ETF Update - Don't Forget Your Dividends

Our S&P 500 ETF holds large and mid-sized companies, and it outperformed our Russell 2000 small cap ETF during the week.  Both of these ETF’s are very low cost, and add important diversification to our Blue Harbinger 15 and to our Lazy Person Portfolio.

Important to note, the S&P 500 ETF pays dividends at the end of each January, April, July and October, which means its dividend payment will be showing up soon if it’s not already in your account.  If you don’t need this dividend for your own personal spending purposes, then it is important to reinvest the cash received so it doesn’t add up and drag down the returns of your account over the long term.

Ideally, we want zero cash in a long-term investment account, but generally speaking it is not the end of the world if you have 1% cash in your account.  But if you accumulate much more than 1% then you should really think about getting that invested as soon as possible.  As a reminder, most discount brokers (E-Trade, Scottrade, TD Ameritrade) offer automatic dividend reinvestment programs, and it’s a good idea to take advantage of these programs if you are a long-term investor and don’t need the cash right away.  However, if you do need the cash then it’s always especially nice to see those dividends come rolling in quarter after quarter.

You can read our complete Russell 2000 Small Cap ETF thesis and research report here, and you can view the same for our S&P 500 SPDR ETF (SPY) here.

U.S. Small Companies ETF (IWM) - Thesis

iShares Russell 2000 Index ETF (IWM)
Expected Return: 8.75% per year
Expected Volatility: 20.0% per year
Rating: BUY

Thesis:
As long-term investors, we believe the equity markets will increase over time, and the small cap portion of the equity markets will increase more than the large cap portion, albeit with more volatility.  The iShares Russell 2000 Index ETF (IWM) offers reliable exposure to the returns of the small cap portion of the U.S. equity market while avoiding the many pitfalls that are common among other ETFs and among other equity investments in general.

Holdings:
IWM invests at least 90% of its assets in securities of the Russell 2000 Small Cap Index.  The fund may invest the remainder of its assets in certain derivatives such as futures, options, swap contracts and cash equivalents.  The index is one of the most commonly followed equity indices in the U.S., and is largely considered the standard benchmark for small cap stocks.  The performance of IWM has historically matched the performance of the Russell 2000 Small Cap Index very closely, and it should continue to track closely in the future because of its construction methodology.  Investors cannot purchase the actual index (the Russell 2000 Small Cap Index), and IWM is the next best thing.

Volume and Liquidity:
As the standard small cap ETF in the US, IWM has significant volume and liquidity (total IWM assets exceed $28 billion).  Because of the volume and liquidity, the bid-ask spread is small (the bid-ask spread is the difference in price at any given time for someone buying the security and someone selling it.  There is a difference because the middle man takes a very small cut).  A small bid-ask spread is good because it saves you money when you trade.  Second, IWM trades very close to its net asset value (NAV) because of the large volume and liquidity.  NAV is the actual value if you add up the value of all the securities held within IWM.  For many less liquid ETFs, the NAV may vary from its actual market price (the price the ETF trades at in the market).  This makes IWM much less risky for investors compared to other ETFs that may vary widely in price versus NAV.  Additionally, small investors don’t have to worry about some big investor coming in, buying or selling an enormous amount of IWM, and subsequently adversely moving the market price away from its NAV because the volume of IWM is already so great that this risk is essentially non-existent.

Low Fees:
The net expense ratio on IWM is currently 20 basis points (0.20%).  This is extremely low for small cap market exposure; it is good for investors because it allows them to achieve better returns on their investment.  For comparison, small cap mutual funds (a common competitor to ETFs) may charge over 200 basis points (2.0%) per year, and they tend to deliver worse performance over the long-term.  Additionally, there is no expensive sales charge or separate investment advisor fee because IWM can be purchased directly through a discount broker (e.g. Scottrade, E*TRADE, TD Ameritrade, Interactive Brokers, etc.).  The discount broker may charge you a one-time trading fee of $8 or less, but this is much better than the 2-5% sales charge/management fee you’d get charged by a full service financial advisor.  Additionally, there is no hidden 25 basis point (0.025%) annual 12b-1 fee paid to someone for “servicing your account.”  The bottom line here is that IWM is a very low cost way to get great exposure to the equity market and to build considerable wealth over the long-term.

Dividend Reinvestment:
One last point of consideration, IWM pays a quarterly dividend (around 1.36% per year), and this dividend is NOT automatically reinvested back into IWM (this is standard protocol for ETFs and stocks).  This mean you’ll build up a cash balance in your account if you don’t withdraw it or manually reinvest it.  As a long-term investor, cash is generally a drag on investment performance.  Unless you plan to withdraw and use the cash, we highly recommend you develop a process to reinvest it.  Most discount brokers (Scottrade, Interactive Brokers, etc.) offer automatic dividend reinvestment programs.  We highly recommend you sign up for these programs to avoid the situation where cash builds up in your account and becomes a drag on your long-term investment performance.  Reinvesting dividends is important.

Conclusion:
IWM is a very low cost, relatively low risk, security that allows investors to build significant wealth over the long-term.  We consider IWM to be a basic building block for long-term wealth, and we rate IWM as a “Buy.”  For more information, you can view the IWM fact sheet here.