The other day, my neighbor asked me what I was investing in right now, and I quickly rattled off a few of my favorite exchange-traded funds (ETFs). His next question was, “What’s an ETF?”
At first, I was shocked that he didn’t know what an ETF is. I’ve been using ETFs in my investment portfolios for nearly a decade now. My acquaintance with these tools produces the same feeling of putting on a favorite shirt, or easily navigating through my house in the dark. The feelings of familiarity are so ingrained, that I often forget many people are still learning about these investment vehicles for the very first time.
If you want a quick primer on what an ETF is, click here. I list some of my favorite reasons I love these tools and what you can expect from them.
He then mentioned that he had invested his money is with a big mutual fund company, mainly because his father used to work there. He proudly announced that he is not required to pay the upfront sales charges on their actively managed funds, mainly because of that legacy relationship. How nice of them! Of course, he probably doesn’t realize that they are skewering him for about 2% in expense ratios on top of horrendous relative performance.
A Better Way To Invest
Those who are just starting out on the path of ETF enlightenment may not understand how they work, which ones to choose, or how to buy and sell them. A lot of people who have always used individual stocks or mutual funds, are now ready to make the switch because ETFs are undeniably a better and cheaper alternative.
If you are one of those people, let me set your mind at ease – you are in the right place.
Maybe it took you a little longer to get here than others, but using ETFs will fundamentally change the way you invest. You won’t have to worry about chasing individual stocks or searching for the best CEO. You don’t have to fret over high fees or surrender charges or trying to beat a benchmark. You simply get diversified exposure to stocks, bonds, or commodities…with as little friction as possible. That’s the bottom line.
Not everyone has the same needs when it comes to their investment endeavors and many will stay with tried and true methods. Nevertheless, you can probably find a spot to replace legacy holdings or allocate new capital to these low-cost funds with very successful results. With a little careful planning and disciplined execution, you can be on your way to investing in ETFs on your terms.
Getting Started With ETFs
When you are get started with ETFs, it’s important to concentrate on how these funds will integrate into your portfolio. You will quickly find many views on the “Top 3 ETFs for Dividends” or “Best ETFs To Own Right Now”. Those types of selection criteria should only be implemented after you fully understand what they are and how they work.
Below are some of my recommendations for getting cozier with ETFs and integrating them in your portfolio for the first time.
- Look for core ETFs in your own backyard. Fidelity, Schwab, Vanguard, and TD Ameritrade offer a great suite of commission-free ETFs that should be your first look. These platforms either have their own in-house funds, or have partnered with top-tier ETF providers to select some of the cheapest and most liquid ETFs on the planet. Use this small pool as a jumping off point to start evaluating and comparing these funds against what you currently own. I think you will be shocked at how much better their relative performance is, versus many actively managed mutual funds and the majority of individual stocks. The ability to buy or sell them with no transaction charge is a huge bonus for investors, further reducing the barriers to ownership and risk management.
Note: each brokerage company will have a slightly different menu of funds available to trade commission-free.
- Understand what you own and why you own it. One of the biggest advantages of ETFs is their transparent structure. The fund companies that create these products post and regularly update the current expenses, yields, portfolio holdings, performance, and more. Using this wealth of knowledge to understand the portfolio makeup, its strengths or weaknesses, and other key points, will help drive your decision making process in the long run.
- Create an ETF watch list. This should include fresh positions that fit your investment criteria or simply potential opportunities for inclusion at a later date. You can monitor and evaluate these holdings without having to deal with the uncertainty of how they will perform versus your current holdings. As a bonus, a well-honed watch list is a perfect place to review when the market takes a dive or you have fresh capital to invest.
- Setup a regular schedule of portfolio analysis. This can be monthly, quarterly, or annually. The objective is to review your positions and consider changes in light of your goals, not the market’s mood. This process may include reviewing new contributions or withdrawal rates, evaluating the performance of the chosen ETFs in your accounts, and making slight adjustments as needed. Many investors overlook the necessity of a regular portfolio checkup – don’t be one of them.
- Be patient. You don’t have to do everything on day one. If you want to buy one share of a commission-free ETF, just to make sure it won’t blow up, go right ahead. You can always add to it incrementally over time or slowly transition your portfolio away from legacy holdings at opportunistic inflection points. Many investors make the mistake of trying to do everything too fast and getting upset with an overlooked risk or timing error.
The Bottom Line
There is no doubt in my mind that ETFs are one of the best tools available for individual investors. They aren’t fool-proof, risk-free, or guaranteed by any measure. But what they do provide, is a solid foundation from which you can build a diversified and flexible investment portfolio; one with dependable results.
If you know you want to make the leap, but aren’t confident in your ability to execute that plan, make sure you partner with an investment advisor that understands the ETF landscape. Such a relationship can lead to continuing education and peace of mind that your portfolio is being managed correctly.
Until next time,
David Fabian is a Managing Partner at FMD Capital Management, a fee-only registered investment advisory firm specializing in exchange-traded funds. He has years of experience constructing actively managed growth and income portfolios using ETFs. David regularly contributes his views on wealth management in his company blog, podcasts, and special reports.