Q & A With Barry Mendelson, CFP®:

Explain ETFs in general. How are they different from, say, index mutual funds? Why are they so hot right now?
Barry: ETF is short for "Exchange Traded Fund" and is exactly what the name implies: a fund that trades on an exchange. Though ETFs are quite similar to mutual funds (they are both baskets of securities), the one big difference is that because they are traded on an exchange, such as the NYSE, they are priced continuously (throughout the day), as the underlying prices of the securities they own change. This is different from mutual funds, in that mutual funds are priced at the end of the day based on the closing prices of the underlying securities for that day. Otherwise, ETFs and mutual funds are quite similar in that they both represent investments where investors pool their capital to purchase a basket of securities.
The fluctuating price thing can be scary. How does an individual investor protect themselves?
Barry: Another factor to consider is your comfort in trading -- that is, actually placing a buy or sell order when the market is open. Most large ETFs (those with at least $100 million in assets) are liquid enough (enough shares trade during the course of the day) that an investor placing a small market order is not likely to move the price one way or the other. However, with less liquid ETFs, larger orders, or less liquid markets (perhaps the market is trending down at that particular moment), it can be much more difficult for an ETF investor to get the price they want. For that reason, the investor may be better off placing a "limit" order, "stop" order, or "stop limit" order. And this is where many investors quickly get out of their comfort zones. Which brings us back to what I feel is one of the greatest advantages of mutual funds: they're priced once, at the end of the day, and everyone who has placed a buy or sell order that day gets that price.
We're always told to "diversify." Are ETFs an efficient way to invest in bulk, or should they be mixed with other methods?
Barry: Both. Broad-based ETFs -- those that invest in a diversified mix of securities and are not concentrated among one sector (such as technology), country (such as Brazil), or security type (junk bonds), can be a great way to capture the returns of the stock or bond markets in general. Though many ETF providers offer such diversified investments, the big ETF players can keep costs down, and in general do it far less expensively than anyone else (with Vanguard, iShares, SPDRs, and Schwab capturing most of that market).

Another way ETFs are used is to gain investment exposure to a specific segment of the market, such as Preferred Stocks, Gold, Commodities, individual countries, you name it. Here an investor might feel particularly bullish (expects prices to rise) about Israel (for example) and buy shares of the iShares MSCI Israel ETF. Of course, any time you invest in a single country, sector, or commodity, the line between conviction and speculation starts to blur, and this is where many investors who use ETFs get themselves into trouble. On the fringe of broad-based ETFs are those that short (expect prices to fall) particular segments of the market, are leveraged (offering two or three times the exposure), or worse yet (in my opinion) are inversely leveraged to the market (seeking "-2 times" the return on something -- Yen, for example). These ETFs often use the monikers, "Short, UltraShort, Bull 3x, Bear 3x," etc.
Do you need a ton of capital to reap the benefits of an ETF?
Barry: To invest in ETFs, all you need is enough money to open a brokerage account -- as little as a few thousand dollars. Perhaps less. ETFs can benefit any investor. They can also hurt any investor.

Investors are a funny group. By that I mean, I spoke with someone recently that had just opened a brokerage account through a bank and was thrilled because they get "200 free trades a year." When I asked how much trading they do a month, they responded, "Not more than a couple." The irony being they're excited to have a service they're barely going to use!

In general, investors should expect to pay a transaction fee or "ticket charge" when they buy or sell an ETF. This could be as little as $5-$9 at the major online brokerages such as eTrade ScottTrade, Schwab, Fidelity, and TD Ameritrade. Or it could be much more at the traditional brokerage firms such as Merrill Lynch, Morgan Stanley Smith Barney, Wells Fargo, etc. If you're investing $100, that $9 is going to take a big chunk out of any returns you might hope to get. If you're investing $1,000, $9 to buy and then sell the security ($18 total), still represents 1.8% of the value of your investment. So having more to invest can certainly reduce the bite of such costs.

Another exciting development in the ETF world is that in the last few years companies such as Charles Schwab, Fidelity, and others have introduced commission-free ETFs. For example, in late 2009, Schwab came out with their own line of ETFs. For Schwab brokerage account customers, these trade without a transaction fee. Similarly, Fidelity offers commission-free trading on 30 ETFs from market leader iShares.
Does trading more often mean more money? And is there a place for people who only have a few hundred dollars to play with?
Barry: In regards to our investor above, the fact that he's not a frequent trader probably bodes well for him. That's because studies have shown that more frequent trading often leads to having less money -- not more. That is, investors who trade more frequently tend to underperform investors who trade less frequently. So in the case of our friend above, his lack of trading may actually lead him to have more money, not less.

What most people don't understand is that money (especially investments) is a lot like a bar of soap -- the more you handle it, the less you have. The point is, investors don't need to be frequent traders to be successful investors. And there are number of very reputable investment firms that offer low minimum investment accounts these days. Scotttrade and eTrade have account minimums of just $500, Charles Schwab $1,000, TD Ameritrade, Vanguard and Fidelity around $2,500. Whether your preferred investment vehicle is an ETF or mutual fund is a matter of choice.

Barry Mendelson, CFP®, is the President and Founder of Elevation Wealth Management in Walnut Creek, Calif.

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