Finding the Right ETF for Your IRA
By Chandler Lutz
April 1, 2008
A stark reality (and not just a cruel April fool’s joke) is that many individual investors at this time of year are faced with the daunting task of choosing one or more investment vehicles for their IRA or other tax sheltered account. What makes the process even more difficult is that the average American is so busy with other activities that IRA investing is usually put off until the last minute. Today, hopefully we can put investors on the right IRA path help facilitate the whole process.
Before we take a look at some actual funds, it is best to lay out some guidelines to determine what kind of funds we should be searching for:
Low Expense Ratio
A low expense ratio, how much the company charges you for managing your money, will ultimately determine the success of your investments. As Richard Ferri pointed out in The ETF Book, studies have shown market indexes and custom indexes generally have the same expected return and the only thing separates the investment success of one index fund versus another is the expense ratio. If you are given two similar ETFs, choose the one with a lower expense ratio. This strategy will help maximize long term returns
Length of time in existence
The world of ETFs is rapidly changing with new funds being created and launched all the time. In fact, it is typical to find ETFs that have been in existence for less than a year. Also, with so many new ETFs coming to the market some of them are bound to fail (by fail, I mean close down not go bankrupt).If an ETF shuts down, investors are given their money back and are forced to find a different investment vehicle. Not only does this increase transaction costs, but it also creates an extra hassle that no one should have to deal with in a long term retirement account. In general, it is best to find ETFs with a track record of at least three years. This will ensure that the ETF has some sort of staying power in the market. I know that three years does not seem like a long time, but it is quite a long time in this nascent industry. Obviously, the longer the ETF has been in business the better.
Diversification
There are many narrowly focused ETFs that invest in companies in a certain industry or certain geographical location. In a long term retirement account, it is best to avoid these types of funds in favor of broadly diversified ETFs. This strategy will not only shield investors from a depression in a certain sector or region, but will also keep transactions low which is paramount to any long term strategy.
Long Term Return
The Last thing an investor should examine is the past performance of the fund. This is antithetical to the actions of most beginning investors who study past returns first. These investors error for two main reasons (1) past performance is not indicative of future results, and (2) many ETF companies present hypothetical results since their funds are so young that actual results are meaningless. Hypothetical results may be manipulated by fund companies and mislead investors. I’m not saying that this practice actually happens, but with your life savings on the line why take the chance?
The Funds
Here is a list of funds that I have found to meet the above criteria. This is by no means a complete list and you should do your own sleuthing before making actual investments. These funds are listed in order of expense ratio with the fund with the lowest expense ratio listed first:
Vanguard Total Stock Market ETF (VTI)
This fund is one of the best known ETFs in the world and is responsible for over nine billion in assets. The expense ratio for fund is the lowest around at just 0.07 percent. The fund aims to track the overall stock market and follows the MSCI US Broad Market index. It has achieved a 5 year annualized return of 13.89 percent and currently sports a dividend yield of 1.96 percent.
Vanguard Extended Market Index ETF (VXF)
This exchange traded fund aims to invest in small and midcap stocks, which tend to be less efficiently priced than their large cap counterparts. The expense ratio is 0.08 percent and the ETF has seen a five year annualized return (actual, not hypothetical) of 17.54 percent.
SPDRs (SPY)
This is one of the most popular indexes around which is evinced by its 66 billion dollars in assets. This fund tracks the ubiquitous S&P 500 index. The expense ratio is a low 0.08 percent and the five year return is 12.62 percent. Investors may want to shy away from this fund, however, due to the extreme popularity of the index. With so much wealth tied to the S&P 500 index it is possible that a premium exists for this group of stocks. This may diminish the returns for an investor of the index. This phenomenon was pointed out by Wharton finance professor Jeremy Siegel.
Vanguard Total International Index (VGTSX)
This fund aims to invest in companies located outside the United States. The expense ratio is 0.1 percent. While this number is still low compared to many index funds, it is high for this group. The fund has about 55 percent of its assets in Europe, 23 percent in the Asian Pacific and the rest in emerging markets. The fund does require a 3000 dollar minimum investment.
This is just a small list of funds that may meet the investment needs for your IRA. Read the prospectus of any fund before you invest. And hurry! The clock is ticking before the IRS deadline.
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