What Are ETFs? How Do You Find The Right One? We Asked An Expert

ETFs continue to grow in popularity. The chart below shows how big this trend is getting. But that’s also why it’s so important to understand what ETFs are and how to find the best ones.

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To learn more about ETFs and provide some clarity for everyone, we reached out to David Fabian. He specializes in exchange traded funds (ETFs) and you can read all of his insights at his blog FMD Capital. What follows are 5 questions that can help anyone better understand these instruments including the complex ones like the double and triple leveraged products.

1. What’s the one advantage you see in ETFs right now that still not enough people understand?

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David Fabian, founder of a fee-only registered investment advisory firm, FMD Capital

How cheap and reliable these vehicles are for core exposure in your portfolio. So many investors are still allocated to high fee mutual funds, hedge funds, and separate accounts that overcharge and underdeliver. There are very few strategies that consistently outperform a comparable ETF over a reasonable 3, 5, or even 10-year time frame – particularly in stocks.

Even traders can benefit from these tools. ETFs provide such an efficient way to access unique subsets of stocks, sectors, or specific factors without having to pick the perfect company.

I often review portfolios for investors and they own a few ETFs here and there, but they haven’t fully bought into using these tools for the majority of their portfolio. In my opinion, there has never been a better time in the history of the world to be an investor with the lowest possible fees and scope of available opportunities using ETFs.

 

2. What are your favorite types of ETFs? Any examples?

Everyone has different needs when it comes to constructing their portfolio. I never like to say that one ETF is better than another because there are many funds in the same categories that are very solid choices.

For instance, you could easily own the Vanguard Total Stock Market ETF ($VTI), iShares Core U.S. Total Stock Market ETF ($ITOT) or the Schwab U.S. Broad Market ETF ($SCHB) and achieve similar results. All of them are broadly diversified, low cost, and very liquid. Those are characteristics I value when assessing opportunities for my client’s portfolios. It may just come down to where your money is parked and which funds you can trade commission-free.

The exciting part for me is getting to customize portfolios based on individual needs or trends that I feel will offer solid long-term value. For instance, a fund that I have owned for my income clients for quite some time is the Vanguard High Dividend Yield ETF ($VYM). This fund tracks 400+ dividend paying stocks in the U.S. and carries an expense ratio of just 0.09%.

I think that factor-based ETFs can also be another way to tailor your portfolio towards a specific group of stocks. These types of funds focus on quality, momentum, volatility, value, size, or some other criteria. There are several options available from BlackRock, PowerShares, and others that offer diversified exposure with reasonable expenses.

 

3. Let’s talk about the ETFs that traders love. Like 2x and 3x ETFs or even the ETFs tied to futures contracts. What do long-term investors need to know about these?

I have always been one to argue that most investors should steer clear of these funds. Leveraged, inverse, and futures-based funds like the $VIX are very aggressive products. These should typically only be used by experienced traders with short holding periods and a disciplined risk management plan (i.e. stop loss).

What most people don’t understand is that high fees, compounding effects, and the complicated strategies necessary to support these products means that they don’t always perform as intended. You can’t assume that a 5% jump in the SPDR S&P 500 ETF ($SPY) over three or four months will perfectly correlate with a 10% jump in the ProShares Ultra S&P 500 ETF ($SSO).

These are meant to be very short-term trading vehicles and the laws of nature work against them.

 

4. Why do you think traders like the above instruments so much? What unique advantages do they have?

Day trading is a whole different type of animal. A trader that is looking to get in, get out, and move on in a matter of hours can use leveraged funds to maximize their available capital.

The advantage of using these types of aggressive ETFs is that you don’t necessarily have to use options, margin, and other legacy methods to magnify your returns. You can scalp quick moves in the market and finish the day with little or zero exposure.

Of course, you must have time, tools, and discipline in order to do that successfully. Most people don’t have all three, so they get themselves in trouble.

 

5. When searching for an ETF are there certain things that we should be looking for? Like assets under management? Or top holdings?

The number one factor that will drive the returns in any ETF is the underlying holdings and how they are allocated. Looking at the top 10 holdings will usually give you a pretty good sense of how an ETF is constructed. Then if you are comparing two or three similar funds, you can dig deeper into fees (expense ratio), trading volume, yield, and assets under management.

The fund company websites do an excellent job of providing useful information for each ETF. There are also third-party websites like ETF.com and ETFDB.com that offer great screening tools for comparing products.

If you are new to ETFs, I always recommend looking in your own backyard to start with. Fidelity, Schwab, TD Ameritrade, and Vanguard either have their own in-house funds or have partnered with an industry-leader to offer a list of commission-free ETFs. This is a great place to begin your search and quickly narrows down the universe from 1,900+ available ETFs to just a hundred or so. I wrote a post of my blog entitled 5 Tips For Getting Started With ETFs that may be helpful as well.

 

If you enjoyed this post or have any additional questions, please reach out to David Fabian and let him know! If there’s another topic or subject you need help understanding, reach out to us on @StockTwits and we’ll find an expert for you. 


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