Drawbacks of an ETF Portfolio

There are many advantages to ETFs but they aren't suited to every investor, especially not if you're a dollar-cost averager. Dollar-cost averagers contribute small amounts of money on a regular basis, and this can be disastrous if you're buying ETFs because every buy and sell order creates a transaction fee. For example, if you contribute $100 per month to a particular ETF and each transaction costs $10, you are instantly losing 10% of your investment every month. Index Funds are a great alternative for dollar-cost averagers. Like ETFs, they track broad indexes but don't charge transaction fees when you contribute more money (more on Index Funds below).

Many ETFs don't do as well as the index that they track so be sure to chart and compare your ETFs to their peers and to their index before you buy (I'll explain how to easily do this below). The most common reason for performance lag is expenses, you can't expect your ETF to track the S&P 500 accurately if it has a 2% expense ratio. There can also be other factors such as poor management or inaccurate rebalancing, but the bottom line is avoid ETFs that don't accurately track their index.

Like stocks, ETFs are very easy to trade. They don't require any minimum investment, they can be traded any time that the market is open, and you can buy and sell as frequently as you like. This makes it tempting to try to time the market or chase returns, and also creates a lot of transaction fees that eat into your profits. ETFs are designed for buy-and-hold investors, they can be very expensive if you trade frequently.

There is a much wider range of ETFs available today, and many are very specialized. Specialization often means an ETF is tracking a much smaller basket of stocks so they tend to be more risky and volatile. If you invest primarily in these sector and specialty ETFs, you're giving up your greatest advantage as an ETF investor, diversification. Stick with the broader indexes, don't give up diversity to try to squeak out an extra 1 or 2% gain, chasing returns backfires every time.
One of the capital gains burdens that you're going to have to deal with on a regular basis as an ETF investor is dividends. They are taxable, and they are unavoidable if you're trading stocks and funds. Fortunately dividends do provide a benefit that offsets the tax liability that they create. Even though you'll have to pay taxes when a company passes you part of their profits in the form of dividends, they are also boosting your returns.

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Energy ETF

It doesn’t take an experienced investor to recognize the potential in almost any energy ETF. Why not? Just consider that there are environmental movements as well as financial indicators that all seem to point towards an energy ETF as an almost "sure thing" which now that I've said guarantees a decline!

For example, a natural gas ETF is something that is going to inevitably yield some impressive returns simply because the industry is positioned to expand and grow by more than 60% within the next two decades.

Also consider that almost all professional investors and market experts are suggesting that all portfolios should contain some sort of energy investments, and that an energy ETF is a great way to get the proverbial foot in the door.

This is because the authorized participants can usually get their investors involved in large energy companies and also with smaller firms too, and usually all in the same fund. This means that a startup alternative supplier may be included in a portfolio that also has holdings in a massive, global energy ETF as well. Clearly, it is this kind of diversity that is so essential to profitable holdings.

Something to remain extremely mindful of when considering any energy ETF is the fact that there should be no over-concentration within any specific sector or category. Yes, the natural gas industry may very well boom in the coming decades, but an investor should not try to benefit from this anticipated growth spurt at the cost to other options and subsector investments. My preference is to ensure that a fund is diverse and balanced which I like to believe is a reasonable approach to profit.

For instance, energy means clean energy, oil and gas supplies, and other natural resources. It is also a wise idea to understand that the ETFs might offer a great "package deal" that touch on firms of many sizes within a single segment, but there are also a few other ways to access the energy market. For instance, there are machine and equipment segments, exploration and production options, and there are the much narrower funds that focus on things like wind or solar power too.

Do a bit of research and comparison shopping when considering any of the energy ETFs. Choose only those that are clearly focusing on the future potential of the energy industry, but which are not losing out on the rapid changes happening today. Often, this means doing a bit of math to ensure that no single company or area of a fund consumes over five percent of the total portfolio – regardless of how profitable it appears.

What are some good options? PowerShares Dynamic Oil and Gas Services (PXJ), iShares S&P North American Natural Resources Sector (IGE), and iShares S&P Global Energy (IXC) are extremely popular.

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Why Would I Buy an ETF?

Most people that are new to investing are curious why there has been such an explosion in ETF popularity in recent years. Part of this is because of their flexibility, you can find a coinciding ETF for just about any type of stock, industry, geographic region or strategy that you'd like to try. You can usually own a share of the Wilshire 5000 or any other index that ETFs track for as little as $50. Can you imagine the cost if you tried to buy one share of every stock in the Wilshire 5000? Even if you could afford to buy a few shares of all 5,000 stocks, the transaction costs would make it a waste of time.

The fact that you can own a broad index when you buy into an ETF also means that you get diversification at a reasonable price, the cost of a single share. Your share will be spread over the same wide range of industries, categories and geographies as the person that owns 1,000 shares, you get the same diversification for 1/1,000th of the price.

ETFs have created an affordable way to have a professional grade portfolio that will outperform the majority of investors. A discouraging statistic for active investors is that only 20% of professional money managers beat the market returns, and this percentage is even lower for the average individual investor. ETF investors are guaranteed at least the market return for the indexes that their ETFs track so they can easily beat 80% of investors as long as they stick to the broader indexes and diversify.

Since an ETF only needs to track an Index, the fund manager will be doing a lot less buying and selling. This doesn't require a Harvard MBA and a team of analysts, the fund just rebalances occasionally to match the index that it tracks. This is why management and administrative expenses are much lower for ETFs than for the average mutual fund.

In addition to being expense efficient, ETFs are very tax efficient as well. Since trading creates the majority of tax liability, and ETFs trade infrequently (only when their index changes), they are much more tax efficient than traditional mutual funds.

You've probably heard that last one a hundred times, but here's a bit of tax info that is less well known and often misunderstood Many of the broader indexes, such as the S&P 500, track the largest and most successful companies in America. How do you get booted from S&P 500? If a company performs poorly and their market capitalization decreases (a fancy way to say the stock price drops) dramatically, they will be replaced. How does this create another ETF tax advantage? If a stock's price is dropping it is losing money. If the index (and your ETF) is only replacing stocks that are losing money, there is no capital gain to pass on to investors.

Finally, ETF investing is a low maintenance passive strategy that is easy to learn and implement in comparison to other investing strategies. What do I mean by low maintenance passive strategy? I mean you can choose several ETFs that track different broad indexes and then buy and hold and hold and hold. The simplicity of the strategy is a big perk, especially when you consider that experienced ETF investors beat most professional fund managers.

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Technology ETF

If you are interested in accessing a popular sector of the investment market, you should consider a technology ETF. This is going to be an investment that can result in exposure to companies involved with the Internet; computer hardware and software; telecommunications; and even semiconductors.

As we saw in 2009/2010 with the financial sector, no market segment is 100% protected from downturns and that includes the technology space. In fact, years before the financial meltdown there was a technology meltdown with many sure-bets falling apart. Despite the risks, one could argue that no other industry is positioned for as much innovation and therefore growth as technology.

Be aware that many technology ETFs have another layer of specialization so don't assume that what you're buying will automatically cover everything from software to semiconductors.

Some broad US-based options include iShares Goldman Sachs Software Index (IGV), iShares Dow Jones U.S. Technology Sector Index Fund (IYW), and Vanguard Information Technology ETF (INT). If you're looking for more global exposure, look into the iShares S&P Global Technology Sector Index Fund (IXN). My preference is to start broad and if the weightings are somehow out of whack, then consider more specific options.

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Small Cap ETF

In order to understand the appeal of a small cap ETF, it is necessary to understand what this type of investment actually is. We all know about companies like IBM, Citi, and Exxon because they operate globally, employ hundreds of thousands of people, and make billions of dollars a year. But smaller companies i.e. those with small market capitalization or small caps for short are another viable option for investors to consider. Small caps tend to focus on the markets in which they operate whether that is in the US or abroad.

When an investor is hoping to round out a portfolio with exposure to up-and-coming companies or ones that are more closely tied to local economies they should turn their attention to a small cap ETF. Their size tends to translate into limited capital and reach beyond immediate borders. Of course this isn't a hard and fast rule with web-based companies able to cross borders with relative ease.

International small caps also provide the additional variable of being more closely tied to currency fluctuations in the region they operate in. Depending on your perspective this can be a good thing or a bad thing. Weaker currencies can offset gains can vice versa so be sure to examine the potential impact before investing.

One thing I like about small cap ETFs is they allow me to get broader exposure to the market -- the US in particular. With market-cap weighted ETFs like SPY, a significant portion of the investment dollars go towards a relatively small percentage of the companies. Investing in a small cap index fund in effect adjusts that weighting to make it more proportional. Combined with a mid-cap ETF you get more control than you would with a single ETF that attempts to cover all bases by tracking something like the S&P 1500.

Some small-cap ETF options to consider include the iShares S&P SmallCap 600 Index Fund IJR. iShares also offers value (IJS) and growth (IJT) variations of this ETF.

For even smaller companies, be sure to check out Micro Cap ETFs.

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Natural Gas Prices At Attractive Levels For Long-Term Investors

Natural gas bulls have been touting for years that natural gas is the fuel of the future, and, therefore, there is only one direction for price to go, and that is up. However, price activity over the last two years has definitely not been straight up. While there are many significant scientific advantages to natural gas, natural gas prices will still fluctuate according to the same basic economic principle that every asset adheres to -- supply and demand.

Investors and analysts who believe Natural Gas is a promising long-term investment tend to predicate that conviction on several key points:

The U.S. Energy Information Association has projected that Natural Gas consumption will increase by 64% by 2030. Thus, demand is expected to increase.There is only a limited supply of oil available and there are major environmental concerns surrounding the use of coal and nuclear energy, which means there will be an increased demand for natural gas alternatives. Again, demand is expected to increase.

Most experts expect U.S. consumption of natural gas to increase only marginally over the next 20 years, so much of the increased demand for natural gas alternatives will most likely come from countries outside the United States.

Currently, the two largest producers, by far, of natural gas are the United States and Russia. Combined, the two countries produce roughly 40% of the world’s natural gas. Forex trading, in general, is not directly impacted by the ebb and flow of natural gas production, but, specifically, Russia’s currency can tend to be impacted in the near-term by natural gas supply/demand levels.

Investors who want to position themselves in order to take advantage of a possible rise in natural gas have several options. First of all, they could buy and hold specific companies that specialize in the exploration and production of natural gas. Secondly, they could go straight to the commodity or futures markets, or thirdly, they could invest in an exchange traded fund.

United States Natural Gas Fund (UNG) is a fund that seeks to track price movements of natural gas by percentage.First Trust ISE Revere Natural Gas Index Fund (FCG) is a fund that seeks returns which correspond to price and yield of an underlying equity index called the ISE-Revere Natural Gas Index.SPDR S&P Oil & Gas Exploration & Production ETF (XOP) seeks returns that basically mirror the performance of the S&P Oil and Gas Exploration & Production Select Industry Index.

ETF’s can serve as an integral part of a long-term investors investment portfolio, and current natural gas price levels look attractive for long-term investment. Natural gas demand definitely has the potential to significantly increase in the future. A forex account can be used to track how currencies are moving in relation to fundamental developments that affect natural gas prices.

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Managing Investment Expenses

Investing expenses can quickly eat into your earnings, especially if your portfolio is still relatively small. There are many types of expenses but the most dangerous to your portfolio are transaction costs, taxes, and investing information costs.

Transaction costs come in many forms but they all chip away at your returns, especially if your average transaction is small. This is how regular and online brokerages make money, they charge you when you buy and sell stocks, bonds or mutual funds.

These fees vary greatly, but one important piece of information I can share with confidence is that it is much more expensive doing business with a local financial planner or broker. They usually charge $35 or more per trade regardless of what type of investment you buy. In addition, planners will charge you for various services or by the hour, depending on the planner, and that can run into the thousands. They also tend to push the funds that pay them the biggest commissions. Beware the planner that ever pushes a fund loaded with fees and expenses, there's no reason to pay them now that you can trade them online for free (see the Mutual Funds Basics guide to learn more about No-Load Funds).

In contrast, the typical online trade is around $9.99 for stocks and most funds trade for free. Brick and mortar brokers and planners justify their much higher transaction fees by saying you are paying for their expertise, not just the transaction. Not many earn that extra money. Great investment advice is pretty cheap nowadays, some of the best investors in the world provide investment advisory services that cost less than $200 per year. There are always exceptions, so if your local planner is great, keeps fees low and outperforms the market, by all means, stick with him. While $9.99 online trades are much cheaper, they can still add up. Take my advice and keep track of all your fees, avoid local brokers and planners, and buy and hold as long as possible unless you've picked up a real dog.

Taxes are another large expense for those of us with portfolios in a taxable account. My first piece of advice is to stick every penny you can into tax deferred accounts (read the 401K, IRA and Roth IRA Basics guide to learn more about tax deferred accounts). This will allow your money to grow tax-free until you retire which will save you a fortune in tax expenses. If you can't put all of your savings into tax deferred accounts, the best way to keep your tax expense low is to hold your investments for as long as possible. Why? If you hold an investment for at least one year before you sell, you only have to pay the long term capital gains tax on the profit which is 15% for most of us and 5% in the lowest tax brackets. If you don't hold your investment for at least a year, you will pay your normal tax rate which can be as high as 35%. Long story short, buy and hold.

The last category, investing advice expenses, consists of the price you pay for whatever type of investing advice you buy each year. It can consist of financial planning, web site subscriptions, monthly investing newsletters, investing classes, and magazines subscriptions to name a few. I can't imagine how you would ever need to spend more than $1,000 per year to get great information. Spend even less if you are a beginner and your portfolio is still small because these expenses cut into a much larger % of your profit.

Of all the different types of investing costs, investing advice expenses are the easiest to manage if you do a little research before you buy. Here are a few tips to help you save money but still get the best investing advice available.

Keep up with the market and the economy:

A 12 month subscription to Smart Money published by the Wall Street Journal only costs $14.99 per year. This magazine contains outstanding content similar to the journal with a little more emphasis on personal finance articles than the Journal.Kiplinger's Personal Finance costs $19.99 per year. Despite the title, this magazine focuses on both the market and personal finance. Great content plus a lot of educational material.Money Magazine $14.99 per year. This magazine contains a little something for everyone, you can always count on each issue to emphasize a different aspect of personal finance and investing. Like this site, they shun the ivory tower mentality. Their publication is a fun and easy read and it always provide a lot of high quality educational content.A weekly subscription to the Wall Street Journal is $99 per year. Heavy emphasis on everything market-related. They can tend to focus on what's hot but the Journal contains a lot of solid and timely analysis.

Investing Advisory services that provide specific buy/sell recommendations and model portfolios:

Equity Fund Outlook for Mutual Funds $149 per year. Edited by renowned fund expert Thurman Smith. Emphasis split between tax deferred and taxable accounts. Provides strategy, model portfolio and specific buy/sell recommendations.Fund Street and ETF World Investor© for Mutual Funds and Index Investors $149 per year. Proven market beater that provides a lot of market analysis and investment/personal finance tools. Emphasis on long-term growth and Index/ETF funds. Provides strategy, model portfolio and specific buy/sell recommendations.The Prudent Speculator for Stocks $195 per year. Market beater for over 25 years. This seasoned investing team is led by Al Frank's protégé and successor, John Buckingham. Emphasis on growth stocks. Provides strategy, model portfolio and specific buy/sell recommendations.

Financial Planners:

If you feel you need a planner to get started, consider trying an hourly planner out rather than the more traditional fee-based planner. They claim you pay a premium for expertise so that's all you should use them for. Don't go through them to buy or sell stocks or funds, just get their advice at a reasonable hourly rate and don't go back if you don't feel you got your money's worth. Generally they are worth the dollars spent if you need help with advanced estate planning, insurance planning, or tax planning.

Investing Education Classes:

Typical investment workshops, seminars and courses cost anywhere from $1,000 to $5,000 and I've yet to see any material that you couldn't have gotten on line for free or at your local bookstore for $20. In addition to ETFTopics.com, there are many other similar sites that offer high quality free information on related topics. Why pay thousands when there's so much great free (internet) and inexpensive (bookstore) investing information available?

Data, charting, and investing analysis web site subscriptions:

Hopefully you'd prefer to at least validate the recommendations you're getting from your advisory services. Since all investing research sites are different and can be tough for the newbie, I'm only going to recommend my favorite and most user-friendly, Morningstar.com. They have a great variety of free investing tools, so check out the free stuff before you sign up for the paid service. Even if you decide to buy, the subscription is only $14.99 per month and it includes exceptional tools for screening, researching, and selecting stocks and mutual funds. If you want to learn more, read Morningstar.com, the Power of Institutional Investors at your Fingertips guide.I highly recommend the approach above (i.e. learning to validate your advisory service's stock and fund selections), but if you don't plan on doing much of your own research and analysis, don't join a pay site. In-depth research and analysis services are wasted on the casual investor that simply buys the stocks, bonds and funds that his advisory service recommends. This type of investor will generally only need to look up quotes, charts, financial results, news and other basic information. If this is you, invest your money at any of the major online brokerages, they will have all the tools the casual investor will ever need.

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