Buying shares of an exchange-traded fund (ETF) is just like buying shares of stock. You bid a certain price, or you take out the offering price. Simple as that. However, before you get started and place that call to your broker or buy shares through an investment app, conduct your due diligence about adding ETFs to your portfolio. Here are some things to consider before making that investment.
What Is Your Investment Strategy?
- Why are you interested in buying an ETF?
- Are you looking for some broad market exposure?
- Do you want to invest in a certain industry?
- Are you looking to hedge a segment of your portfolio?
Determining the correct investment strategy will set you on the correct path for picking the most effective ETF for your portfolio. From the general market and index funds to a specific sector or region funds, or even commodity funds, there are so many different ETFs to consider, and one will surely fit your investment strategy.
What Are Your Investment Goals?
- How long do you plan to hold this ETF?
- Are you in it for the long haul, or is this a short-term investment?
There are different advantages and disadvantages of ETFs, depending on your investment horizon. For example, ETFs allow for liquidity—investors can buy and sell their shares pretty much as often as they like. This ease of trading can be beneficial for investors who may want to use the money they've gained from their investment in an ETF.
However, since ETFs track an underlying index, investors will most likely see a larger return on their investment over a longer period.
Understand the ETF and Its Assets
Research your chosen ETF and all of its holdings. Even though you are looking for overall country, market, or sector exposure, that doesn’t mean you shouldn’t examine the equities in an ETF. Just as you scrutinize any stock before you invest, you should research all the assets in the ETF. For example, some ETFs hold a few hundred stocks of technology companies, such as the Vanguard Information Technology ETF (VGT), while others may hold fewer. If there is any equity that could hinder performance (in your opinion), it may not be the ideal investment for your portfolio.
Know the Costs, Commissions, and Fees
ETFs can be a cost-effective investment in most cases, but you still have to weigh the related costs of an ETF against similar investments like indexes and mutual funds. Moreover, today, many online brokerage platforms feature commission-free trading in ETFs.
Some ETFs are close-ended and, therefore, carry extra management fees (known as the ETF's expense ratio). Also, if you are actively trading ETFs, make sure to include commissions in your cost calculations, as even when trading is commission free, you must be aware of the bid-ask spread. Be aware of all related costs before purchasing an ETF.
And when it comes to trading fees, ETFs are cost-efficient. When you buy or sell an index basket, you would potentially pay commissions on each individual stock trade within it.
The same goes for mutual funds. When you buy or sell an ETF, it’s one trade—one transaction. And while ETFs have expense ratios and management fees, they generally tend to be lower than those of mutual funds. For example, the Vanguard Information Technology ETF (VGT) has an expense ratio of just 0.10%—just $10 per $10,000 invested.
ETFs Still Have Tax Implications
How can the purchase or sale of an ETF affect your tax return? While U.S.-based ETFs have many tax advantages, a foreign ETF may not be so tax-friendly and, therefore, not cost-effective. Tax implications vary from region to region. Regardless, you may still have to pay tax on gains on your investments in ETFs, just as you would with other investments.
The beauty of ETFs is that they are easy to buy and easy to trade. To buy an ETF, all you need is an online broker. ETFs, for the most part, are liquid and trade openly during market hours.
However, that doesn’t mean you should just jump in the ETF waters without considering the factors that may or may not make these investments the right choice for your portfolio.
You Can Inversely Track an Index With ETFs, Too
Yes, you read that right. You can buy an ETF and put on a short position. These are called "inverse ETFs," and they allow you to inversely track an index or underlying asset without having to worry about margin restrictions or short selling. This option can help you hedge against a down market. And if you're an even more experienced investor, you can use an inverse leveraged ETF to see even bigger returns.
Inverse leveraged ETFs can be very risky. Leveraged ETFs aim to return 1x to 3x the returns of the underlying index. And inverse ETFs aim to return the opposite of the underlying index. So if the market does down, an inverse ETF will go up. And if it's leveraged, you could see even larger returns. However, if the market goes up, your inverse leveraged ETF will go down—and the losses might be even bigger.
ETFs and Your Portfolio
ETFs are great plays for earnings season. There are leveraged ETFs for investors who have a higher risk tolerance, and traders can play volatility with ETF option straddles. The strategies are limitless.
If you like to play the market, hedge your risk, or even invest in foreign sectors, then you might consider buying an ETF. Exchange-traded funds are getting more popular by the day and the selection has never been higher for good reason. Consider your options, and then buy the best ETFs for your portfolio.