A Suze Orman exclusive

So, you ask, "What about bonds and ETFs?"

A Bonding Moment
Earlier I mentioned that I am not a big fan of bond funds. Here’s why: The beauty of owning bonds directly is that if you choose a high-quality bond you are pretty assured that when the bond matures you will be repaid your entire initial investment, or “principal.” So not only do you get the periodic interest payments from the bond, but there’s an extremely high probability you will get your principal back. In fact, if you invest in a U.S. Treasury bond, you are guaranteed to get your principal back at maturity. And when you buy a bond directly, you lock in the interest rate for the entire length of the bond. If you buy a 10-year bond with a 5 percent yield, you will get 5 percent for the next 10 years.

But a bond fund is different. That’s because there’s a manager at the helm who is actively buying and selling bonds rather than buying and holding them until maturity. So you lose the certainty of getting your principal back. And by the way, you have to pay that manager; the typical expense ratio on a bond fund is about 1 percent. You’re lucky to get a yield of 4 percent on a high-quality Treasury bond fund and you’re going to give back one quarter of that performance in a fee? That just doesn’t make sense to me.

Granted, with a talented manager all that buying and selling can produce returns that exceed the buy-and-hold strategy of owning a bond directly. But there’s no guarantee of that. Moreover, there is no locked-in interest rate. The yield on the fund will fluctuate based on what the manager happens to own at any particular time. When rates are falling, a bond fund’s yield is going to fall too. Whereas if you owned a bond directly, your higher rate would still be locked in for as long as you owned the bond. Back in the days when I was a financial advisor, I had clients buy 30-year Treasury bonds in 1980 yielding more than 14 percent. I guarantee that no long-term bond fund today has a 14 percent yield—you’re lucky to get 5 percent—but anyone who bought one of those 30-year bonds is still getting their 14 percent!

Of course, there’s the reverse scenario that can work against you when you own directly: when interest rates are rising, the interest rates of a bond you own directly is not going to rise. You will be locked in at your same lower rate. That’s why you want to have a laddering strategy where you own a few different issues that mature every few years; then you can periodically reinvest at higher rates. Between laddering and having the assurance of getting your principal back, direct investment in bonds beats bond funds any day. After all, the whole point of bond investing is to not take risks. Bonds are designed to bring safety and stability to your overall investment portfolio. So I wouldn’t use bond funds. Instead, go to www.treasurydirect.gov; it’s a great site that will walk you through how to buy U.S. Treasuries directly.

A Smart Fund with a Twist
I think low-cost no-load mutual funds are a terrific investment, but I’ve got an even better alternative I want you to consider: Exchange Traded Funds (ETFs). An ETF is an index fund that has an even cheaper expense ratio. The other difference between a regular index fund and an ETF is in how you buy and sell them. An index fund is priced just once a day, after the market closes at 4 pm EST. You can call your fund company at 11 am and request to buy or sell shares, but your trade will not be processed until the end of the day when the fund is “priced.” So let’s say you see the market is down 5 percent and you want to sell some of your fund shares. You call at 11 am and place the order. But between your call and the market close, the market drops another 5 percent. The loss on your trade is going to reflect the entire 10 percent drop, because the fund price will be calculated at the end of the day. There is no ongoing pricing while the market is open.

With an ETF you get constant pricing throughout the day. An ETF is basically like a stock, but you are invested in an entire index. Just like a stock, you can buy and sell based on the market price at the time you request a trade. You sell at 11 am and you will get the market price when your order is placed. No waiting until the bell at 4 pm.

Now I hope all of you are focused on the long term and aren’t trying to time every little twist and turn in the market, but even for a patient investor the extra flexibility of ETFs can be very useful at times. And they are cheaper, which is why I really love them. The biggest ETFs are iShares funds. And Vanguard also has ETF carbon copies of its index mutual funds. You can learn more about ETFs at the Yahoo! Finance ETF Center.

The one ETF catch is that you must buy them through a brokerage or discount brokerage. So every ETF trade is going to cost you a commission. Even if you use a terrific low-cost discount brokerage, I wouldn’t recommend an ETF if you are investing every few weeks or once a month; those brokerage costs are just going to eat up your investment. An ETF is best used when you have a lump sum to invest once or twice a year. If you are making periodic investments—what’s known as “dollar cost averaging”—I would stick with an index mutual fund.