The Smart Investor's Guide for Investing

TABLE OF CONTENTS

Chapter 1. ETFs: How and Why They Work

Chapter 2.  24 Key Advantages to Investing in ETFs

Chapter 3.  Before You Invest: 20 Risk Factors to Consider

Chapter 4.  Asset Allocation:
How to Choose the Best ETF for Your Investment Needs

Chapter 5.  Investment Timing Indicators

Chapter 6. Option Strategies and Hedging

Chapter 7.  Evaluating Performance and Tax Considerations: 
Index and ETFs Investing vs. Actively Managed Funds

Chapter 8.  A Guide to Choosing ETFs: Current Listings by Geographic Region, Domestic vs. International, Industry, Major market Indexes, and Symbols

Chapter 9. Fixed-Income ETFs, Recent Developments, and Sources of Information

CHAPTER 1

ETFs: How and Why They Work

Getting Started

You have some money and you want to invest it. You’ve heard the buzz about exchange-traded funds and you’d like to be a part of the action. Assets in exchange-traded funds now exceed $100 billion. This chapter will walk you through the basics of investing in exchange-traded funds. But before you jump into the investment pool, it’s time to do some research.

What are exchange-traded funds (ETFs)?

ETFs are funds that are listed and traded on an exchange and use indexing as an investment strategy. Indexing is the weighing of a portfolio to match the performance of an index. An index in the securities market measures the price movements of groups of stocks. Indexes for specific sectors of the market, such as banks, pharmaceuticals, or utilities, measure the price changes of these specific sectors. Each ETF represents an investment in an underlying portfolio that seeks to track the performance of a specific index.

In 1993, the S&P 500 SPDR came on the scene as the first ETF on the American Stock Exchange (AMEX). The S&P 500 SPDR Trust is a pooled investment designed to track the price and yield performance of the S&P 500 Index. Its portfolio holds all the S&P 500 index stocks. It is a representative segment of the market of all publicly traded stocks. As of November 15, 2002, assets for the S&P 500 SPDR Trust (SPY) exceeded $42 billion.

Each index fund represents an investment in an underlying portfolio that seeks to track the performance of a specific index. A pharmaceutical index such as PPH tracks the performance of a basket of pharmaceutical companies, including Pfizer, Merck, Johnson & Johnson. There are indexes that track the performance of stocks of foreign countries, mid-sized U.S. companies, aggressive or conservative companies ... you name it! A list of exchange-traded funds is presented in Chapter 8.

Exchange-traded funds essentially are designed like mutual funds but trade like stocks. This is especially attractive to day traders and investors who wish to buy or sell at a specific price during the day rather than wait until the end-of-day prices. Traditional mutual funds are executed at end-of-day prices, which may be higher or lower than prices at a specific point in time during the day’s trading hours.

What are some of the unique features and benefits of ETFs?

There are twenty-four key benefits to investing in exchange-traded funds: exchange listing, a single transaction portfolio, intraday trading and tracking, diversification, asset allocation, tax efficiency, selling short on a downtick, lower costs, market price near NAV, margin eligibility, convenience of execution, liquidity, transparency, consequences of other shareholders’ redemptions, no bankruptcy, limit and stop-loss orders, replacement of stocks, hedging and risk management solutions, long-term performance, gifts to minors, falling in love with one company,  cash-flow management, year-end tax-loss planning and strategies, and availability of many ETFs. These are explained in detail in Chapter 2.

4. DIVERSIFICATION

If you have had the experience of going through a bear market, or a period of declining prices (1974, 1982, 1987, 2000–2002), you know that investors who have diversified portfolios are subject to lower volatility and less risk and are more likely to attain their long-term investment goals.  Most investment advisers and financial planners emphasize the need for diversification in order to help preserve investors’ capital.

When you buy a basket of stocks, you are not subject to the risk of a single catastrophic loss due to a big decline in one stock. Your portfolio will rise or fall with the fluctuations of the sectors of securities you own. The goal of diversification is to protect your portfolio from losing substantial value in case of a large decline in one single stock. ETF selection achieves less volatility than stock selection.