Getting Started with Exchange Traded Funds (ETFs)

Getting Started - The Early Years

So you've decided you want to invest in the stock market but you're not sure where to start. Yes, there are many, many options to choose from and if you follow headlines from the popular TV shows, you'll be inundated with choices for buying individual stocks. If you think about building wealth as similar to building a house, you would start with a good, solid foundation on which everything else can build upon. To me, that solid foundation is a broad set of companies, such that there is no single point of failure. The S&P 500 is a stock market index that tracks the performance of 500 companies listed on stock exchanges in the U.S. Note that contrary to popular opinion, the S&P 500 is not simply the 500 largest companies, but is based on an index methodology designed to include stocks of companies that can act as a proxy for the entire U.S. stock market.

Now, you can go and buy shares of all 500 companies yourself, which would be challenging as buying even just a single share of all 500 companies would cost you about $105,500 as of February, 2024. So, instead we can look at ETFs or Exchange-Traded Funds that track the index. Buying a single share of one of the most popular S&P500 ETFs, VOO, or Vanguard S&P 500 ETF, will cost you $466.78 as of last trade date 2/23/2024. And of course many brokerages allow you to buy fractional shares, so you can still participate in this ETF with as little as $10 or $20.

Let's talk a bit about a few of the ETFs that track indexes made up of hundreds or thousands of companies. Exchange-Traded Funds (ETFs) have revolutionized the investment world, offering diversification, lower expense ratios, and ease of trading. Vanguard, a leading investment management company, offers a variety of ETFs that cater to different investment strategies and risk profiles. Among these, the Vanguard S&P 500 ETF (VOO), Vanguard Total Stock Market ETF (VTI), and Vanguard Growth ETF (VUG) are particularly noteworthy.

Investment Strategies, Holdings, and Performance

VOO, VTI, and VUG each offer unique investment strategies and holdings. VOO is designed to track the S&P 500 Index. VTI offers a broader market exposure as it tracks the CRSP U.S. Total Market Index, which includes over 3,800 individual stocks. VUG, on the other hand, is an index fund that tracks the performance of the CRSP U.S. Large Cap Growth Index, with a heavy emphasis on the technology sector.

In terms of performance, VOO has demonstrated strong long-term returns, reflecting the overall growth of the U.S. stock market. VTI, with its broader market exposure, has also shown robust returns, albeit slightly lower than VOO. VUG, with its focus on growth stocks, has outperformed VOO over the past 10 years. However, its focus on growth stocks means it may experience higher volatility and underperform in bearish markets.

Expense Ratios, Dividend Yields, and Risk-Adjusted Performance

The expense ratios of VOO and VUG are 0.03% and 0.04% respectively, significantly lower than the average expense ratio of U.S. equity ETFs at 0.20%. This makes both funds cost-effective investment options. In terms of dividend yields, VOO offers a higher yield compared to VUG, while VTI's dividend yield stands at around the same level as VOO.

The Sharpe Ratio, a measure of risk-adjusted performance, is roughly equal for VUG and VOO, suggesting that both ETFs have provided relatively good returns per unit of risk taken. However, holding both ETFs may not provide significant diversification benefits during market downturns as they have a very strong positive relationship between their price movements.

Choosing the Right ETF: VOO, VTI, or VUG?

VOO, VTI, and VUG each offer unique advantages and cater to different investor preferences. VOO provides a focused investment in the largest U.S. companies with stable dividends and lower volatility. VTI offers broader exposure to the U.S. stock market, including small- and mid-cap stocks, which may lead to higher returns in bull markets. VUG is suited for investors seeking higher growth potential but comes with higher volatility and sector risk.

The choice between VOO, VTI, and VUG should not solely depend on the individual's investment philosophy and the economic segments they believe will lead the market's future growth trajectory. Factors like risk tolerance, investment horizon, and financial goals should also guide your choice.

As you can see, there are a lot of factors to consider when deciding if you should invest your money in an ETF. However, there can be just as many decisions to make when investing in individual stocks, and generally, investing in individual stocks is much riskier than investing in a broad market ETF as the risk is spread out amongst hundreds or thousands of companies. The effect of one company's stock dropping will not necessarily have a material impact on the remainder of the index. Don't quote me on that. In addition, companies are regularly added and dropped from an index like the S&P500 in response to corporate actions and market developments. For example, a company may be removed from the index if the stock has been delisted or the company has declared bankruptcy. This 'natural selection' process helps to keep the index filled with some of the strongest and most profitable companies.

As always, this is not investment advice and it's essential to do your research and consider your financial goals before making any investment decisions.