Exchange-traded funds (ETFs) are collections of stocks, bonds, or other securities bought and sold daily on stock exchanges. When you buy shares of an ETF, you buy an interest in all of its held investments. Learn how ETFs are used so you can start investing in them.
How ETFs Can Benefit Your Portfolio
ETFs have many benefits, including:
- Affordability: Most ETFs have low minimum investment requirements, often less than $1,000. ETFs can be used to invest small amounts of money into many individual stocks or bonds.
- Portfolio diversification: Investors can use ETFs to diversify their portfolio with various assets (e.g., stocks, bonds, real estate, and commodities), even with small portfolios.
- Transparency: Most ETFs disclose their holdings daily.
- Professional management: Portfolio managers select individual investments based on the objective of the ETF.
Understand the Costs Associated With ETFs
ETFs have benefits, but it is important to understand the potential costs associated, as well. ETFs charge shareholders annual operating expenses, but they are generally inexpensive, with low fees and costs—about 0.45% in 2019. Some broker-dealers may charge commissions when you buy and sell ETFs and other investment products, so find out about any commissions and account fees in advance.
There may be tax implications, too. Investors are taxed on ETF capital gains and dividend distributions. Investors can be taxed on capital gains when the ETF sells underlying investments, but ETFs are structured so that they generally avoid this problem. ETF investors also pay tax on capital gains when the shares are sold, and some ETFs (such as some precious metal ETFs) can have higher capital gains rates.
Determine Your ETF Investing Strategy
If you’ve decided to invest in ETFs, choose ETFs that suit your investment risk and your time horizon (how long you can leave your cash in the market). You’ll also want to consider your risk tolerance—do you have a conservative investing style or a more aggressive style?
Investment plans usually begin with deciding how much money will go into the different types of assets (such as stocks, bonds, and commodities), also called "asset allocation." Multi-asset ETFs combine different types of assets to create outcomes for conservative, moderate, and aggressive investors.
A multi-asset ETF may be a good choice for a novice investor, because the portfolio manager decides different asset class allocations and the individual investments. The investor only needs to determine what type of portfolio they want.
For example, an aggressive multi-asset ETF might have only 17% invested in bonds, and more than 80% invested in stocks. A conservative multi-asset ETF could be 66% bonds, with the rest allocated to stocks, cash, and money markets.
Overall, an ETF’s risk is based on the strategy and underlying investments. However, ETFs trade on exchanges, and the shares’ market price can be lower or higher than their net asset value (NAV). It’s possible (although unlikely) for an ETF’s share price to decrease even though the value of the underlying investments has increased.
Open an Online Trading Account
To invest in ETFs, open an account with a broker-dealer. There are several online broker-dealers servicing do-it-yourself investors, such as E-Trade, Fidelity, TD Ameritrade, and Vanguard.
Opening an online account typically doesn't require a minimum investment. After opening an account, you can access a broad menu of investment products, investor research, and education resources online or on an app.
Research the Types of ETFs
Online broker-dealers offer robust ETF screeners, which are research tools to help you identify ETFs by size, asset class, management style, index tracked, risk profiles, and many other characteristics.
ETFs come as two basic types. Passive ETFs hold underlying investments to match a financial index, like the S&P 500. For example, the SPDR S&P 500 ETF Trust (SPY) tracks the S&P 500.
Active ETF portfolio managers select investments in an attempt to outperform a benchmark, like the S&P 500, rather than match it like a passive ETF. Generally, active funds are more expensive than passive funds.
Types of ETFs within these two buckets include:
- Sector ETFs: These offer exposure to specific economic sectors like technology or utilities.
- Foreign market ETFs: These target investments in economic blocks like the European Union, regions like Asia, or specific countries.
- Investment style and preference: ETFs can invest according to styles and preferences, such as funds that invest in large-cap stocks, or stocks that pay high dividends.
- Asset class: Some ETFs only hold one type of asset, such as high-risk bonds. Other ETFs specialize in unusual asset classes, like commercial real estate or a specific currency.
Compare the fund’s ratings, expenses, and historical performance using your broker-dealer’s online tools. If you’re just beginning, look for ETFs highly rated by one of the agencies, such as Morningstar or Factset. ETF providers include iShares, Vanguard, and State Street Global Advisors.
Some ETFs are only appropriate for experienced, sophisticated investors who understand the risks. For example, leveraged ETFs magnify both gains and losses, as they deliver the multiple of an index return, daily. For example, a 2x S&P 500 ETF is designed to double the S&P 500 return on a daily basis. Inverse ETFs track a specific index, but investors profit when the index is down. Inverse ETFs can also be leveraged.
If you don't have the time or the expertise to research ETFs, consider getting help from an investment professional.
Buy Shares of an ETF
Now that you’ve opened an account and researched your options, learn how to buy and sell ETF orders through your online broker’s tutorials. While there may not be a minimum for opening an account, you’ll want to make sure you’ve transferred enough money into your account to purchase the desired number of ETF shares.
You can purchase shares of an ETF online or through your broker-dealer’s app. You may also be able to call the customer service number for guidance through the process.
- ETFs are an affordable way to gain diversification and professional portfolio management.
- Buy shares of ETFs that match your investment style, preference, risk tolerance, and goals.
- You can get started investing in ETFs by opening an account with an online broker-dealer.
- Online broker-dealers offer low minimum deposit accounts as well as research tools to help you learn more about your investments.