How to diversify with Exchange Traded fund (ETF): Vanguard, iShares, Powershares?

Exchange Traded fund (ETF) is an investment fund traded on various stock exchanges. An ETF consists either bonds or stocks or combination between stocks and bonds and trades at NAV (net asset value) of its assets. Most ETFs are tracking an index such as Dow Jones, S&P 500, Russell, and MSCI EAFE etc.

Three reasons why ETFs are attractive compare to typical Mutual funds:

• ETFs are very tax efficient since ETFs don’t distribute any capital gain for its owner. Typical mutual fund will have distribution of capital gain near end of the year or mid of year.
• ETFs have a very low cost especially index ETFs. For example, SPY or S&P500 index ETF offer by State Street Global Advisors (SSGA) has only 0.09% expense ratio. The expense ratio is minuscule.
• ETFs are traded like stock. You can purchase any ETFs during the trading day (pre-market, market and post-market). ETF is very liquid compare to mutual fund. Mutual funds can only be purchased by end of the day.

Similar to Closed-End Fund (CEF), ETFs have similar classifications. They are:

• Fixed income / Bond: Short term bond, Intermediate term bond, Long Term Bond, Investment Grade, High Yield, Treasury Inflation Protected (TIP) Bond
• Equity / Stock: Large Cap, Mid Cap, Small Cap, REIT (Real Estate Investment Trust), Emerging Market, Foreign Large Cap, Foreign Small Cap.

• State Street Global Advisor SPDR such as SPY (S&P500), DIA (Dow Jones Industrial Average)
• Invesco Powershares: QQQQ (Nasdaq 100 index)
• Vanguard: VV (Large Cap), VO (Mid Cap)
• BlackRock ishares: IVV (S&P500), IJR (S&P small cap)

I usually buy the following ETFs for my investment account. The ETFs have been chosen due to low expense ratio and their liquidity. Illiquid ETFs can be very hard to trade and bid to ask spread gap can be very large.

You can have an asset allocation according to your risk appetite. I have provided the following sample asset allocation for ETFs. You can tweak as you see fit your long term goal. To have diversification of ETFs is important for long term investor. As you know, similar to mutual funds, ETF also can be clasiffied to various classes such as:

• Bond ETFs: Municipal ETF, Government Bond ETF, Corporate Bond ETF (Investment Grade or High Yield), Treasury Inflation Protected Securities (TIPS) ETF and more
• Stock ETFs: Domestic Stock ETF, International Stock ETF, Emerging Market ETF, Secotr ETF, Gold ETF, Silver ETFs and many more

Stock ETF is usually more volatile compare to bond ETF. International stock ETF is also more volatile than domestic stock ETF.

Usually you will need a brokerage account to buy ETFs, however, many ETF’s providers recently have provided an incentive by waiving fees to buy or sell ETFs when you open a brokerage account with them. These include Vanguard, Fidelity (ishares ETFs), and Charles Schwab.

If you have $25,000 of money to invest, you can consolidate your account in one of these discount brokerages:

• Zecco - Good discount brokerage. Decent interface, not the best execution, very user friendly for beginner trader.
• Wells Fargo Wells Trade account - I never use Wells Trade. My friend has used and found no issue. Very simple interface though.

If you have less than 25k, you can open multiple accounts with Vanguard, Fidelity or Charles Schwab since there is no fees to buy ETFs. I have accounts with Vanguard and Fidelity. Fidelity has good interface for trading. It also provides good research for the ETFs. Vanguard has simple interface and it only offers vanguard ETFs. I also found the quote in Vanguard is not competitive compare to Fidelity.

• Fidelity - Offer 25 ishares ETF for free. No minimum trading requirement.

Other choices to buy ETFs are discount brokerages such as Just2trade, Lightspeed, optionhouse, sharebuilder, etrade, firstrade, scottrade, etc. Just2trade has the lowest commission of $2.50 to buy/sell stocks/ETFs.

The leverage ETFs usually try to achieve 2x or 3x market index movement (such as S&P 500 index). Two prominent leverage ETFs are Proshares & Direxion. The leverage ETFs can be a bear or a bull fund. I personally avoid buying these ETFs. It is also important to never ever holding leverage ETFs for any long period (more than 5 days). Also, they have high expense ratio (1%-2%).

The following chart will explain why leverage ETF is bad for investment vehicle. As you can see, over the long term the leverage ETFs doesn't follow their index. This happen because of the leverage ETFs were adjusted everyday and slippage occurred.

I did purchase Leverage ETFs from time to time, however this is only high probably trade. I usually only hold these ETFs for day trade or short term trade (i.e. less than 5 days). Only use this investment vehicle if you understand the ETFs.

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