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Banking your retirement on stocks is risky enough; banking your retirement on any individual stock, or even a handful of stocks, is Evel Knievel-jumping-the-Snake-River investing. Banking on individual bonds is typically less risky (maybe Evel Knievel jumping a creek), but the same general principle holds. There is safety in numbers. That’s why teenage boys and girls huddle together in corners at school dances. That’s why gnus graze in groups. That’s why smart stock and bond investors grab onto ETFs.

Just as a deed shows that you have ownership of a house, and a share of common stock certifies ownership in a company, a share of an ETF represents ownership (most typically) in a basket of company stocks. To buy or sell an ETF, you place an order with a broker, generally (and preferably, for cost reasons) online, although you can also place an order by phone. The price of an ETF changes throughout the trading day, which is to say from 9:30 a.m. to 4:00 p.m. New York City time, going up or going down with the market value of the securities it holds. (Sometimes there can be a little sway – times when the price of an ETF doesn’t exactly track the value of the securities it holds – but that situation is rarely serious, at least not with ETFs from the better purveyors.)

Originally, ETFs were developed to mirror various indexes:

✔ The SPDR S&P 500 (ticker SPY) represents stocks from the S&P (Standard & Poor’s) 500, an index of the 500 largest companies in the United States.

✔ The DIAMONDS Trust Series 1 (ticker DIA) represents the 30 underlying stocks of the Dow Jones Industrial Average index.

✔ The NASDAQ-100 Trust Series 1, which was renamed the PowerShares QQQ Trust Series 1 (ticker QQQ), represents the 100 stocks of the NASDAQ-100 index.

The component companies in an ETF’s portfolio usually represent a certain index or segment of the market, such as large U.S. value stocks, small growth stocks, or micro cap stocks. (If you’re not 100 percent clear on the difference between value and growth, or what a micro cap is, rest assured that I define these and other key terms in Part II.)

Sometimes, the stock market is broken up into industry sectors, such as technology, industrials, and consumer discretionary. ETFs exist that mirror each sector.

Regardless of which securities an ETF represents, and regardless of what index those securities are a part of, your fortunes as an ETF holder are tied, either directly or in some leveraged fashion, to the value of the underlying securities. If the price of Exxon Mobil Corporation stock, U.S. Treasury bonds, gold bullion, or British Pound futures goes up, so does the value of your ETF. If the price of gold tumbles, your portfolio (if you hold a gold ETF) may lose some glitter. If GE stock pays a dividend, you are due a certain amount of that dividend – unless you happen to have bought into a leveraged or inverse ETF.

As I discuss in Chapter 6, some ETFs allow for leveraging, so that if the underlying security rises in value, your ETF shares rise doubly or triply. If the security falls in value, well, you lose according to the same multiple. Other ETFs allow you not only to leverage but also to reverse leverage, so that you stand to make money if the underlying security falls in value (and of course lose if the underlying security increases in value). I’m not a big fan of leveraged and inverse ETFs, for reasons I make clear in Chapter 6.

Choosing between the classic and the new indexes

Some of the ETF providers (Vanguard, iShares, Schwab) tend to use traditional indexes, such as those I mention in the previous section. Others (Invesco PowerShares, WisdomTree, Guggenheim) tend to develop their own indexes.

For example, if you were to buy 100 shares of an ETF called the iShares S&P 500 Growth Index Fund (IVW), you’d be buying into a traditional index (large U.S. growth companies). At about $117.30 a share (at this writing), you’d plunk down $11,170 for a portfolio of stocks that would include shares of Apple, Microsoft Corp., Walt Disney, Facebook, Amazon, and Johnson & Johnson. If you wanted to know the exact breakdown, the iShares prospectus found on the iShares website (or any number of financial websites, such as http://finance.yahoo.com) would tell you specific percentages: Apple, 7.48 percent; Microsoft Corp., 4.10 percent; Walt Disney, 1.75; and so on.

Many ETFs represent shares in companies that form foreign indexes. If, for example, you were to own 100 shares of the iShares MSCI Japan Index Fund (EWJ), with a market value of about $13.30 per share as of this writing, your $1,330 would buy you a stake in large Japanese companies such as Toyota Motor, Honda Motor, Mitsubishi, and Softbank Corp. Chapter 5 is devoted entirely to international ETFs.

Both IVW and EWJ mirror standard indexes: IVW mirrors the S&P 500 Growth Index, and EWJ mirrors the MSCI Japan Index. If, however, you purchase 100 shares of the PowerShares Dynamic Large Cap Growth Portfolio (PWB), you’ll buy roughly $3,100 worth of a portfolio of stocks that mirror a very unconventional index – one created by the PowerShares family of exchange-traded funds. The large U.S. growth companies in the PowerShares index don’t include Apple, Microsoft, or Amazon, but rather companies like Schlumberger N.V., Bristol-Myers Squibb, and MasterCard Incorporated. Invesco PowerShares refers to its custom indexes as “enhanced.”

A big controversy in the world of ETFs is whether the newfangled, customized indexes offered by companies like Invesco PowerShares make any sense. Most financial professionals are skeptical of anything that’s new. Those of us who have been around for a while have seen too many “exciting” new investment ideas crash and burn. But I, for one, try to keep an open mind.

Another big controversy is whether you may be better off with an even newer style of ETFs – those that follow no indexes at all but rather are “actively” managed. I prefer index investing to active investing, but that’s not to say that active investing, carefully pursued, has no role to play. More on that topic later in this chapter and throughout the book.

Other ETFs – a distinct but growing minority – represent holdings in assets other than stocks, most notably bonds and commodities (gold, silver, oil, and such). And then there are exchange-traded notes (ETNs), which allow you to venture even further into the world of alternative investments – or speculations – such as currency futures. I discuss these products in Part II of the book.

Preferring ETFs over individual stocks

Okay, why buy a basket of stocks rather than an individual stock? Quick answer: You’ll sleep better.

You may recall that in August 2010, HP CEO Mark Hurd suddenly resigned over a sex scandal. The stock plummeted, and HP shareholders lost billions. A few years before that, the always fashionable Martha Stewart was convicted of obstruction of justice and lying to investigators in an insider-trading case involving a small company called ImClone. Within hours, shares in Stewart’s namesake firm, Martha Stewart Living Omnimedia, tumbled 23 percent.

Those sorts of things – sometimes much worse – happen every day in the world of stocks.

A company I’ll call ABC Pharmaceutical sees its stock shoot up by 68 percent because the firm just earned an important patent for a new diet pill; a month later, the stock falls by 84 percent because a study in the New England Journal of Medicine found that the new diet pill causes people to hallucinate and think they’re Ghandi – or Martha Stewart.

Compared to the world of individual stocks, the stock market as a whole is as smooth as a morning lake. Heck, a daily rise or fall in the Dow of more than a percent or two (well, 2 or 3 percent these days) is generally considered a pretty big deal.

If you, like me, are not especially keen on roller coasters, then you are advised to put your nest egg into not one stock, not two, but many. If you have a few million sitting around, hey, you’ll have no problem diversifying – maybe individual stocks are for you. But for most of us commoners, the only way to effectively diversify is with ETFs or mutual funds.

Distinguishing ETFs from mutual funds

So what is the difference between an ETF and a mutual fund? After all, mutual funds also represent baskets of stocks or bonds. The two, however, are not twins. They’re not even siblings. Cousins are more like it. Here are some of the big differences between ETFs and mutual funds:

✔ ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their prices change throughout the trading day. Mutual fund orders can be made during the day, but the actual trading doesn’t occur until after the markets close.

✔ ETFs tend to represent indexes – market segments – and the managers of the ETFs tend to do very little trading of securities in the ETF. (The ETFs are passively managed.) Most mutual funds are actively managed.

✔ Although they may require you to pay small trading fees, ETFs usually wind up costing you less than mutual funds because the ongoing management fees are typically much less, and there is never a load (an entrance and/or exit fee, sometime an exorbitant one) as you find with many mutual funds.

✔ Because of low portfolio turnover and also the way ETFs are structured, ETFs generally declare much less in taxable capital gains than mutual funds.

Table 1-1 provides a quick look at some ways that investing in ETFs differs from investing in mutual funds and individual stocks.

Table 1-1 ETFs Versus Mutual Funds Versus Individual Stocks