the Beast .23 Choosing between the Classic and the New Indexes .25 x Exchange-Traded Funds For Dummies, 2nd Edition Preferring ETFs over Individual Stocks .26 Distinguishing ETFs from Mutual Funds 27 Why the Big Boys Prefer ETFs 28 Trading in large lots .28 Savoring the versatility 28 Why Individual Investors Are Learning to Love ETFs 29 The cost advantage: How low can you go? 30 Uncle Sam’s loss, your gain .32 What you see is what you get 35 Getting the Professional Edge .37 Consider a few impressive numbers 37 You can do what they do! 38 Passive versus Active Investing: Your Choice 38 The index advantage 38 The allure of active management .39 Why the race is getting harder to measure . and what to do about it .40 Do ETFs Belong in Your Life? 41 Calculating commissions .41 Moving money in a flash 41 Understanding tracking error .41 Making a sometimes tricky choice .42 Chapter 3: Getting to Know the Players 45 Creating an Account for Your ETFs 45 Answering a zillion questions .46 Placing an order to buy 48 But wait just a moment! .49 Trading ETFs like a pro 49 Introducing the Shops 50 What to look for 50 A price structure like none other .51 The Vanguard Group 51 Fidelity Investments .52 Charles Schwab .53 T. Rowe Price .53 TD Ameritrade .53 Scottrade 54 Other brokerage houses 54 Presenting the Suppliers 55 It’s okay to mix and match – with caution .55 Check your passport 57 BlackRock iShares .57 State Street Global Advisers (SSgA) SPDRs .58 Vanguard ETFs 58 Invesco PowerShares .60 ProShares .60 Van Eck (Market Vectors ETFs) 61 WisdomTree 61 Table of Contents xi Guggenheim .62 Other suppliers .63 Familiarizing Yourself with the Indexers .63 Standard & Poor’s .64 Dow Jones 64 MSCI 64 Russell 65 Barclays 65 Meeting the Middlemen .65 NYSE Arca 66 NASDAQ .66 Meeting the Wannabe Middlemen 67 Commissioned brokers 67 Separately managed accounts (SMAs) .67 Annuities and life insurance products .68 Mutual funds of ETFs 68 Part II: Building the Stock (Equity) Side of Your Portfolio . 69 Chapter 4: Risk Control, Diversification, and Some Other Things You Need to Know . 71 Risk Is Not Just a Board Game 72 The trade-off of all trade-offs (safety versus return) .72 So just how risky are ETFs? .73 Smart Risk, Foolish Risk .74 How Risk Is Measured 76 Standard deviation: The king of all risk measurement tools .76 Beta: Assessing price swings in relation to the market .78 The Sharpe, Treynor, and Sortino ratios: Measures of what you get for your risk 79 Meet Modern Portfolio Theory .81 Tasting the extreme positivity of negative correlation .81 Settling for limited correlation 83 Reaching for the elusive Efficient Frontier 84 Accusations that MPT is dead are greatly exaggerated 85 Mixing and Matching Your Stock ETFs 86 Filling in your style box 86 Buying by industry sector .88 Don’t slice and dice your portfolio to death .89 Chapter 5: Large Growth: Muscular Money Makers 91 Style Review 93 What makes large cap large? .93 How does growth differ from value? 93 Putting these terms to use .94 xii Exchange-Traded Funds For Dummies, 2nd Edition Big and Brawny .94 Contrary to all appearances .95 Let history serve as only a rough guide .95 ETF Options Galore 96 Strictly large cap or blend? 96 Blended options for large cap exposure 98 Strictly large growth .100 ETFs I wouldn’t go out of my way to own 102 Chapter 6: Large Value: Counterintuitive Cash Cows . 103 Six Ways to Recognize Value .104 Looking for the Best Value Buys .106 Taking the index route .106 Making an ETF selection 107 Chapter 7: Small Growth: Sweet Sounding Start-ups 111 Getting Real about Small Cap Investments .112 Your Choices for Small Growth 113 Small cap blend funds 114 Strictly small cap growth funds 116 Smaller than Small: Meet the Micro Caps 118 Chapter 8: Small Value: Diminutive Dazzlers . 121 It’s Been Quite a Ride .123 Latching on for fun and profit .123 But keeping your balance 123 What About the Mid Caps? 126 Chapter 9: Going Global: ETFs without Borders 127 The Ups and Downs of Different Markets around the World 128 Low correlation is the name of the game 129 Remember what happened to Japan 130 Finding Your Best Mix of Domestic and International .130 Why putting two-thirds of your portfolio in foreign stocks is too much 131 Why putting one-fifth of your portfolio in foreign stocks is insufficient .132 Why ETFs are a great tool for international investing .133 Not All Foreign Nations — or Stocks — Are Created Equal 134 Choosing the Best International ETFs for Your Portfolio 136 Four brands to choose from 136 All the world’s your apple: ETFs that cover the planet .137 European stock ETFs: From the North Sea to the shores of the Mediterranean .138 Pacific region stock ETFs: From Mt. Fuji to that big island with the kangaroos 140 Table of Contents xiii Emerging-market stock ETFs: Well, we hope that they’re emerging .142 iShares value and growth: Two special ETFs for style investing abroad 144 Small cap international: Yes, you want it 145 Chapter 10: Sector Investing: ETFs According to Industry 147 Selecting Stocks by Sector, not Style .148 Speculating on the Next Hot Industry 150 Sizzling and sinking 150 Momentum riders and bottom feeders 150 Doing Sector Investing Right .151 Calculating your optimal sector mix 151 Seeking risk adjustment with high and low volatility sectors 152 Knowing where the style grid comes through 153 Combining strategies to optimize your portfolio .154 Seeking low correlations for added diversification 154 Sector Choices by the Dozen 155 Vanguard ETFs 156 Select Sector SPDRs: State Street Global Advisors (Part I) .157 SPDRs: State Street Global Advisors (Part II) 158 BlackRock’s iShares 160 PowerShares 161 Chapter 11: Specialized Stock ETFs 165 Investing for a Better World 166 Tracking the history of SRI performance .166 Your growing number of choices for social investing .167 A close-up look at your SRI options .168 Dividend Funds: The Search for Steady Money 170 Your high dividend ETF options .170 Promise of riches or smoke and mirrors? .171 Investing in Initial Public Offerings 174 The rollercoaster of recent IPO performance .174 Taking a broader look at IPOs .175 Funds That (Supposedly) Thrive When the Market Takes a Dive .175 Entering an upside-down world 176 Boasting a track record like none other 177 Funds That Double the Thrill of Investing (for Better or Worse) .177 Crazy math: Comparing leveraged funds to traditional ETFs .178 Examining a rather pathetic track record .179 All-In-One ETFs: For the Ultimate Lazy Portfolio 180 Getting worldwide exposure to stocks and bonds .180 Russell’s average review for the average reader on an average day .182 xiv Exchange-Traded Funds For Dummies, 2nd Edition Part III: Adding Bonds, REITs, and Other ETFs to Your Portfolio 183 Chapter 12: For Your Interest: The World of Bond ETFs . 185 Tracing the Track Record of Bonds .186 Portfolio protection when you need it most .188 History may or may not repeat .189 Tapping into Bonds in Various Ways .190 Finding strength in numbers .191 Considering bond fund costs 191 Casting a wide net .192 Sampling Your Basic Bond-ETF Menu 192 Tapping the Treasurys: Uncle Sam’s IOUs 193 Gas at $5.00 a gallon? Getting inflation protection in a flash 196 Banking on business: Corporate bond ETFs .197 The whole shebang: Investing in the entire U.S. bond market .199 Moving Beyond Basics into Municipal and Foreign Bonds .201 Municipals for mostly tax-free income .202 Foreign bonds for fixed-income diversification 203 Emerging-market bonds: High risk, high return 205 Determining the Optimal Fixed Income Allocation 206 60/40? 50/50? Finding a split that makes sense .207 Meet Joe, age 67, with a little more than $600,000 in the bank .208 Meet Betsy and Mike, age 36, with $30,000 in the bank .209 Chapter 13: Real Estate Investment Trusts (REITs): Becoming a Virtual Landlord 211 Considering Five Distinguishing Characteristics of REITs 212 Limited correlation to the broad markets .212 Unusually high dividends 213 Different taxation of dividends .213 Special status among financial pros .213 Connection to tangible property 214 Calculating a Proper REIT Allocation .214 Judging from the past .214 Splitting the baby: Domestic and international REIT funds 215 Picking REIT ETFs for Your Portfolio .216 U.S. domestic REIT ETFs 217 Global REIT funds .218 Chapter 14: All That Glitters: Gold, Silver, and Other Commodities . 219 Gold, Gold, Gold! .220 Midas touch or fool’s gold? .221 A vastly improved way to buy the precious metal .222 The tax man cometh .223 Table of Contents xv Silver: The Second Metal .223 Quick silver on the move .223 If you must 224 Oil and Gas: Truly Volatile Commodities 225 Oily business .225 No experience necessary .226 The sad saga of contango 226 Taxing your tax advisor .227 (Somewhat) Safer Commodity Plays 228 General commodity index funds .228 Actively managed, or quasi-actively managed, commodity funds 230 Awaiting new developments .231 Playing the Commodity Market Indirectly 231 Tapping into commodity companies .232 Tapping into commodity-rich countries 234 Chapter 15: Working Non-ETFs and Active ETFs into Your Investment Mix . 235 Tinkering with an Existing Stock or Mutual Fund Portfolio 236 Improving your diversification .236 Minimizing your investment costs .237 Using ETFs to tax harvest 238 Looking Beyond the Well-Rounded ETF Portfolio 239 Mutual funds as cheap as ETFs: Vanguard Admiral shares 239 Where few investors have gone before: DFA funds 240 Timber REITs .241 I Bonds: An Uncle Sam bond with a twist 242 Market-neutral mutual funds .242 A commodity fund without too much hassle 243 Fixed immediate annuities .244 Venturing into exchange-traded notes .244 Going Active with ETFs 246 Part IV: Putting It All Together 249 Chapter 16: Sample ETF Portfolio Menus . 251 So, How Much Risk Can You Handle and Still Sleep at Night? 252 A few things that just don’t matter .253 The irony of risk and return 254 The 20x rule .254 Other risk/return considerations .256 The limitations of risk questionnaires .256 Keys to Optimal Investing .258 Incorporating Modern Portfolio Theory into your investment decisions .258 Minimizing your costs 258 xvi Exchange-Traded Funds For Dummies, 2nd Edition Striving for tax efficiency .259 Timing your investments (just a touch) 259 Finding the Perfect Portfolio Fit 260 Considering the simplest of the simple .260 Racing toward riches: A portfolio that may require a crash helmet .261 Sticking to the middle of the road 263 Taking the safer road: Less oomph, less swing 267 Chapter 17: Exercising Patience: The Key to Any Investment Success 271 The Tale of the Average Investor (A Tragicomedy in One Act) .274 Returns that fall way short of the indexes .274 ETFs can make failure even easier! .275 The lure of quick riches .276 The Value Line Paradox .277 Paper versus practice 277 The lesson to be learned .278 “Investment Pornography” in Your Mailbox (and Mine) .278 Welcome to the wild, wacky world of investment advice .279 Caveat emptor: ETF-trading websites for suckers 280 Patience Pays, Literally 281 Talk about unpredictability .281 A short history of the market’s resiliency .282 Chapter 18: Exceptions to the Rule (Ain’t There Always) 285 Rebalancing to Keep Your Portfolio Fit .286 How rebalancing works 286 How often to rebalance 288 Rebalancing for retirees .288 Contemplating Tactical Asset Allocation 289 Understanding the all-important P/E ratio 289 Applying the ratio to your portfolio .290 Buying unloved assets .291 Investing the SweetSpot way .291 Harvesting Tax Losses, and the IRS’s Oh-So-Tricky “Wash Rule” 293 What the heck is “substantially identical” anyway? .293 As always, consider cost 294 Revamping Your Portfolio with Life Changes: Marriage, Divorce, and Babies 294 Betsy and Mark: A fairly typical couple .295 One year later 296 Yet one year later .297 Are Options an Option for You? .297 Understanding puts and calls .298 Using options to make gains without risk .299 Insuring yourself against big, bad bears 300 Table of Contents xvii Seeming almost too good to be true 300 Weighing options strategies against the diversified ETF portfolio 301 Factoring in time and hassle .301 Chapter 19: Using ETFs to Fund Your Golden Years 303 Aiming for Economic Self-Sufficiency .304 Taking the basic steps 305 Choosing the right vessels 305 Curing the 401(k) Blues .309 Lobbying the benefits manager 310 Introducing the Roth 401(k) 312 Strategies for the Self-Employed .314 The traditional IRA versus the Roth IRA 314 Taxes now or taxes later? 315 Ushering Your Portfolio into Retirement Readiness 315 15+ years and counting 315 Less than 15 years to retirement 316 Withdrawing Funds to Replace Your Paycheck 316 Don’t obsess over maintaining principal or drawing from dividends .317 As always, watch the fees 319 Take your minimum required distributions 319 IRA, 401(k), or regular (taxable) brokerage account: Which to tap first? .320 Part V: The Part of Tens . 321 Chapter 20: Ten FAQs about ETFs . 323 Are ETFs Appropriate for Individual Investors? .323 Are ETFs Risky? .323 Do I Need a Financial Professional to Set Up and Monitor an ETF Portfolio? 324 How Much Money Do I Need to Invest in ETFs? .325 With Hundreds of ETFs to Choose From, Where Do I Start? .325 Where Is the Best Place for Me to Buy ETFs? .326 Is There an Especially Good or Bad Time to Buy ETFs? 326 Do ETFs Have Any Disadvantages? 326 Does It Matter Which Exchange My ETF Is Traded On? 327 Which ETFs Are Best in My IRA, and Which Are Best in My Taxable Account? 327 Chapter 21: Ten Mistakes Most Investors (Even Smart Ones) Make 329 Paying Too Much for an Investment 329 Failing to Properly Diversify 329 Taking on Inappropriate Risks 330 xviii Exchange-Traded Funds For Dummies, 2nd Edition Selling Out When the Going Gets Tough .330 Paying Too Much Attention to Recent Performance .330 Not Saving Enough for Retirement .331 Having Unrealistic Expectations of Market Returns 331 Discounting the Damaging Effect of Inflation 332 Not Following the IRS’s Rules 332 Failing to Incorporate Investments into a Broader Financial Plan .332 Chapter 22: Ten Forecasts about the Future of ETFs and Personal Investing . 333 ETF Assets Will Continue to Grow . for Better or Worse .333 More Players May Enter the Field, but Only a Few 334 Investors Will Get Suckered into Buying Packaged Products .334 ETF Investors Will Have More, and Better, Options 335 The Markets Will (Unfortunately) See Greater Correlation than in the Past .335 Asset Class Returns Will Revert toward Their Historic Means 336 Taxes Will Rise 336 Inflation Will Remain Tame .337 Private Pensions (of Sorts) May Emerge from the Rubble 337 Hype Will Prevail! 338 Part VI: Appendixes . 339 Appendix A: Great Web Resources to Help You Invest in ETFs . 341 Appendix B: Glossary . 347 Index 353 Introduction E very month, it seems, Wall Street comes up with some newfangled investment idea. The array of financial products (replete with 164-page prospectuses) is now so dizzying that the old lumpy mattress is starting to look like a more comfortable place to stash the cash. But there is one relatively new product out there definitely worth looking at. It’s something of a cross between an index mutual fund and a stock, and it’s called an exchangetraded fund, or ETF. Just as computers and fax machines were used by big institutions before they caught on with individual consumers, so it was with ETFs. They were first embraced by institutional traders — investment banks, hedge funds, and insurance firms — because, among other things, they allow for the quick juggling of massive holdings. Big traders like that sort of thing. Personally, playing hot potato with my money is not my idea of fun. But all the same, over the past several years, I’ve invested most of my own savings in ETFs, and I’ve suggested to many of my clients that they do the same. I’m not alone in my appreciation of ETFs. They have grown exponentially in the past few years, and they will surely continue to grow and gain influence. While I can’t claim that my purchases and my recommendations of ETFs account for much of the growing $1 trillion+ ETF market, I’m happy to be a (very) small part of it. After you’ve read this second edition of Exchange- Traded Funds For Dummies, you may decide to become part of it as well, if you haven’t already. Since the First Edition . Many changes have taken place in the investment world, both on Wall Street and Main Street, since the first edition of this book was published in 2007. For one thing, a much larger pot of money is now invested in ETFs: $1.1 trillion as of this writing (up from a mere $300 billion in 2007). Also, when I introduce myself as the author of Exchange-Traded Funds For Dummies, I no longer get a look as if I’m speaking some strange language with a lisp. Many people today, perhaps most, are at least somewhat familiar with the term exchange-traded funds. ETFs have, after all, made a few headlines. 2 Exchange-Traded Funds For Dummies, 2nd Edition Out of the shadows The rising popularity of ETFs has been a news story in and of itself. Many educated folks are now aware that ETFs are low-cost investment vehicles that can serve as building blocks for a diversified portfolio. But ETFs have gotten a bad rap, too, especially for the role they played in the infamous “flash crash” of May 6, 2010 (see Chapter 2) and for the ongoing role they are playing in the increasingly nauseating volatility of the markets. According to one 2010 report from the Ewing Marion Kauffman Foundation, “ETFs are choking the recovery and may pose unrecognized risks to the financial markets.” Well, I’m not so sure about that (especially given that the stock market shot up 10 percent in the six months immediately following the Kauffman report). I discuss the overall effect that ETFs have had on financial markets, but what I concentrate on most in this second edition is how changes in the ETF market affect you — the individual investor. And in that arena, without question, there have been many changes both positive and negative. Filling the investment voids One very positive change in the past several years is that the “black holes” that I identified in the first edition of this book have largely been filled. That is, half a decade ago, you could not buy an ETF that would give you exposure to tax-free municipal or high-yield bonds. Or international bonds. Or international REITs. All that has changed. There are now ETFs that represent all those asset classes, and many more. Building an entire well-diversified portfolio out of ETFs was not humanly possible several years ago; it is very possible today. I’ve done it numerous times! Another very positive development: ETFs have recently been making a grand entrance into employer-sponsored 401(k) plans, where many of America’s hard-working people store the bulk of their savings. And they’ve been appearing lately in college-saving 529 plans, too. Insurance companies have also jumped into the fray, offering ETFs in some of their annuity plans (which, unfortunately, are still often overpriced). Creations of dubious value Many of the newer ETFs are bad investments, pure and simple. They were introduced to take advantage of the popularity of ETFs. They are overly expensive, and they represent foolish indexes (extremely small segments of the market, or indexes constructed using highly questionable methodologies). Much of this book is designed to help you tell the good from the bad. Introduction 3 Many of the newer ETFs are also specifically designed for short-term trading — which you would know if you read the really small print at the bottom of the advertisements — and short-term trading usually gets small investors into big trouble. A scary number of the newer ETFs are based on “back-tested” models: They track whatever indexes, or invest in whatever kinds of assets, have done the best in recent months or years. These ETFs (or the indexes they track) have shining short-term performance records, which induce people to buy. But past short-term performance is a very, very poor indicator of future performance. Morphing into new creatures Actively managed ETFs have been slower to take off than Wall Street had hoped but have made inroads since the first edition of this book. These ETFs differ radically from the original index ETFs. Actively managed ETFs don’t track any indexes at all but instead have portfolios built and regularly traded by managers attempting to beat the indexes. Active management, study after study has shown, usually doesn’t work all that well for investors, even though the managers themselves often get very rich (more in Chapter 2). And finally, many of the newer exchange-traded products aren’t ETFs at all but very different financial instruments called exchange-traded notes (ETNs). ETNs aren’t bad, per se, but they represent risks that ETFs do not . and that too few people understand (see my discussion in Chapters 14 and 15). About This Book As with any other investment, you’re looking for a certain payoff in reading this book. In an abstract sense, the payoff will come in your achieving a thorough understanding and appreciation of a powerful financial tool called an exchange-traded fund. The more concrete payoff will come when you apply this understanding to improve your investment results. What makes me think ETFs can help you make money? ✓ ETFs are intelligent. Most financial experts agree that playing with individual stocks can be hazardous to one’s wealth. Anything from an accounting scandal to the CEO’s sudden angina attack can send a single stock spiraling downward. That’s why it makes sense for the average investor to own lots of stocks — or bonds — through ETFs or mutual funds. 4 Exchange-Traded Funds For Dummies, 2nd Edition ✓ ETFs are cheap. At least 150 ETFs charge annual management expenses of 0.20 percent or lower, and a few charge as little as 0.06 percent a year. The average actively managed mutual fund, in contrast, charges 1.33 percent a year. Index mutual funds generally cost a tad more than their ETF cousins. Such cost differences, while appearing small on paper, can make a huge impact on your returns over time. I crunch some appropriate numbers in Chapter 2. ✓ ETFs are tax-smart. Because of the very clever way ETFs are structured, the taxes you pay on any growth are minimal. I crunch some of those numbers as well in Chapter 2. ✓ ETFs are open books. Quite unlike mutual funds, an ETF’s holdings are readily visible. If this afternoon, for example, I were to buy 100 shares of the ETF called the SPDR (pronounced “spider”) S&P 500, I would know that exactly 3.44 percent of my money was invested in Exxon Mobil Corp, 2.59 percent was invested in Apple, Inc., and 1.77 percent was invested in General Electric Co. You don’t get that kind of detail when you buy most mutual funds. Mutual fund managers, like stage magicians, are often reluctant to reveal their secrets. In the investment game, the more you know, the lower the odds you will get sawed in half. (News flash: Regulators are still debating just how open the portfolios of the newer actively managed ETFs will have to be. For the time being, however, most ETFs track indexes, and the components of any index are readily visible.) And speaking of open books, if the one you’re now reading were like some (but certainly not all) mutual funds, it would be largely unintelligible and expensive. (It might be doubly expensive if you tried to resell the book within 90 days!) Luckily, this book is more like an ETF. Here’s how: ✓ Exchange-Traded Funds For Dummies is intelligent. I don’t try to convince you that ETFs are your best investment choice, and I certainly don’t tell you that ETFs will make you rich. Instead, I lay out facts and figures and summarize some hard academic findings, and I let you draw your own conclusions. ✓ Exchange-Traded Funds For Dummies is cheap. Hey, top-notch investment advice for only $26.99 (plus or minus any discounts, shipping, and tax) . Where else are you going to get that kind of deal? And should you come to the conclusion after reading this book that ETFs belong in your portfolio, you’ll likely get your $26.99 (plus any shipping costs and tax) back — in the form of lower fees and tax efficiency — in no time at all. ✓ Exchange-Traded Funds For Dummies is tax-smart. Yes, the money you spent for this book, as all other outlays you make for investment advice, may be deducted from your federal income taxes (provided you itemize your deductions). Go for it! ✓ Exchange-Traded Funds For Dummies is an open book. We’ve already established that! Introduction 5 If you’ve ever read a For Dummies book before, you have an idea of what you’re about to embark on. This is not a book you need to read from front to back. Feel free to jump about and glean whatever information you think will be of most use. There is no quiz at the end. You don’t have to commit it all to memory. Conventions Used in This Book To help you navigate this text as easily as possible, I use the following conventions: ✓ Whenever I introduce a new term, it appears in italic. You can rest assured that I provide a definition or explanation nearby. ✓ If I want to share some interesting information that isn’t crucial to your understanding of the topic at hand, I place it in a sidebar, a gray box with its own heading that is set apart from the rest of the text. (See how this whole italic/definition thing works?) ✓ All website addresses appear in monofont so they’re easy to pick out if you need to go back and find them. Keep in mind that when this book was printed, some web addresses may have needed to break across two lines of text. If that happened, rest assured that we haven’t put in any extra characters (such as hyphens) to indicate the break. So, when using one of these web addresses, just type in exactly what you see in this book, pretending as though the line break doesn’t exist. What You’re Not to Read When my computer is ill, and I call “Tom” (Dell’s man somewhere in India or the Philippines), all I want is for Tom to fix my problem, whatever that is. I’m not in the market for explanations. On the ETF front, however, I really like knowing all the technical ins and outs. That may not be your thing. You may be like me with my computer problems: “Just tell me how to make money with these things, and keep the technical stuff to yourself, Russ.” Okay, I do that. Sort of. Throughout this book, you usually find the heavy technical matter tucked neatly into sidebars. But if any technicalities make it into the main text, I give you a heads up with a Technical Stuff icon so you can skip over that section, or just speed-read it if you wish. 6 Exchange-Traded Funds For Dummies, 2nd Edition Foolish Assumptions I assume that most of the people reading this book know a fair amount about the financial world. I think that’s a fairly safe assumption. Why else would you have bought an entire book about exchange-traded funds? If you think that convertible bonds are bonds with removable tops and that the futures market is a place where fortunetellers purchase crystal balls, I help you along the best I can by letting you know how to find out more about certain topics. However, you may be better off picking up and reading a copy of the basic nuts-n-bolts Investing For Dummies by Eric Tyson (published by Wiley). After you spend some time with that title, c’mon back to this book. You’ll be more than welcome! How This Book Is Organized Here’s a down-and-dirty look at what’s in store in the next 350 or so pages. Part I: The ABCs of ETFs Just what is an ETF, after all? The beginning of the book would seem like a logical place to cover that topic, and I do. You also find out what makes an ETF different — more sleek and economical — than a mutual fund. (Think Prius versus SUV.) This section of the book also begins the discussion of how to actually buy ETFs — the very best of them — hold them, and, when necessary, cash them out. Part II: Building the Stock (Equity) Side of Your Portfolio You wouldn’t want a closet filled with nothing but black slacks or red sweaters, and similarly, you don’t want a portfolio filled with, say, nothing but tech stocks (remember 2000–2003 when your tech portfolio suddenly went poof?). ETFs are wonderful diversification tools, if used right. In Part II, I show you how to mix and match your stock ETFs to build a portfolio that will serve you well in both good times and bad. Introduction 7 Part III: Adding Bonds, REITs, and Other ETFs to Your Portfolio In this part, I walk you through the construction of a portfolio beyond its stock components. I introduce you to a bevy of bond, real estate (otherwise known as REIT), and commodity ETFs, and I show you how to massage those into your portfolio for maximum diversification. (Oh, have I not mentioned that diversification is all-important?) Afterward, I discuss non-ETF investments (such as mutual funds, individual stocks, and exchange-traded notes) and how to determine if those are appropriate and desirable additions to your portfolio. Part IV: Putting It All Together Here, you find sample portfolios. You may find one that fits you like a glove. Or you may find one that you can tinker with to make it your own. After that business is done with, you enter a section of this book that I almost titled “Zen and the Art of ETF Portfolio Maintenance.” After all, after you have your ETF portfolio, you need to know how to maintain it, tweak it from time to time, and use it to serve both your material and spiritual needs — preferably with a cool head and calm spirit. Part IV helps you to address those needs. Part V: The Part of Tens A classic feature in the For Dummies series, The Part of Tens offers concise advice and food for extra thought, all in handy dandy list form. Part VI: Appendixes Here’s where you find websites you can visit to get even more information about this investment tool and a glossary to help you navigate any ETF resource. Icons Used in This Book Throughout the book, you find little globular pieces of art in the margins called icons. These admittedly cutesy but handy tools give you a heads up that certain types of information are in the neighborhood. 8 Exchange-Traded Funds For Dummies, 2nd Edition Although this is a how-to book, you also find plenty of whys and wherefores. Any paragraph accompanied by this icon, however, is guaranteed pure, 100 percent, unadulterated how-to. The world of investments offers pitfalls galore. Wherever you see the bomb, know that there is a risk of your losing money — maybe even Big Money — if you skip the passage. Read twice! This icon indicates that something important is being said and is really worth putting to memory. If you don’t really care about the difference between standard deviation and beta, or the historical correlation between U.S. value stocks and REITs, feel free to skip or skim the paragraphs with this icon. The world of Wall Street is full of people who make money at other people’s expense. Where you see the pig face, know that I’m about to point out an instance where someone will likely be sticking a hand deep in your pocket. Where to Go from Here Where would you like to go from here? If you wish, start at the beginning. If you’re interested only in stock ETFs, hey, no one says that you can’t jump right to Part II. Bond ETFs? Go ahead and jump to Part III. It’s entirely your call.