Exchange-traded funds, or ETFs, are becoming increasingly popular with investors — and for good reason.
SMI executive editor Mark Biller explained the attraction of ETFs yesterday on Moody Radio's MoneyWise Live. Mark also answered caller questions.
To listen, click the play button below — or, if you prefer, scroll down for a transcript. (For more radio appearances by members of the SMI team, visit our Resources page.)
MoneyWise Live, with hosts Rob West and Steve Moore, airs daily at 4:00 p.m. ET/3:00 CT.
To ask a question on a future program, call 1-800-525-7000 and mention you have a question for either Mark Biller or Matt Bell of Sound Mind Investing.
Steve Moore: The pros and cons of exchange-traded funds. That's next on MoneyWise Live.
Rob West: Rob, it's always great to have Mark Biller with us as the executive editor at soundmindinvesting.org. He has to stay on top of the markets and market trends so we don't have to.
Rob West: Well, that's right. (chuckle) He does make things a lot easier for us. And Mark, it's a treat to have you with us. Welcome back to MoneyWise Live.
Mark Biller: Thanks guys. Good to be here.
Rob West: Now, give us the story with the free trading news at the big discount brokers, because we've seen a lot about that recently.
Mark Biller: Yeah, absolutely. So you know, the big picture here, Rob, is the cost of trading stocks has been falling for decades now. It used to cost hundreds of dollars for every stock trade that an individual would place. And it was still a big deal when commissions fell all the way under $20 a trade in the late 1990s. But last month things changed yet again when Schwab "went nuclear" as one trade publication put it — and Schwab completely eliminated trading commissions on stocks and exchange-traded funds or these "ETFs." So stocks and ETFs now trade for free. And not surprisingly Schwab's big competitors — which are TD Ameritrade, E-Trade, and Fidelity — they really didn't have any choice but to match that free trading, which they did shortly thereafter.
Rob West: And the ETFs, you mentioned, a lot of investors are still hazy on what those are, so let's begin to dive into that area. Why don't you start with a definition?
Mark Biller: Sure. The simplest way to understand an ETF is to think of it as a mutual fund that trades like a stock. So like traditional mutual funds, exchange-traded funds offer a really convenient way to invest in a pre-assembled basket of stocks. But instead of being priced just once a day, like mutual funds are after the market closes, ETFs trade continuously throughout the day the way individual stocks do.
Most ETFs are index funds. They're similar to traditional mutual funds that track the performance of a particular stock market index. And some of those are broad and well known, like the S&P 500 index. And then others are extremely narrow and, frankly, are a made up index because someone wanted to start an ETF to track a particular slice of the market, so they created an index that that ETF could track and follow along with. So these days, the big picture really is that there's basically an ETF for any slice of the market that an investor would want to track or invest in.
Rob West: Yeah. What are some of the other differences that might make ETFs either more or less attractive to investors?
Mark Biller: Yeah, so a couple of advantages before we move to some disadvantages. One thing that we've seen that individual investors really like about ETFs is there's no minimum investment amount. You can literally go in and buy a single share of an ETF. So whereas most traditional mutual funds have a minimum of say $500 or $1,000, something like that, if you're looking to diversify across a handful or several different ETFs, it's usually possible to do that for a very small amount of dollars — especially now that you're not paying trading commissions to be able to do that. So that's a big deal.
And then another advantage that ETFs have is they do tend to be among the very lowest expense type of investing you can do. Traditional mutual funds that are index funds are going to be low expense ratio as well. But ETFs are definitely going to be in that very low cost bucket, which is obviously appealing.
Now a couple of disadvantage of ETFs. Ironically the biggest disadvantage is really the same thing we just said as one of their big advantages — and that's the fact that they trade like individual stocks throughout the day, and that "trade anytime" aspect kind of does create more of a short term mentality that works against the long-term "slow and steady" approach that we're always talking about on MoneyWise. So that can be a problem. That can be a little bit of a temptation to trade more frequently.
And also the fact that they trade like stocks does make them a little bit more complicated to trade than traditional mutual funds. With a traditional mutual fund, usually all you need to know is the ticker symbol and how much you want to buy. "I need $500 of XYZ fund" — and you're good to go. With an ETF, you've got to do a little math. "Okay, how much, how many shares can I purchase with the $500 I have?" And then you've got to figure out which order type you're going to use. None of these things are really hard, but you do need to learn a few basics to be able to enter those trades successfully.
Rob West: Hmm. Your questions for Mark Biller today before our lines fill up — if you have an investing related question, we'd love to hear from you: 800-525-7000.
Mark, you mentioned that these are often low-cost, but also low minimums. Is that why we see so many ETFs used with robo-advisors? Because you're able to take a small amount of money and allocate it across a large number of, not only investments, but asset classes and even getting international and bond exposure — that type of thing?
Mark Biller: Yeah, I think that's exactly it, Rob. It does make it a very appealing vehicle for that. And, you know, that brings up another interesting point though — and that is that one reason a lot of investors are not all that familiar with ETFs is because ETFs typically are not available through company retirement plans. That's clearly a disadvantage at this point since that's where a lot of individuals do their investing. And the reason for that is, to this point, you don't have the ability to trade fractional shares of an ETF. And that kind of gets back to what we were talking about a minute ago, where if you're in a 401(k) and you're saying, I've got $100 a month to invest with traditional mutual funds, they take that full $100, put it to work, and they can do fractional shares very easily to put the whole $100 to work. But that's not the case with ETFs, at least to this point. There have been some rumblings about some things changing down the line in terms of fractional ETF shares, but at this point that's the main reason they're not available through most company 401(k), 403(b) plans.
Steve Moore: Guys, let's see if we can squeeze in a couple of phone calls up to New Hampshire. Deanna, thanks for calling in today. You're on with Rob West and Mark Biller. What's your question?
Caller: Oh, hi. Thank you for taking my call.
Steve Moore: Sure.
Caller: I work for the government and I have a 401(k) and a Roth IRA and I was just always wondering how much to put in each one.
Mark Biller: That's a great question, and usually the first rule of thumb that we look at is if there's a match to the 401(k). If you are eligible for a match from your employer, then we always want to go to the 401(k) first because that's free money that they'll put into the account for you. Now, beyond the matching amount — so if they'll match, say the first 3% or 6% whatever the case is — beyond that amount, it becomes more of a question of "Do you like the investment choices in your company plan, or would you prefer to have other investment choices that you could access through the IRA?" And if that's the case, then a lot of times people will invest their first dollars in the 401(k) up to the match, and then they'll switch over and start funding their Roth IRA with a remainder of their savings.
Rob West: Deanna, does that make sense to you?
Caller: Oh, yes, very much. I thank you so much. And just one more thing I keep hearing about a recession. I'm 59. I have no idea when I'm going to retire. I like what I'm doing, so do I need to worry or...
Rob West: Mark give us the month that the recession is — no, I'm just kidding. (laughter) But seriously, you know, we are 11 years into a bull market. We know these things work in cycles. To Deanna's point, Mark, how should somebody who's perhaps somewhere between five and 10 years out from retirement begin thinking about their allocations toward investments in light of the fact that the economy and the market is cyclical and no one knows when the next bear markets coming?
Mark Biller: Yeah, I think you buried the answer in the question there, Rob. It really comes down to the allocations. It's not the kind of thing where we would encourage people to just stop, you know, contributing to their plan altogether. But for all the reasons you just mentioned, it is a time to be thinking very carefully about the level of risk that you're taking on, and the easiest lever to pull to change that risk is the asset allocation between stocks and bonds.
So it could be a time to lower the stock allocation if you've been kind of a high stock allocation person, or maybe you're just putting your new contributions in a less risky allocation, putting more of your new money into bonds — you know that's going to be more dependent on where you are already and what your allocation is already. But it's definitely time to be looking at the risk level of the portfolio. The return of your capital is becoming more important than the return on your capital at this point in the market cycle.
Rob West: Yeah. I think the thing we don't want to do, Mark, is stay fully invested all in on stocks, wait for the market to take a dive, and then go to cash. We want steady plotters, right?
Mark Biller: That's right. That's truly the worst case scenario, and unfortunately that is what happens to a lot of people if they're stock-heavy on the way into a bear market.
Steve Moore: Mark, we have to hit a break here. Just a real quick question. Doesn't need a long involved answer — you know how you get some times. But I'm thinking, I'm thinking "turkey futures." What do you think? Between now and the end of the month?
Rob West: I'd say go big.
Steve Moore: Go big or go home — or go get on someone else's radio program. He's Mark Biller. He's Rob West. I'm Steve Moore. Give us a call. 800-525-7000 we'll be back with more after this.
Steve Moore: Let's go back to our phones. Chicago, Illinois. Tanya, you have an interesting question today. What are you thinking about investing in?
Caller: Yes sir. I am a cub investor. I know nothing. And so I wanted — first of all, I'd like to say hello to both you and Mr. West and thank you for having me. I work part-time for Uber and, as you know, they went public and I looked up their stocks and initially and they were like $47-$48 a share, and some people say you shouldn't invest when it's that high. But then I looked it up the can and it had went down. And so I don't know if that's good or bad. If you have $1,000 can you really invest in, um, what do you recommend like if you have $1,000 to invest? That's my big question. And the next question. So can actually disconnect me after this. I just want to know, is there a Chicago location that you can refer me to that can help me in this further? And those are my questions.
Rob West: Very good. Well, Tanya, first of all, thank you for listening. We appreciate your calling. You know, we don't give specific stock recommendations but you ask a very important question that really I think we can handle in addressing from principles. And you know, Mark, somebody who's a novice investor — she works for this company of course is an independent contractor. Uh, talk to us about IPOs, talk to us about individual stocks — especially when you're just starting out. Tanya's got $1,000 to invest.
Mark Biller: That's a great question. And we've been helping people like Tanya for many, many years get started as new investors. And what we generally prefer is to use the mutual fund or, as we've been talking about today, the ETF exchange-traded funds rather than individual stocks. And the reason for that is just the way that mutual funds and ETFs give you the ability with a very small amount of dollars starting out to get broad diversification very easily through a mutual fund or maybe one or two, a collection of mutual funds. When you buy an individual stock, you're very concentrated in the fortunes of that particular firm. Sometimes that works out great. People who invested in the Amazon IPO, they've done very, very well. But there are lots of other stories of hot, trendy companies that go public, have an IPO, and the stock either goes down, as Uber has since their IPO, or maybe it just doesn't do a whole lot of anything over time, and you're hitched to that one particular wagon. Whereas we would prefer to see a new investor invest in the market more broadly so that as some companies do well and others do poorly overall, we know that the trend of the market over history has been higher. That's not the case of any individual company necessarily. So that would always be the direction we would recommend for newer investors, Rob, is broader-based mutual funds or ETFs.
Rob West: That's great, counsel. Tanya as to the second part of your question, head over to soundmindinvesting.org for some great ideas based on God's word.
Steve Moore: Back to our phones. We'll remain in Chicago this time — Laurie, how can we help you today?
Caller: Yes, hi. I'm going to be getting an inheritance from my mom who recently passed on of about $150,000. I'm 69 years old. Our house is paid for. We don't have bills. I want to park it somewhere safe. What should I do with it?
Rob West: Talk to us about when you say you want to park it somewhere safe, are you looking to draw an income off of this Laurie? Or is this money that you don't plan to touch for some significant period of time, barring something unforeseen?
Caller: Correct. I don't need to use it for anything. I just thought it'd be great to let it grow.
Rob West: Yeah, very good. And by the way, congratulations on living within your means being debt free. Mark, where would you direct her from an investment standpoint with this inheritance, beyond any giving that she might want to do?
Mark Biller: Laurie, the the "risk ladder," if you will, starts with at the bottom with the lowest risk type of investments. Those are typically like bank investments, like CDs, things you're familiar with at your local bank. The next rungs of the risk ladder as you move up would be short-term bonds. And then as your bond length gets longer, you're going up the risk ladder. So one idea would be to diversify into some good short and intermediate term bond funds. Keep your risk low, get some income flowing, and that would be a good place to start.
Rob West: I'd recommend, Laurie, you check out a Certified Kingdom Advisor there in Chicago. You can do that on our website — moneywiselive.org. Just click "Find a CKA."
Mark, always a treat to have you with us, my friend. Thanks for stopping by.
Mark Biller: Thanks guys. Good to be with you.