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Adding ETFs To Your Portfolio

05/24/06 11:47:24 AM PST
by John Devcic

Is it time to consider adding exchange traded funds to your portfolio?

With so many different ways that an investor can put their money to work these days, it can be a daunting task to decide which method is the best. You may have considered using exchange traded funds (ETFs) as part of your investing portfolio. Whether you've heard about them on TV or read about them, there is no doubt that ETFs are this year's widely talked about vehicle to play the market. As with anything relatively new, it is often misunderstood by the investing public at large. Do you know what an ETF is, or do you think they are a type of mutual fund? Such misunderstandings have clouded the public's perception of what ETFs are, and it is time to clear those up and unveil what an ETF is and how it might fit into your investing strategy. Let's look at what ETFs are and how they can be incorporated in your portfolio.

WHAT IS AN ETF?
Before you can make any kind of investment decision regarding ETFs, you have to know what they are. So what exactly is an exchange traded fund? Like stocks, they are traded in the markets. Each ETF represents a basket of securities that trades under a ticker symbol. This makes them sound like a mutual fund. So you can view them as a hybrid between a stock and a mutual fund. ETFs can represent industries, sectors, or indexes, which makes them a great diversification tool. So with an ETF, you have something that you can trade during market hours instead of having to wait till the market close to find their value; with an exchange traded fund, you have a trading vehicle that lets you diversify within sectors/indexes, and you don't have the fees associated with mutual funds. Even the lowest-cost mutual fund has a hard time comparing to the savings and value offered by an ETF. So what are the disadvantages? There are some, but a solid understanding of ETFs will make them much easier to consider.

ADVANTAGES
Diversification: Exchange traded funds allow you to diversify via industry, sector, or index; you do not have to worry about choosing a single stock or commodity to invest in. Those of you who time the market can benefit from ETFs if you are sure of a sector moving higher but cannot decide on which individual security to buy. You can buy an ETF of that sector, and if there is a move in the direction you predicted, you can benefit from the move.

Trade like stocks: The second-biggest advantage of ETFs is that they trade just like stocks. You can trade them during the trading day unlike mutual funds, where the transactions occur at the market close. You can buy long or go short an ETF just like you can with a stock.

Cost: ETFs compare favorably to even the lowest-cost mutual funds available. Remember, mutual funds have active managers who are paid for their investment decisions, whether or not they are correct. Those costs are always handed down to the fund holders. ETFs are passively managed, and there is no fund manager making investment decisions.

DISADVANTAGES
Now that we have looked at the advantages, let's look at the other side of the coin.

Commissions: The biggest disadvantage ETFs have is that you need a broker in order to buy them. And just like with stocks, brokers charge a commission for their transactions both for buying and selling. So brokerage fees become an important factor when making a decision regarding ETF purchases.

May not be suited for small investors: ETFs are not really suited for small investors who cannot buy in bulk. So if you can only afford to buy a small amount every month, that's fine, but you must remember that each time you do buy more, you are using a broker and paying a commission to do so like you would with any other stock you purchase through your broker.


FIGURE 1: MOST POPULAR ETFS

MOST POPULAR ETFS
Figure 1 shows a list of the most popular ETFs trading currently. The name of the ETF, a brief description, and the ticker symbol are displayed.

After looking at Figure 1, it becomes obvious that you can indeed use ETFs to track the performance of an index, or they can be used to track the performance of a particular sector as in the SPDR Energy ETF. All the ETFs listed are traded on the American Stock Exchange. Some ETFs track commodities, such as the iShares COMEX Gold Trust, which trades under the symbol IAU, or the streetTRACKS Gold Shares, which trade under the symbol GLD. On April 28, 2006, a brand-new ETF called iShares Silver Trust was added, which can be used to track the silver market. This ETF trades under the symbol SLV. For investors new to the commodities market or those who want to trade the commodities market, a good way to familiarize yourself with that market can be through trading commodity ETFs.

ETFs offer a great deal, and since they allow an investor to take positions in sectors or indexes that might otherwise not be an option for them, buying ETFs is indeed a good way to take advantage of market moves without having to pick one or two stocks. While ETFs offer the benefits of a mutual fund they do not come with the disadvantage of a mutual fund, that being cost. An investor who wants to manage his or her own money can do so using ETFs. Like almost all investment vehicles, ETFs are not for everyone, and you should consider their disadvantages as well as their advantages before deciding whether to include them in your portfolio. For some, their biggest advantage, that they trade like stocks, can also be a disadvantage. Costs are always a concern, and with the price of brokerage fees, it makes trading in ETFs difficult and costly for some investors.

ETFs, if used properly, can help you participate in market moves that you may not otherwise be able to. Like mutual funds, ETFs offer investors a prospectus that can be a good way to decide if a particular ETF you have in mind is a good fit for your portfolio.

SUGGESTED READING
Devcic, John [2006]. "Winning With The Underdogs," March 17, Working-Money.com.



John Devcic

John Devcic is a market historian and freelance writer. He may be reached at drmorgus@gmail.com

E-mail address: drmorgus@gmail.com


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