Should You Put ETFs in Your Portfolio?

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Shutterstock"ETFs bring diversification to investors of all sizes as with a single share you can access entire markets."
By Kyle Woodley

Yes. The answer to the question is yes -- everyone should have exchange-traded funds in their portfolio.

But like there's an obvious answer if anyone ever asks you if you're a god (think "Ghostbusters"), there's a no-brainer answer when someone asks whether they should harness the power of ETFs.

They make you better. Why bury the lead? Simply put, individual investors are bad at investing. While there are stats galore, perhaps one of the best illustrations of this point comes via this BlackRock chart from 2012:

Money Game chart showing how investors underperform
Courtesy: BlackRock
So how do ETFs make us any better?

In short, individuals have a swath of investment baggage -- personal biases, the tendency to trade on emotion and the inability to time the market. However, ETFs allow investors to make long-term bets in broad asset classes which, when allowed to play out, help cut down on some of the ways we individuals love shooting ourselves in the foot.

You get diversification. "Don't put all your eggs in one basket." If you believe that, then you believe in the power of diversification -- holding stocks of different sizes in different sectors and different geographies, as well as holding a number of other asset classes.

But most stocks don't go up in perpetuity, and you'll find that over time, stocking your portfolio with individual stocks, then rotating them in and out as their stories ebb and flow, you've not only likely missed a lot of entry and exit points, but you've also incurred a ton of trading fees.

ETFs do it better.

"ETFs bring diversification to investors of all sizes as with a single share you can access entire markets," says Jeff DeMaso, editor/research director for The Independent Adviser for Vanguard Investors newsletter. Indeed, a single ETF can give you exposure to hundreds or even thousands of stocks, allowing you to invest in broad categories while taking on minimal single-stock risk.

Take the iShares Nasdaq Biotechnology ETF (IBB), which allows investors to get into the red-hot biotech sector via 144 companies -- a nice alternative to sweating out your small-capitalization biotech's Phase 2 trial. And despite the lower risk, IBB isn't hurting for returns -- the ETF has ripped off annual gains greater than 30 percent for the past five years.

And for sheer broad-market exposure, it's hard to beat the SPDR S&P 500 ETF (SPY). By purchasing SPY for roughly $190 for a single unit, you instantly are invested in the Standard & Poor's 500 index's 504 stocks (that weird math comes courtesy of multiple share classes) -- the most widely used measure of the U.S. stock market.

And you get them cheap. "Buying the market" via the SPY is dirt-cheap. The expense ratio of the SPY is 0.0945 percent, which essentially means you're paying less than $10 for every $10,000 invested. Some mutual funds can charge far more for the same privilege -- consider the Rydex S&P 500 H Shares (RYSPX), which charges 1.58 percent, or $158 for every $10,000 invested.

"Low costs are self-explanatory -- what you don't pay in fees, you keep in returns," DeMaso says. But in case you need an explanation, here you go:

Let's say you invested $10,000 in the SPY for 30 years, and the S&P 500 returned 8 percent annually over that time. Backing out fees, you'd be sitting on a return of $97,812. But that same amount invested in the Rydex fund would return only $62,404. Fees alone would eat some $13,000 extra -- and that's $13,000 less you'd have to reinvest, compounding the woes for the final return.

Granted, not every mutual fund has an exact ETF counterpart. But you can find many investment flavors tackled by expensive, actively managed mutual funds that have cheap, index-based ETF alternatives that perform as well if not better, and for a fraction of the cost.

David Fabian, managing partner and chief operations officer of FMD Capital Management, strongly recommends bailing from mutual funds for their cheaper exchange-traded counterparts. "If you still primarily own high-fee mutual funds, now is the time to evaluate ETF alternatives to improve your long-term results."

Strategies for everyone. You can do much, much more with ETFs than just track the S&P 500, of course.

As of the end of 2014, there were more than 1,400 funds in the ETF universe. In that universe, investors have access to multiple funds focused on broad sectors and more specific industries, master limited partnerships, real estate investment trusts, bonds, gold, silver, domestic stocks, international stocks.

And while there's a ton of oomph in plain-vanilla index funds, ETFs have their twists, too.

"The most popular new trend has been toward 'smart beta' ETFs, which seek to provide better return/risk tradeoffs than traditional index funds," says Joseph LaCorte, president of S-Network Global Indexes Inc.

In short, rather than simply track an index, a smart beta ETF will make a few tweaks -- say, giving equal weight to all holdings rather than weight them by market cap, or create additional screens based on valuations or dividends. The goal: a more targeted and profitable strategy, but one still run by computers and not advisors, helping to keep costs down.

ETFs can get downright kinky, ranging from funds that hold Japanese stocks while hedging against the yen (DXJ) to funds that mimic covered call strategies on gold (GLDI).

In short, if you've got an investing idea, there's probably an ETF that covers it.

As of this writing, Kyle Woodley was long IBB and was considering opening a position in GLDI.
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