ETF Basics: Investing in Corporate America

The easiest ways to buy American.

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Stocks represent an ownership piece of corporate America. No other basket has grown as much during the last 100 years. From 1925 through 2004, large and small company stocks appreciated 10.4 percent and 12.7 percent per year, respectively. To illustrate the magic of compound returns, between 1925 and 2004, large companies appreciated 2,860 times. That extra 2.3 percent return for small companies allowed them to grow 12,650 times their value!

That's not to say stocks will reward you without some ups and downs along the way. The S&P 500 has been flat from 2000 through this year. And from the stock market's peak in October 1929 (right before the crash), it took investors more than 21 years to match the returns of bond investors. And while stocks protect you over the long term from inflation (companies can raise prices to fend off that threat), in the short term, stocks often decline in value when there is a fear of inflation. That double whammy occurred from 1973 to 1974, when inflation rose by 37 percent, stock prices declined by 22 percent, and investors watched their stock portfolios decline on an inflation-adjusted basis by about 50 percent. It's a bumpy ride, but in the long run, you get higher returns owning stocks.

As Warren Buffett has always said, "it is a bad idea to bet against American business." There are four basic ways investors can use ETFs to invest in U.S. stocks:

1. The lazy way. You can buy one security to own the U.S. stocks that account for most of the value of American corporations. For smaller portfolios, we recommend Vanguard's Total Stock Market ETF (symbol VTI). For an expense of just 0.07 percent per year (that's $7 for every $10,000 invested), Vanguard manages a basket of 1,200 to 1,300 US stocks—in just one ETF. Over time, VTI will capture most of the returns of America's companies. Because stocks in the basket are allocated based on market capitalization, larger companies will represent the predominant portion of the basket. That's why you might want to try #2.

[See ETF Basics: How To Invest in Commodities.]

2. Three-legged stool. If you want the flexibility to "lean" more into small-, mid-, or large-cap stocks, alter your allocations to these groups with three ETFs: the iShares S&P SmallCap 600 Index (IJR), iShares S&P MidCap 400 Index (IJH), and the S&P 500 (SPY). We recommend allocating equally into each of these ETFs. With this method, if you want to weight or underweight one of these groups, you can do so over time.

3. Value and growth believers. For those who like to have some combination of value or growth stocks, you can get even more granular and buy six ETFs to lean heavier in one direction or the other. We recommend Vanguard's Small-Cap Value and Growth ETFs (VBR and VBK), iShares Mid-Cap Value and Growth ETFs (IWS and IWP), and iShares Russell 1000 Large-Cap Value and Growth ETFs (IWD and IWF). Use the same ETF provider in each group, i.e., use Vanguard for both small cap ETFs so that between both ETFs, you get all the stocks in the class.

4. Sector players. Select Sector SPDRs divides the S&P 500 into nine sector ETFs so you can overweight or underweight particular sectors. If you want more exposure to utilities and consumer staples sectors (people need heat and have to eat) and less to financials (you think banks are still going down), you can allocate accordingly. If you pursue this strategy, get some exposure to all nine of the sectors and add some small and mid-cap exposure using the selections in #2 and #3 above.

[See ETF Basics: How to Invest in Emerging Markets.]

Pick a method and stick with it. Trading in and out of ETFs creates taxable income, which can eat into returns over time. The magic of ETFs is that if you buy, hold, and rebalance the same ETFs, your savings will grow and you'll be deferring taxes on the increase in value.

Does it matter which method you choose? Over 20 years, it may not. If are right over and over, year after year, about your weightings and leanings, then maybe you can create additional returns. But there are only 2,800 firms that comprise 95 percent of the value of all U.S. public companies. All of these methods are just another way of slicing and dicing ownership in these same names. By using ETFs, you'll be paying an average of 0.15 percent to 0.20 percent and saving yourself 80 percent of costs for similar mutual fund fees. That's worth doing!

Mitch Tuchman is CEO and Founder of MarketRiders, an online investment advisory and management service helping Americans invest for retirement. MarketRiders gives investors greater piece of mind knowing that they are leveraging the best thinking of Nobel Laureates and the investing methods used by the world's most elite institutions and wealthiest families. MarketRiders is on the investor's side, helping reduce investment costs and risks, and increasing retirement savings.