Small-Cap Investor’s Guide to Exchange-Traded Funds (ETFs)

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In this market, it’s not enough to simply invest in the “next hot stock.” As penny stock investors, we are looking at all our options. We’ve received tons of emails about one particular investment, and we want to share our response with you today…

By now, you’ve probably heard a lot about exchange-traded funds (ETFs). Since their inception in the early 1990s, the financial world has been aflutter with investors hungry for the efficiency and ease of buying ETFs. Want to know how you can cash in on the ETF craze? Here’s a look at exchange-traded funds…

If you’re wondering what an ETF is, you’re not alone. ETFs are portfolios that you can buy and sell ownership in. Basically, an ETF is a lot like a mutual fund that trades on an exchange like a regular stock. That’s an important distinction, because unlike open-ended funds, which buy back their own shares, ETF owners can sell their funds to anyone in the stock market who’s willing to buy. That and higher levels of transparency make for an investment that trades much closer to its actual value than a regular mutual fund.

Advantages of ETFs

There are a few reasons why ETFs look good… ETFs offer instant diversification, lower costs, and ease of purchase that you can’t find anywhere else.

As an investor, one of the smartest things you can do with your portfolio is diversify. That’s because a diversified portfolio can make more gains at a lower risk than a single investment. Since ETFs own a bunch of different securities (like stocks and bonds), when you buy an exchange-traded fund your portfolio is instantly diversified.

Besides diversification, one of the biggest reasons to get into an ETF is cost. For starters, ETFs can substantially reduce the transaction costs associated with diversification. Instead of paying commissions for each individual stock you buy to diversify your portfolio, when you buy an ETF, you only pay commissions for the ETF itself. ETFs also have considerably lower expense ratios than mutual funds.

Expense ratios are the management fees funds charge to their investors. With an ETF, expense ratios are generally between 0.1% and 1% — compare that to the 1% to 3% generally charged by mutual funds, and it’s clear that ETFs are the winner here.

One of the reasons ETFs have been so successful is their accessibility. ETFs trade on stock exchanges, which means that any investor has access to them without minimum investments restrictions. That means that they’re the easiest way to get into a managed fund investment.

Kinds of ETFs Available

Today, new types of ETFs are springing up, giving individual investors more investment options than ever before. Here are some of the main types of ETFs:

Stock Index ETFs: The most common type of ETF today. These funds are designed to track major stock indexes like the S&P 500 or the Dow Jones Industrial Average. In fact, the most popular ETF of all-time, Standard & Poor’s Depositary Receipts ( SPY: AMEX ). is an ETF that tracks the performance of the S&P 500.

Bond funds: Another type of investment represented by ETFs. Funds like the iShares Lehman Inter Govt/Credit Bond ETF ( GVI: NYSE ) aim to match Lehman Bros. bond indices (which continue to operate under Barclays ownership).

Commodities ETFs: A category of exchange-traded fund that has popped onto the scene recently. Commodities — like oil, gas, grains, and gold — were once a tougher market to get into for small investors. Now commodities plays like the U.S. Oil Fund ( USO: AMEX ). which significantly outperformed the S&P 500 in 2008, are showing the financial world that opportunities abound in the ETF world.

Managed ETFs: In 2008, the Securities and Exchange Commission decided to allow actively managed ETFs for the first time, meaning that ETFs weren’t relegated to tracking an index or commodity. The first group of actively managed ETFs was put out by PowerShares in July 2008.

Finding Small-Cap ETFs

As a penny stock investor, small-cap ETFs are a very interesting idea. There are a number of index ETFs that invest in small-cap plays, including the iShares Russell 2000 Index ETF ( IWM: NYSE ). the Vanguard Small-Cap ETF ( VB: AMEX ). and the iShares Morningstar Small Core ETF ( JKJ: NYSE ).

We’ll continue to pour through the hundreds of different funds available to small-cap investors. We’ll let you know when we find something worth investing in. Until then, be sure a keep an eye out for an upcoming opportunity called Retirement: Plan B. which will focus on investments such as these.

Cheers,

Jonas Elmerraji

October 30, 2008