Thanks for submitting this question, Elli. All the way from Canada too...
Disclaimer: as with all Big Later content, the following should not be taken as investing advice. This article will outline the pros and cons of various investing styles, how to conduct your own research, and provide some tools to support that research. Also, since this is a blog post and not a dissertation, we’re just going to focus on funds that track stocks (in financial jargon, they are the same as “equities”). That means we’re ignoring bonds, commodities, and real estate. If you’d like to learn about those things, let us know and we’ll write a blog post. Alllllllrighty then.
A quick refresher before we dive in
ETFs (Exchange Traded Funds, for long) and Index Funds are designed to track the performance of big chunks of the market, sometimes the entire market. Buying these funds gives you exposure to “bundles” of stocks which means you can reap the benefits of being in the stock market without the risk of having to venture aimlessly into the world of hand-picking individual stocks. We like them. I assume Elli likes them too, because she’s asking how to conduct her own research.
Here’s the annoying thing about ETFs and Index Funds…
There are a ton of them to choose from. Literally thousands. There are more ETFs than there are stocks (but why… yeah we’re wondering that too). So picking ETFs or Index Funds is a lot going down the cereal aisle of any major supermarket for the first time. It’s exciting, but it’s overwhelming too. (Where are my Grape Nuts fans at? You guys are psychos).
The good news: the work that goes into making a “good” choice is practically done. How’s that? You have already decided that you want to use these funds to invest. That’s half the battle. Now we’re just tuning in the details. With this post, you’ll learn that many of these funds set out to achieve the same thing, some are more popular than others, every imaginable slice of the market is served, and there are a few categories that new investors should probably avoid.
We’re going to look at 3 categories of ETFs
Broad Market (track it all), Sector (track specific industries), and Thematic (track specific trends). In each section below, I’ll provide a little overview and some tools to help your decision-making process. We’ll wrap up with a few things to be wary of and then call it a day because I have to tend to my herb garden and you have to do whatever you’re doing today.
Keeping it simple
For those folks who are just looking to invest broadly in the stock market, perhaps with an S&P 500 fund or a Nasdaq 100 fund, we’ve got you covered. This is a time-tested strategy and there’s nothing wrong with it (in fact, the research would suggest there’s quite a bit right with it).
Since we’re friends, I’m going to save your fingers the hassle of googling and give you a gift. Here are the Top 10 Broad Market ETFs and Index Funds By Assets (i.e. the popular kids… but not the ones that grow up to be assholes):
These funds have low expense ratios (fees) and solid returns over long periods of time. Pay attention to the relationship between the inception year and the rate of return. You will notice that newer funds may have higher returns than older ones. Keep in mind that despite higher returns in the short-term, the longer the track record, the better.Broad Market ETF Resources:
- The table right above this section…
There are eleven sectors (the more you know)
Sectors break up the stock market by the major buckets of the economy — things like information technology, health care, financials, communication services, etc. Here is a snapshot from Fidelity of each sector’s cumulative performance, ranked by 10-year performance.
Sectors can also be broken down further into industries and even further into sub-industries. For example, Airlines are a sub-industry of the Transportation industry, which rolls up into the Industrials sector.
A few things to consider with Sector funds
With anything more narrow than a broad market index, you’re effectively saying, “long term, I believe this chunk of the market will do better than the entire market as a whole.” It is an “outperformance” mindset. Has the IT Sector massively outperformed the S&P 500 over the past 10 years? Yes. Does that mean it will continue to? That’s a judgment you’ll have to make. And with any decisions that have that I-think-I-can-beat-the-market smell, proceed mindfully and do your best to approach the decision with the most Spock-like part of your brain.
Sector ETF Resources:
Thematic ETFs are great if you’re feeling particularly excited about the future outlook of certain trends. They are similar to Sector funds in that they offer a narrower slice of the market, but different in that you could have companies from multiple sectors contributing to a single trend.
How about some examples:
- You notice kids are obsessed with video games, so you want to invest in an ETF that has companies that support the growing popularity of video games. That would likely include companies that make video games (duh), but also the companies that design and produce gaming consoles, organizations that host e-sports events, companies that create the chips that gaming consoles run on, technology that enables in-game marketing and advertising, etc.
- You notice that people are buying more and more stuff online (as opposed to doing their shopping in brick-and-mortar retail locations), so you want to invest in an ETF that empowers e-commerce. As expected, this fund would be mostly comprised of technology companies that help creators sell their content online (think Amazon, Shopify, Etsy, Alibaba, eBay…), but also companies that have a big online presence, like Wayfair or Stamps.com.
- You want to take a more ethical approach to the companies that you invest in. This is also known as “Socially responsible” or “ESG” investing — which stands for environmental, social, governance — and focuses on companies that are forging ahead as corporate leaders in sustainable and societal impact. There are ETFs for that!
Thematic investing is a newer trend, but gaining popularity quickly as it offers investors more control over the focus areas of their portfolio but doesn’t entail any individual stock picking.
Weighing the potential risks and rewards
While you have a bit more control over what companies you’re buying, they’re also a tad more “expensive” (which is just to say that their expense ratios are usually closer to 0.5% or 0.75% versus the 0.05% that an S&P 500 ETF might cost you). And finally, many of the thematic funds are very new. So there’s not a ton of data to support their performance over long periods of time AND, since the market has been very hot in the last decade (thank you technology), always keep in mind that historic performance is not indicative of future performance.
Thematic ETF Resources:
- (ARK Innovation)
- (Global X)
Things to be aware of
We covered expense ratios and performance in Chapter 4, but the main takeaway is that as you go from broad market ETFs to more focused ETFs, expense ratios go up (i.e. fees are higher). You also want to be aware of the following:
- Volume (how often something is traded on the market)
- Assets Under Management (how “big” the fund is)
- Fund Overlap (becomes relevant if buying multiple funds)
The first two are important because they indicate the liquidity and reputation of the fund. Huh?
The higher the volume, the easier it will be to sell your investment (i.e. it is more “liquid”). The higher the AUM, the less likely a “closing event” becomes (i.e. the people who manage the fund decide to shut it down… which is a logistical pain in the bum for the investors).
Be mildly cautious of funds with less than $200M AUM (for reference, SPY has AUM of $290 BILLION) and also anything that trades with a 3 Month Avg. Volume of less than 100,000. This doesn’t mean those funds aren’t good! They could just be new. But volume and AUM are good indicators of popularity… and funds that lack sufficient popularity could carry additional risk.
Regarding “fund overlap,” all you have to know is that you don’t want to build up a strategy with multiple funds only to find that you have 30% of your investment allocated to one stock. For example, if you invested equally into an S&P 500 fund (SPY), an information technology sector fund (XLK), and the Vanguard ESG ETF (ESGV), then you would have nearly 12.5% of your portfolio invested in Apple. That’s not a bad thing per se (Apple has done really well over many decades…), it just means 1/8 of your portfolio is resting on 1 company’s long term success.
(To figure out that percentage, I used the site and fidgeted around to get an equal dollar amount of SPY, XLK, and ESGV.)
Things to avoid (at least for now)Rule of thumb: if you don’t understand it, proceed with caution. I’m talking about any fund that has the following in its title:
- 2X or 3X Leveraged ETFs
- Inverse ETFs
- Volatility ETFs
Wrapping up…As stated at the beginning of this article, there are a lot of funds out there. Fortunately, if you…
- Have an idea of the types of investments you want to make (broad market, sector, thematic)
- Know how to size up a fund or funds (age, performance, fees, AUM, volume, overlap)
- Are aware of what to look out for (stay clear of anything 3x leveraged or inverse for now)
Stuff we didn’t cover in this postThese are more “intermediate” in my book — fortunately, “intermediate” doesn’t mean “better” from a wealth creation standpoint, but good to be aware of for anyone that is excited by, interested in, or curious about expanding their investing knowledge.
- Investing in international and emerging markets
- Other Asset Classes (Bonds, REITs, Commodities, etc.)
- Growth vs. Value investing
- Factor investing