The stock market’s volatility has frightened many investors, and some have skittered off into the shadows for good. If you’re worried about the market but not yet ready to abandon it, perhaps it’s time to consider exchange-traded funds, or ETFs, as an alternative to individual equities.
ETFs look like mutual funds but behave like stocks. They are ideal for the individual investor in that they offer low cost and quick diversification—many funds spread assets across dozens or even hundreds of individual securities. You can buy as few as one share, unlike mutual funds. ETFs mirror an index or a basket of stocks or a commodity and don’t require a manager, so fees are usually quite small.
However, when evaluating a potential ETF investment, it’s important to consider the composition of the underlying assets and the methodology used to assemble them. According to Kiplinger’s, benchmarks that utilize market cap-weighting strategies have the potential to result in a heavy concentration of holdings in a handful of stocks—something that is undesirable for those who value true diversification and elimination of any company-specific risk.
If you value diversification—that is, spreading risk among many individual holdings—then you can pick an ETF that covers a truly diverse set of companies. A popular fund that holds stocks in all of the companies represented in the S&P 500 index is the SPDR S&P 500 ETF (NYSE: SPY), commonly known as a “spider.”
One proven strategy is to begin building your ETF portfolio by investing in funds that include stocks in the biggest and strongest companies. The Vanguard Mega Cap 300 Growth Index Fund (NYSE: MGK), for example, is likely to do well if the market rallies but ought to fall less than the overall market in a sharp selloff. Its biggest holdings: Microsoft (MSFT), Apple (AAPL), International Business Machines (IBM), Cisco Systems (CSCO), Google (GOOG), Wal-Mart Stores (WMT), Hewlett-Packard (HPQ) and PepsiCo (PEP).
You also can find ETFs that track developed foreign markets, stocks in individual countries or various emerging markets. Others track the price of gold, oil-exploration stocks and much more. Want bonds? You can invest in ETFs that mirror the entire U.S. bond market, the corporate bond market, indices of short-, intermediate- or long-term Treasury bonds and TIPS (Treasury Inflation Protected Securities). Another ETF to consider if you’re looking to add bonds to your portfolio is iShares S&P National AMT-Free Municipal Bond ETF (NYSE: MUB). Also, iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE: LQD) invests in high-quality corporate bonds.
Despite the benefits of ETFs, they are not for everybody. ETFs are traded through brokerages, which often charge commissions every time an investor buys or sells shares. If you like to mix up your portfolio weekly or monthly, ETFs may not be the best choice. If you do choose to invest in ETFs, you should be comfortable with a strategy that calls for fewer transactions. A buy-and-hold investor, in fact, may find that ETFs offer just what the doctor ordered.
And if you look hard, you can find ETFs that offer commission-free trades—Charles Schwab offers such a product, for example.
Finally, standard advice still holds: Most healthy portfolios include a mix of different investments. Talk to your broker or financial planner first to decide whether ETFs should be a part of your portfolio.
