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Investing with Exchange-Traded Funds Made Easy: Higher Returns with Lower Costs - Do It Yourself Strategies Without Paying Fund Managers

Understanding Exchange-Traded Funds

Getting Started in Exchange Traded Funds (ETFs)

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Why Invest in ETFs?

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Fixed-Income (Bond) ETFs

Stock ETFs

About 95% of ETFs are stock ETFs—they track indexes that contain stocks exclusively. The specific indexes tracked by stock ETFs break down into several categories:

Broad market
Market-cap
Growth and value
Sector (industry)
International
Dividend
Custom

Broad-Market ETFs

The investing industry divides stocks into various broad-market indexes, which serve as a benchmark for the performance of the entire stock market, or for a portion of the market. For instance, when investors say “the market was up today,” they’re generally referring to the Dow Jones Industrial Average®, an index that contains 30 stocks of major corporations that together serve as a benchmark for the entire market.

The weighting of each index—the percentage of the overall value of the index that each stock represents—can be determined by a number of factors, such as the market cap or the price of each stock in the index.

Cap-weighted indexes: These indexes weight stocks by market cap (short for market capitalization), which refers to the total value of the stock’s available shares. As a company’s stock’s share price changes, so do does its market cap. Cap-weighted indexes favor stocks with high market caps by owning more of those stocks than stocks with lower market caps. For example, in a cap-weighted index of 100 stocks, the 10 stocks with the highest market caps might make up 30% or more of the index’s value.
Price-weighted indexes: These indexes weight stocks by share price. Stocks with higher share prices represent a greater percentage of the index’s overall value than stocks with lower share prices.
Equal-weighted indexes: These indexes contain the same amount of each stock in the index, regardless of market cap or share price.

The Three Most Popular Broad-Market Indexes

The very first ETFs, introduced in the early 1990s, were designed to reflect the performance of the three major U.S. indexes: the S&P 500®, the Dow Jones Industrial Average®, and the NASDAQ 100®.

S&P (Standard & Poor’s) 500: A cap-weighted index of the stocks of 500 major U.S. companies across a broad range of industries.
Dow Jones Industrial Average (DJIA): A price-weighted index of the stocks of 30 major U.S. companies traded on the New York Stock Exchange and NASDAQ. Often referred to as the Dow, the DJIA is the world’s oldest and most closely watched index.
NASDAQ 100: A cap-weighted index of the stocks of 100 major domestic and international securities listed on the NASDAQ stock market. Many of the companies in the NASDAQ 100 are in the tech industry.

Other Popular Indexes

Wilshire 5000 Total Market Index®: A cap-weighted index of more than 6,500 publicly traded U.S. companies
Russell 3000®: A cap-weighted index of the 3,000 largest publicly traded U.S. companies
Russell 2000®: A cap-weighted index of the 2,000 smallest companies in the Russell 3000
Russell 1000®: A cap-weighted index of the 1,000 smallest companies in the Russell 3000

Popular Broad-Market ETFs

The expense ratios in the table below (and in all the tables throughout this guide) are intended to provide a rough comparison of the current expense ratios of popular ETFs. Since expense ratios change often, it’s essential to research the current expense ratio of any ETF you’re considering buying.

Symbol	Index Tracked	Expense Ratio
SPY	S&P 500	0.10%
DIA	Dow	0.18%
QQQQ	NASDAQ 100	0.20%
SVH	Wilshire 5000	0.21%
IWB	Russell 1000	0.15%
IWM	Russell 2000	0.20%
IWV	Russell 3000	0.20%

Market Cap–Based ETFs

The investing industry classifies stocks into five general groups based on market cap. Various ETFs are available that track indexes containing stocks that fall within each of the following market cap ranges:

Mega-cap stocks: Giant companies with market caps over $100 billion, such as GE and Microsoft.
Large-cap stocks: Companies with market caps of $10–100 billion. Large-cap stocks are typically well-known household names, such as Apple.
Mid-cap stocks: Companies with market caps of $2–10 billion. Examples of mid-cap companies include Hilton Hotels and Urban Outfitters.
Small-cap stocks: Small, often less-known companies with market caps of $100 million–$2 billion.
Micro-cap stocks: Very small companies with market caps under $100 million.

Market Cap and Risk

Each market-cap range tends to offer a different amount of risk and, therefore, potential return.

Stocks with smaller market caps tend to be more risky but have stronger prospects of high returns.
Stocks with larger market caps tend to be less risky but offer weaker prospects of high returns.

Based on these general guidelines, an investor looking for low risk and volatility might buy a large-cap ETF, whereas an investor looking for high returns (with the prospect of higher risk) might buy a small-cap ETF.

Popular Market Cap–Based Market ETFs

Symbol	Index Tracked	Expense Ratio
IOO	Mega-cap companies	0.40%
VV	Large-cap companies	0.07%
VO	Mid-cap companies	0.13%
VB	Small-cap companies	0.10%
PZI	Micro-cap companies	0.72%

Growth and Value Stock ETFs

The investing industry also divides stocks into two broad categories: growth stocks and value stocks. Various ETFs are available that track indexes containing just growth stocks or just value stocks.

Growth stocks: The stocks of rapidly expanding companies whose sales and earnings growth are expected to outpace that of the market as a whole. Though share prices of growth stocks may rise more quickly than share prices of value stocks, growth stocks are considered riskier than value stocks because they tend to be priced at a premium to the overall market and rarely pay dividends.
Value stocks: Stocks that appear to be undervalued relative to underlying fundamentals. Fundamentals are company financial statistics such as sales, earnings, and dividend yield. Value stocks often are older companies that pay dividends and tend to be less risky and volatile than growth stocks, though they also tend to offer less opportunity for high returns.

Various ETFs are available that track indexes that contain only value stocks, or only growth stocks. These indexes often combine the growth or value classification with a market- cap classification. For instance, rather than buy a small-cap ETF and a growth ETF, investors can buy a small-cap growth ETF and gain exposure to an index of small-cap companies with strong growth prospects.

Popular Growth- and Value-Stock ETFs

Symbol	Index Tracked	Expense Ratio
IWF	Large-cap growth stocks	0.20%
VOT	Mid-cap growth stocks	0.13%
VBK	Small-cap growth stocks	0.12%
JKF	Large-cap value stocks	0.25%
VOE	Mid-cap value stocks	0.13%
VBR	Small-cap value stocks	0.12%

Sector ETFs

In investing, the term sector is essentially a synonym for industry. The U.S. economy is typically divided into 12 sectors, from healthcare to technology to utilities. Sector ETFs track indexes composed entirely of companies within a particular sector. Investors buy sector-based ETFs when they believe a certain sector will outperform the overall market. For example, if you think tech stocks are poised to rise in value, you might buy a technology ETF. Sector-based investing is inherently riskier than buying broad-market ETFs: sectors are much more volatile than the market as a whole, as shown by the infamous tech crash of 2000.

Popular Sector-Based ETFs

Symbol	Sector Tracked	Expense Ratio
IYM	Basic materials	0.60%
IYK	Consumer goods	0.60%
IYC	Consumer services	0.60%
XLE	Energy	0.24%
XLF	Financial services	0.24%
IYH	Healthcare	0.60%
XLI	Industrial materials	0.24%
IGE	Natural resources	0.50%
XLK	Technology	0.24%
IYZ	Telecommunications	0.60%
IYT	Transportation	0.60%
XLU	Utilities	0.26%

A number of ETFs attempt to replicate the performance of stocks in even more narrowly focused industries, such as semiconductors (symbol: IGW), biotechnology (symbol: IBB), water (symbol: PHO), and so on.

International Stock ETFs

International stock ETFs allow investors to diversify their stock holdings by investing in a wide array of foreign markets. Investing in those markets directly, without using an ETF, can be costly, difficult, and sometimes impossible for U.S.–based investors. There are three main types of international stock ETFs:

Regional: These ETFs track broad indexes of entire overseas markets, such as Europe or Asia-Pacific.
Single-country: These ETFs track indexes of stocks based in specific countries, such as Austria or India.
Emerging markets: These ETFs track broad indexes of stocks in various developing countries. Emerging markets ETFs may be regional or single-country.

For most investors, buying regional ETFs makes the most sense: those ETFs are more broadly diversified and less risky than single-country ETFs.

Popular Regional ETFs

Symbol	Regional Tracked	Expense Ratio
ILF	Latin America	0.50%
ADRA	Asia-Pacific	0.30%
IEV	Europe	0.60%
EFA	Europe, Asia, Australia	0.35%

Popular Single-Country ETFs

Symbol	Country Tracked	Expense Ratio
EWZ	Brazil	0.74%
EWW	Mexico	0.54%
FXI	China	0.74%
EWZ	Japan	0.59%
EWC	Canada	0.54%

Popular Emerging Markets ETFs

The two leading emerging market ETFs are the Vanguard Emerging Markets Stock ETF® (symbol: VWO) and iShares MSCI Emerging Markets Index ETF® (symbol: EEM). Though emerging markets ETFs have fared well in recent years, all but the most risk-tolerant investors with long time horizons should avoid them due to their high volatility and risk.

Dividend Stock ETFs

Dividend stock ETFs, or dividend ETFs for short, track indexes of stocks that pay dividends—payments that companies make directly to shareholders. Though most dividends are paid in cash, companies also sometimes issue stock dividends, in which investors receive additional shares of stock for free. The stocks in the indexes that dividend ETFs track typically issue high dividends, have high dividend growth rates (meaning they increase the amount of their dividends consistently), or a combination of both.

Investors buy dividend ETFs to benefit from the mix of growth and income that the stocks in these indexes tend to provide. The average dividend ETF has a dividend yield—the percentage of the value of each share that it pays to shareholders—that exceeds that of most other ETFs.

Popular Dividend Stock ETFs

The tables below show the most popular domestic and international stock dividend ETFs. Note that the dividend yields quoted change constantly—the yields shown are intended to give you a rough sense of how the average annual yields of these ETFs compare.

Domestic Dividend Stock ETFs

Symbol	Expense Ratio	Dividend Yield
DVY	0.40%	3.12%
SDY	0.30%	2.84%
PEY	0.61%	2.79%
VYM	0.25%	2.73%
DTN	0.38%	3.44%

International Dividend Stock ETFs

Symbol	Expense Ratio	Dividend Yield
PID	0.60%	2.72%
DOO	0.48%	4.01%

Custom Index Stock ETFs

Rather than track existing indexes, some ETFs track custom indexes or modified versions of popular existing indexes.

ETFs that Track Custom Indexes

ETFs such as the PowerShares WilderHill Clean Energy ETF® (symbol: PBW) track unique indexes that have been developed exclusively for the ETF. For instance, the Clean Energy ETF tracks an index that consists entirely of alternative energy companies.

ETFs that Track Modified Versions of Popular Indexes

ETFs such as the Rydex S&P Equal Weight ETF® (symbol: RSP) take a novel approach to conventional indexes. This ETF tracks an index that contains all 500 stocks in the S&P 500, but with equal weighting rather than the traditional cap-weighting of the regular S&P 500 index. Equal weighting has so far proven to be superior to the S&P’s cap-weighting: the Rydex ETF has outperformed the S&P 500 every year since its introduction in 2003.

Acknowledgments & Disclaimer

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Why Invest in ETFs?

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Fixed-Income (Bond) ETFs

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