DIY: The Diversified Portfolio using ETFs

The 10 Second Download

I think it is easiest to start most discussions about what investments to buy, with Exchange Traded Funds (ETF). In this post, I will tell you why I like ETFs for ‘entry-level’ investing, provide some recommendations and fun ideas to get you started, and highlight watch-outs you should keep in mind when deciding to own them. Probably the coolest thing about ETFs are their ability to give novice traders similar tools to that of the professionals, including, exposure to new markets, market leverage, and inverse market positions.

Exchange Traded Funds (ETF) allow you to easily diversify (or de-risk) your portfolio at a low-cost and are traded as easily as regular common stock. I use ETFs to get exposure to markets that I couldn’t otherwise. Some examples of those markets include commodities (gold, copper), international (Europe), real estate (REIT), and different US industries. ETFs have risk also, but you can use them responsibly as a passive investor to manage your investments based on economic cycles.

Invest in yourself. Financial Intelligence pays off.

If you want to know more about how to invest in ETFs, please keep reading…

Why you should care about ETFs…

You have probably started hearing this acronym thrown around a lot lately in financial circles, so let’s dig a little deeper on the topic of ETFs, or Exchange Traded Funds. These have become an increasingly popular investment vehicle over last few years as passive money management has become all the rage (there are actively managed ETFs, but I will be highlighting passive funds).

With the advent of technology, in-home trading platforms, and more real-time information at the fingertips of retail investors (a.k.a. Me or you, or investors who do not trade professionally for a living) than ever before, active money managers are becoming increasing less relevant for trading, within this demographic. I view them more as ‘financial advisers’ who will look at my family’s total portfolio of assets and liabilities to determine a plan for the future into our retirement years.

So, what is an Exchange Traded Fund? It is a financial instrument that tracks the value of Index Fund or a basket of assets. Let’s use the example (probably the easiest to understand), of the SPY which is an ETF that tracks the value of the overall S&P 500 Index. This is a way for you and me to ‘buy the market’, instead of just individual companies. The criticism of a lot of managed funds is that it is very hard to consistently beat the market (S&P 500), so why not just passively ‘buy the market’ and call it a day? This ETF allows us to do just that and, oh by the way, through its dividend, this fund pays you 2% a year and will cost you virtually nothing to own.

Start your ETF investing journey

Step 1: You have opened an online brokerage account (I have 4 because I am a nerd about trading platforms which all have their unique set of analysis tools and mobile interfaces) and you want to get started trading, but you aren’t sure where to start.

Best resource for knowing what you are buying

A great resource is etf.com Analytics ETF Finder, which is a free database containing all the information you need to know about every ETF. Below is a screenshot from ETF.com which shows you the asset concentration of the Top 10 holdings within SPY (S&P 500). Notice that the top four holdings in this fund are Technology stocks which comprise almost 11% of the value of the portfolio. There are 500 holdings in this fund but less than 1% of them make up almost 11% of the value! I only show you this to illustrate that, because it is a basket of funds you get when you own an ETF, it is important to know what you are buying.

Top 10 holdings within SPY ETF as shown on etf.com

~ screenshot from etf.com

With their increasing popularity, more ETF symbols are being created every week and the list is extensive and confusing. If you want to own US sectors, stick to picking from the list in this table below and you’ll be in good shape. For the most part, he first row is the ‘broad’ index funds and as you go down the columns it outlines more sector-specific funds. If you stick to the first row, your expense ratios will be low. ETFs charge annual expense ratios to cover the costs of the investment bank who assembled to the product. The cost of most of these top row items is around 0.14% a year (or $1.40 on every $1,000 invested) which is nothing to worry about.

One thing to highlight is that the economy moves in cycles of growth and contraction, so I have arranged these in such a manner as to highlight the best performing US sectors within their respective economic cycle (left to right). You can buy these funds whenever you’d like, they just tend to perform better during the highlighted economic cycles.

Top US sector ETFs paired with related economic cycle

You want to buy? Here it is in 3 simple steps.

ETFs are ridiculously easy to trade because they share a lot of the same interface as common stock transactions (as if you were going to buy Coca-Cola (KO) or McDonald’s (MCD)). Just open a brokerage account and navigate to the Trade page within your account.

  1. Symbol: Enter the ticker symbol (usually 3 letters in length)
  2. Quantity: Enter the number of shares you want to buy (one, or more, at a time)
  3. Order Type: Enter the Limit price you want to pay for each share
Charles Schwab trading platform for ETFs & Stocks

~screenshot from Charles Schwab

Trade like a Professional using ETFs

#1 Diversify your Holdings

Over time, if you have accumulated positions in all of these funds you will have a well-diversified portfolio. Of course, the proportion that each makes up within your portfolio will determine your risk and exposure to the market. I have ordered these from, what I believe to be, the most volatile to the least volatile in order to help you allocate your money on, either the aggressive or conservative side.

  • VNQ = Real Estate Fund
  • VGK = European Fund
  • IWM = Russell 2000 Small Cap US
  • SPY = S&P 500 Large Cap US
  • GLD = Gold Fund
  • LQD = Corporate Bond Fund
  • TLT = 20 Treasury Bond Fund

#2 Play with Leveraged Funds

Scenario: You are convinced that the bank stocks are going to take off this week and you want to lean into that position pretty heavily.

Buy FAS which is an ETF that is leveraged at 3 times the exposure of XLF (Large Cap Financial stocks). In other words, this tool allows you to gain leverage in the market without understanding how to trade derivatives (options) or need to have the cash-on-hand.

#3 Play with Inverse Market Funds

Scenario: You are convinced that the bank stocks are going to tank off this week and you want to fade that position pretty heavily.

Buy FAZ which is an ETF that is leveraged at 3 times the exposure of the INVERSE of XLF (Large Cap Financial stocks). In other words, this ETF allows you to short the financial stocks without needing to have margin account (borrow money from the bank).

I want to reiterate, both Inverse and Leveraged Funds are designed for short-term investment ONLY! If can avoid it, do not buy and hold these for longer than a week, maybe two. The way these funds are built (daily) they can become distorted through rebalancing over time and you could lose the money you invested in it.

4 ETF watch outs to keep in mind

#1 Watch out is Liquidity

Liquidity is your ability to trade the fund on the open market, without large spreads (bid/ask) that cost you money, allowing you to easily unload the asset to a willing buyer. The funds that have been highlighted so far in this post are liquid enough to not have to worry.

#2 Watch out is Inverse/Leverage

These type of funds, as I mentioned above, give you the ability to apply a protective trade against a short-term downturn in the market (without liquidating your existing long positions — tax purposes) or capture a quick steep upturn/downturn without putting as much money at risk.

#3 Watch out is Fund Holdings

As we talked about earlier, just be aware of what positions your fund contains and how the holdings within it are weighted.

#4 Watch out is the Bubble?

In order to provide more complete information, I wanted to make you aware that, as with any financial instrument that gains popularity, there has been some concern in the marketplace regarding an ETF bubble. The Investopedia article “ETF Bubble or No Bubble?” By Sheila Olson does a great job of outlining recent concerns around this topic. I would suggest reading this to get a rounded perspective on this investment vehicle. http://www.investopedia.com/articles/etfs/etf-bubble/

ETFs & 401Ks are like oil and water

I mentioned that whenever someone asks me about getting started investing I lead with ETFs, however, the conversation usually starts out more like this, ‘My company has this 401K plan where they provided a list of investments (mutual or blended funds) that I can choose from. How do I know which ones to pick?’

Most companies do not offer ETFs in their retirement plans, not because they aren’t awesome investment tools, but more due to concerns other than offering its customers the best product on the market (e.g. incentives and kickbacks for brokerage firms pushing their own assets, etc.). The bottom line here is that if your company doesn’t offer you the ability to transfer your money to a trading account (e.g. Fidelity Investments’ 401K Brokerage Link) then you will be unable to purchase ETFs. Because every company has different 401K investment options, and if not only for that very complicated reason, I often do not get into specifics in conversations regarding people’s 401k investment options.

However, in a follow-up post, we may get into mutual funds, blended funds, and fixed income funds (items often offered in 401K plans).

Invest in yourself. Financial Intelligence pays off.

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