A few posts ago, we discussed why you may never want to touch a mutual fund again. Since almost 80% of all equity mutual funds fail to perform as well as the stock market, shifting your under performing mutual funds to market performing Exchange Traded Funds (commonly known as ETFs or index funds) could make a significant long term impact in helping you to retire early. And since ETFs also have lower fees and share the diversity of an index, investing in index funds can provide that same comfort level as our mutual funds investments, except you can have a better performing investment plan.
With all the benefits we have covered so far, the only thing we don’t know about investing in ETFs is which ETF to invest in. Fortunately, investing in ETFs is easy as investing in mutual funds. The only consideration you need to make is how to begin.
Considerations for choosing the right ETF
Popular investors like Warren Buffet have previously suggested to “put [your money] in a low-cost index fund that tracks the S+P 500 index, and get back to work…” And I agree that using ETFs should be a cornerstone of your portfolio, but blatantly selecting only the S+P 500 index may not necessarily be the best course of action.
Here are other considerations to help you choose what’s important to you:
The economy: Buffett made this comment because for the last century, the best performing returns have come from the stock market. Why? Stock prices are (usually) reflective of a company’s growth. The more an individual company grows, the better the stock prices perform. And if more companies do well, the more the economy grows as a whole. So the future growth of the US economy is vital for your investments to grow. However if the economy doesn’t grow, your ETF won’t go!
I am not suggesting you become a professional prognosticator to determine the future growth of the economy, but by simply paying attention to how the economy is doing will be sufficient. Is it growing, slowing or contracting? Ask your broker or pick up a financial magazine, but don’t ask a friend.
Past Performance: While past performance is not indicative of future performance, I also recommend looking at past performance. Sure… we don’t know how our economy will do, especially among a growing globalized economy. There are so many variables, but unless we see a clear cut, head for the hills change in our economy, I like to look at long term past performance. Forget looking at 1 or 3 years of past performance. Try to look at the long term performance for the last 10 years. You can get such data from Morningstar, AAII, or possibly your broker. A longer history shows how well an index has done through good times and bad.
Diversification: One great benefit to choosing most ETFs is diversification. ETFs mirror an index, which is a basket of stocks, bonds, real estate, etc. The S+P 500 ETF (the “SPY”) has 500 stocks. You don’t need to diversify further in that respect. However, you still may want to consider diversification outside the market of what you initially chose. For instance, if you initially select a small cap ETF, you may want to consider an international ETF, a European ETF, a Clean Energy ETF or a Real Estate ETF, just to name a few alternatives. But again, don’t forget to look for long term past performance or value how you think growth in a particular economy or sector will do in the future.
Your financial goals: The ETF you choose should meet your financial goals. While that sounds obvious, choosing an aggressive ETF like the Emerging Markets Fund (EEM) can offer greater returns, but may have years of significant loses. Be sure to choose an ETF you feel comfortable with in good years and in bad.
Where to begin?
Now that you know what to look for, where do you start? My favorite place is Yahoo Finance, where you can sort through a bevy of choices. You can also try your broker, financial magazines, Morningstar or ETF Connect. A good website should give you the option to sort out ETFs by fund family, fund objective (large cap, international, sector funds, etc), fees, performance or other characteristics.
Quite often, one index may have several different ETFs mirroring the same index. They may all look like the same, but each ETF mirror comes from a different family, just like a mutual fund. You could see popular ETF families like iShares, Rydex, Amex Spiders, Power Shares and Vanguard all providing a similar ETF to the same index.
While some ETFs try to be perfect mirrors of an index, other funds try to improve their performance by offering “actively managed” index funds. This basically means that the fund family took a particular ETF and mathematically changed its composition to try to offer better returns. Power Shares, Rydex and Wisdom Tree specialize in offering these types of managed funds. Although they may have achieved better returns, these families also charge slightly more fees in return for this optimized fund.
No matter which ETF index you decide to go with, you should always have a plan of attack. This means using a stop loss program, setting profit goals and having a step by step approach which I cover in my guide that will lead you to fulfilling your retirement plan
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