Exchange Traded Funds (ETFs)
Exchange Traded Funds (ETFs) offer a quick and efficient method for investing in well-known stock market indices.
Instead of paying a fund manager 1.5% and then hoping and praying to beat the market, you simply mimic the market return while keeping your management costs as low as possible.
In the meantime, you get to enjoy all the benefits of a diversified stock portfolio without the risk of underperforming the market!
What's an Exchange Traded Fund (ETF)?
An Exchange Traded Fund (ETF) is an investment vehicle which represents a broad portfolio of securities, yet it's traded in the same way as an individual stock on the major stock exchanges.
ETFs can cover a wide variety of securities such as stocks, bonds, commodities, or even specific sectors of the stock market.
Because of this, the market price of an ETF tends to reflect the underlying value of the securities it represents...
The most popular ETFs track widely followed market indices, such as the Dow Jones Industrial Average, the Russell 3000, or the S&P 500.
For instance, the SPDR Trust (SPY), tracks the performance of the S&P 500.
As a result, when you buy a single share of SPY, it's as though you've purchased fractional shares of stock in all 500 companies in the S&P 500.
Exchange Traded Fund (ETF) Advantages
ETFs not only give you broad market diversification with a single purchase, they also offer low cost and liquidity advantages over traditional mutual funds...
Save Money on Management Fees
Exchange Traded Funds (ETFs) offer enormous cost savings over actively managed mutual funds when it comes to annual management fees.
ETFs typically charge a fee of somewhere between 0.08% and 0.09% of assets versus a typical actively managed mutual fund which charges an average fee of 1.5%.
If you're a long-term buy-and-hold investor, the cost difference adds up to a substantial amount of money.
For example, let's say your Roth IRA returns 10% annually before expenses over a 30 year period...
Scenario 1 shows your return from an ETF with a 0.09% expense ratio versus Scenario 2 which shows an actively managed mutual fund with a 1.5% expense ratio. The results are dramatically different...
Expense Ratio: 0.09%
Future Value: $133,042.43
Expense Ratio: 1.50%
Future Value: $110,883.63
That's a 19.9% difference in your retirement, or in this case, $22,158.80...!
If you trade frequently or you simply want to purchase securities at a real-time price while the market is open, then Exchange Traded Funds offer the advantage of instant liquidity.
Since they're treated just like stocks, Exchange Traded Funds (ETFs) are bought and sold in real-time throughout the trading day. This allows you to receive real-time quotes on your securities as well as execute real-time buy and sell orders, so you can share in the rest of a trading day's gains or losses.
Mutual funds, on the other hand, gather requests for new orders and redemptions during the course of the trading day and then issue or redeem shares at the close of the market based on the net asset value (NAV) of the fund's holdings at the market close.
This is a disadvantage because the price you pay can fluctuate dramatically in either direction by the time of the market close...
But with ETFs, you don't have to worry about these price swings.
Excessive Transaction Costs
When it comes to making long-term investments, you need to limit your transaction costs and trading fees as much as possible.
Because just a fraction of a percentage point shaved off of your annual return adds up to a lot over 20 or 30 years. So always keep an eye on these costs!
One apparent disadvantage of an ETF versus a no-load mutual fund is that a mutual fund usually allows you to add small incremental contributions on a regular basis without incurring additional transaction fees or trading costs.
So if you're trying to dollar cost average over a long period of time, or if you only have small amounts to invest on a regular basis, such a feature could save you a lot of money.
However, online discount brokers like Sharebuilder essentially allow you to do the same thing with ETFs. With Sharebuilder, you can regularly purchase small pre-determined dollar amounts of stocks or ETFs while paying a flat fee for a set number of trades.
A number of online discount brokers offer this service, so fears of incurring excessive trading costs with ETFs are unwarranted.
In the end, ETFs and no-load mutual funds are both capable of protecting shareholders from the high transaction fees associated with front-end, back-end, or level-load mutual funds.
Of course, it always depends on the particular fund or ETF in question as well as your individual funding plan...
As a general rule, you shouldn't spend more than 2% of your principal buying into any investment.
Obviously, the lower your cost, the better your return in the long run.
Your Roth IRA and Exchange Traded Funds (ETFs)
If you want your Roth IRA to experience the long-term inflation-beating benefits of the stock market, but you don't have the time to research your own stock picks, then a market index Exchange Traded Fund (ETF) is your best bet.
You save money...
You save time...
And you save sleep, confident your investments won't underperform the market...
Buy a broad-based market index ETF, and your Roth IRA is essentially on worry-free autopilot (assuming you have at least a 15 year time horizon).
You won't be boasting to your friends about beating the market...
But you don't have to worry about underperforming it either.
Instead, your money will grow like compound interest in a savings account except, unlike a savings account, the annual interest rate will tick upward over the long haul...
How can I be so sure?
Because of dividends.
Most discount brokers allow you to reinvest dividends free-of-charge, so even if your ETF shares don't substantially increase in price, you should realize a sizeable inflation-beating gain from dividend reinvestment alone.
In his book The Future for Investors, Wharton business school professor Jeremy Siegel vividly illustrates the power of dividends. He points out the following...
"From 1871 through 2003, 97 percent of the total after-inflation accumulation from stocks comes from reinvesting dividends. Only 3 percent comes from capital gains."
For example, assume for the sake of argument that you had put all of your retirement money in a total market index fund at the market peak in 1929. If you relied solely on capital gains (that is, rising stock prices) to fund your retirement, 25 years would have gone by before you broke even on your original investment!
But if you had reinvested your dividends over the same time period, you would have received an annual return of approximately 6%...
In this case, dividends literally made the difference between a 0% annual return and a 6% annual return!
So even if you had made one of the most ill-timed investment calls in stock market history, you still would've come out on top in the long-run...
But only by taking advantage of the power of dividends.
The lesson here is that if you invest in the stock market and reinvest your dividends, and you'll do just fine in the long-term.
If you think this makes sense, and you want to put your Roth IRA on worry-free autopilot and reinvest your dividends, make sure to use a discount broker who provides free automatic reinvestment of dividends. In most cases, it's as simple as checking a box in the Settings section of your account.
If you choose this Roth IRA investing strategy, you have one more important decision to make...
What ETF Should You Invest In?
That's a good question, and the answer's not the same for everyone.
Take your time and research the best exchange traded funds. Compare expense ratios, dividend yields, and levels of diversification... For instance, is it a total market ETF or just a particular sector like financials?
Go with the one you're most comfortable with.
My personal recommendation is the Vanguard Total Stock Market (VTI) ETF.
1) Its expense ratio of 0.07% is among the best in the industry.
2) It pays a regular dividend which you can automatically reinvest.
3) It seeks to track the performance of the entire market, rather than a select portion.
The third characteristic is especially important.
As a general rule, the broader the market index, the better.
For instance, a rather fine ETF is The SPDR Trust (SPY), which tracks the performance of the S&P 500. While the S&P 500 accounts for a large portion of the U.S. stock market's value, it doesn't include every company...
When any fund excludes a large number of smaller companies, investors miss out on the long-term profit potential of some of the fastest growing companies in the world. Oftentimes, those small companies become the large companies of tomorrow.
But don't spend too much time overthinking what is or isn't the perfect ETF...
What's most important is picking the right ETF for you. Once you've settled on an ETF, your only remaining goal should be to maximize your annual Roth IRA contribution and plow as much money as possible into your account.
Put your Roth IRA on autopilot...
And invest in an ETF.
Does this sound like the plan for you?
Then you're ready to move on to the next step in taking control of your financial future...
Move to Step 3 - Successfully Executing Your Investment Strategy >>>
However, maybe an ETF isn't right for you...
Does putting your Roth IRA on autopilot sound boring?
You might want to try your hand at picking individual stocks. If so, click the link below to learn everything you need to know about investing in common stocks...
Learn about Investing In Common Stocks >>>
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