Your Jumpstart Guide on Getting Ready for ETF Investing – Long Term and Value Minded

How to Choose an ETF to Meet your Goals for both Money and Time

An ETF is known as an exchange-traded fund which trades exactly like stocks. If you are a value investor, dividend investor or the like you are probably quite familiar with what an ETF is and what it accomplishes to do. But far less discussed is what you should be doing with an ETF. Are you buying the wrong one for your timetable and for your financial goals? You might be and hardly even know it.

The majority of ETFs are index funds which will hold a basket of securities in order to match the performance of a given market, sector, or country. Perhaps the most common of these are those that track the S&P500 which first originated in 1993. Today there are ETFs that track thousands of stocks in thousands of different sectors, industries, market caps and regions.

First, you will need to find out what your financial goals are if you have not already. I assuming if you are reading my blog and actively involved in the market you have financial investing goals and timetables to get those complete. These are very important because you need to have achievable results to work towards and know how your money is working for you or eventually will.

A simple exercise would be writing everything down. Write down everything you own and what you may imagine to occur in the near or short term. For example, marriage, school, birth of a child, a home, vacation, retirement, etc. If you are seeing most of your goals requiring capital in the 2-5 year range your money might best be in CDs, money market accounts, and guaranteed income.

Look at Costs aka Commissions

All ETFs have a cost associated with them. Some of them are less so as a result of commission free trades which are available from a growing number of brokers and a select brand or style of ETF. If the ETFs you are looking at are commission free examine why they might be. Do they have a great daily volume that warrants that price or are they specialty ETFs that need more action so they are all of the sudden free?

It’s important to remember though that taxes are incurred and you can be hit with other trading fees you were not aware of that do not apply to a particular ETF. For example, if it is considered a foreign security it may be an additional charge. Thus it is important to buy your ETFs in lump sums, not in a bit by bit manner that is more conducive when buying in DRIPs or DSPPs.

Generally speaking though, ETFs costs are very comparable to stocks at most brokerages.

Keep an Eye on Bid/Ask as well as Premium/Discount

When buying an ETF you pay a higher price known as the ask and when it is time to sell you are selling at a lower price known as the bid. Keep in mind this is only relative to the current price of shares of the fund. You are not going to necessarily going to buy at a higher price and sell at a lower one. You may buy at a higher price compared to what the market has valued it. Or you may sell your shares in the fund at a price lower than the market average.

The trick with this is to be careful of boutique and small or otherwise unpopular ETFs. Historically these ones have a habit of having larger gaps in the bid/ask price. You are much safer to stick with popular high volume ETFs as well as those that track general indexes such as the S&P500 or the Dow Jones. Even a precious metals ETF like GLD which tracks gold would be appropriate.

The words premium and discount apply very rarely to ETFs in any way that would affect the average investor. An ETF is said to be trading at a discount or premium when it is priced higher or lower than its net asset value (NAV).

These amounts are often too negligible to account for and occur when there is an issue with a lack of liquidity. If an ETF is limited in number but a large number of investors want exposure to it it may trade at a premium. Whereas if an ETF is just not popular enough to warrant any competition for the number of shares available it could very well trade at a discount.

The only important point to remember is that these loses due to a premium purchase or discount at the time of sale may never be recovered.

Don’t be Alarmed by Dividend Drag

Dividend drag is a term used to describe the tight SEC laws requiring ETFs to pay out dividends from their holdings as cash and not be reinvested. It may not seem like a big deal but whether or not these are automatically reinvested can have dramatic effects on your portfolio. Generally speaking, the dividends are placed in your brokerage account, waiting for you to make a decision.

This problem turns off a lot of investors who might rather enjoy being able to avoid the work of depositing their dividends somewhere else or manually buy new shares with them. Look at it as a way to have more choice. Yes, it may be more work but it provides more control over your money. Although most would argue against it, you can cash out those dividends from your brokerage as they usually sit in a money market account with them until you decide what to do with it.

Keep Good Records of Your Exposure and Diversify

ETFs give you a really great opportunity to hold stocks in so many different sectors and industries that it would actually cost you thousands of dollars in commissions just to buy the individual stocks themselves, not to mention the price per share on those. But you can run into some trouble if you have exposure to too many of the same things in separate ETFs.

For example, if you have an emerging markets ETF, a fund that tracks stocks in emerging economies but also own another ETF that tracks stocks of Indonesia and another that tracks stocks of Brazil you are likely over exposed to the emerging markets.

Take the time and do the research to find out which ETFs will give you the least overlap. This will lead to greater diversification overall and better overall long term returns.

Minimize Transactions and Keep your Profts

Whether you are investing in dividend paying ETFs or just broad market funds it is important to remember that as a value investor you are looking to save a few bucks wherever you can. As you see your ETFs increase in value and price over the long term withhold the temptation to sell unless it is in line with your goals.

Selling too soon or too often is a classic problem that the worst investors are involved in. After we make money we tend to forget that there is still a cost to sell. By the same token, selling losers too soon can also be an appetite for financial destruction. ETFs are intended for most people and most situations to be long term and slow growth. Keep that mindset.