Last week, we talked about the importance of diversification in your portfolio — making sure you snatch up a variety of stocks in terms of market cap, industry and other factors.
There are two main types of funds: mutual funds and exchange-traded funds. The latter is a great option (for a number of reasons) for young investors with a brokerage account.
All funds have what’s called an “expense ratio,” which represents the percentage of the fund’s assets that go purely toward the expense of running the fund. (You don’t “pay” this, per se; it’s automatically taken out of the fund’s performance.)
However, ETFs tend to be cheaper than mutual funds.
Part of that’s because most mutual funds are “actively managed,” which means there’s an actual manager with a specific strategy who will hand-pick what the fund holds. Meanwhile, most ETFs (though not all) tend to be “passively managed,” which means their performance is simply tied to a computer-generated index — and thus are able to charge less without a manager to feed.
For example: According to Fidelity, the average actively managed mutual fund in 2010 had an expense ratio of 1.45%, meaning that $14.50 was taken annually from every $1,000 you invested. However, all ETFs on average charged just 0.6% that year, or just $6 from every $1,000 invested. That said, even indexed mutual funds charged 0.73% — still more than the overall ETF average.
ETFs also don’t have “sales loads” — an additional fee charged by some mutual funds. Nor do they require minimum purchases; mutual funds often will make you buy at least, say, $1,000 worth of units. (Though the figure can be more or less than that.)
The only downside: Unlike mutual funds, ETFs aren’t an option in 401ks … so you have to have a brokerage account.
Still, you can see why an ETF would look attractive to a beginner investor starting with a small nest egg.
There are few better examples of how ETFs can help you diversify than the SPDR S&P 500 ETF (NYSE:SPY), which tracks the performance of the S&P 500 Index.
Other ETFs come in much more specific flavors — many targeting each of the four areas of diversification we discussed last week: markets, size, sector and style. The SPDR Select Sector ETFs, for instance, track different S&P 500 sectors. If you’re looking to add bank stocks to your portfolio, the Financial SPDR (NYSE:XLF) gives you a variety of S&P 500 components in the financial sector, including JPMorgan Chase (NYSE:JPM) and Goldman Sachs (NYSE:GS).
So, if you were to buy even a handful four funds with different flavors, you’d naturally have far greater variety (and thus greater protection) than if you simply bought a handful of stocks.
Let’s say you own four funds with 25 stocks each. If all the stocks were equally represented in those four funds, each stock would represent 1% of your portfolio — so even if one stock took significant losses, your portfolio as a whole would not be drastically altered. However, imagine you put the same amount of money into just four stocks, and one of those stocks took the same losses. You’re looking at 25% of your portfolio that’s in play. (Of course, the reverse is true — broader exposure does limit your potential for gains.)
On top of that, trying to achieve the same diversity via individual securities sure ain’t cheap.
To start, there’s a transaction fee for each stock purchase — $7.99 in the case of my brokerage account. So in the case of the SPY, you’d have to pay nearly $4,000 in transaction fees just to get exposure to all 500 stocks, vs. the $155 cost for a unit of the SPY. But what would really add up would be the cost of buying every single stock; tech giant Apple (NASDAQ:AAPL) alone would cost you more than $430 for a single share.
I recently bought the Market Vector Retail ETF (NYSE:RTH), a relatively new retail-focused fund with a relatively modest 25 holdings (stocks). Even then, buying one share of each holding would cost you. Here’s a look:
|Company||Ticker||Cost Per Share||COMPANY||TICKER||COST PER Share|
|CVS Caremark||CVS||$53.26||Bed Bath & Beyond||BBBY||$60.76|
Thus, one share of each of the 25 funds would ring you up a whopping $1,843, while one share of the ETF goes for a paltry $48.25.
It should be noted that you don’t get the same exposure to stocks via an ETF as you would if you bought one of each. For instance, if you bought one of all 25 stocks (and only owned those stocks), Walmart — which costs $73.22 per share — would represent roughly 4% of your $1,843.52 portfolio. However, in the RTH, Walmart represents 11.3% of the fund.
And similarly, your gains are limited by how much you invest. It’s simple math. If you spent $1,843.52 on all 25 stocks, or just the $48.25 for the ETF, and if both had the same percentage return — say, 5% — you’d obviously gain much more via the stocks. You’d have to invest a similar amount in the RTH to receive the same nominal amount of return (in this scenario).
But again, what you’re really trying to accomplish here is getting some level of “exposure” to a number of stocks — not owning a full share of each — and keeping your costs down by reducing transaction fees.
There’s plenty more to the world of exchange-traded funds, and we’ll cover those issues in the coming weeks, but the basic takeaway is simple: ETFs offer instant diversification, even to those with little money to invest.
As of this writing, Alyssa Oursler was long RTH.
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