How Investors Earn Income From Investing in ETFs
Exchange-traded funds (ETFs) are similar to mutual funds; however, they're not the same thing. They trade like stocks under their own ticker symbol, and investor capital is contributed to a pool fund that invests in certain assets. The shares are then traded on national stock exchanges.
There are many different ways to invest in ETFs, and many different methods when managing them. Some methods are good to use in stable economic times, and some can work in tumultuous times as well.
It is important to know what methods you can use, so no matter the market circumstances, you are able to mitigate risks and continue earning.
ETF Investing in Volatile Economic Times
The world is in flux: There are concerns over the changing climate and weather patterns, viruses are trekking across the globe, and political relationships are constantly wavering. Economies, and thus exchanges, feel the effects of these fluctuations, causing investors to be unsure of how they can proceed in times of uncertainty that lead to market volatility. ETFs have some methods that be used to continue earning and mitigate the risks of wild swings due to volatile economic times.
One option investors have is to use limit orders instead of market orders. A market order sets in motion a purchase at the next best price. The risk with this technique is that the next best purchase price might be one that you cannot afford. Likewise, the next best sale price might be one that costs you dearly.
Limit orders put high and low prices on assets you are trading. This allows you to minimize risk by setting the maximum purchase or selling price you can tolerate to spend or lose.
Avoid Opening and Closing Trades
Opening and closing prices are different when the market opens and closes. These times are generally known to have wild swings as investors anticipate what might happen based on occurrences throughout the trading day or developments overnight.
You can mitigate risk by waiting to trade until an hour after the market opens to let price swings settle down, and stop trading an hour before the market closes to allow end-of-day swings to occur without your involvement.
If you place orders at closing, and something happens that change the price of your chosen purchases, you may end up paying far too much or collecting far too little on trades initiated at closing.
Premiums and Discounts
You should trade keeping premiums and discounts in mind. ETFs trade at a premium—when the market price is higher than its intraday net asset value (iNAV), or at a discount—when the market price is below its iNAV.
Understanding the iNAV of a security can help keep you from purchasing at a premium or selling at a discount without knowing about it. ETFs are comprised of securities based on other assets; the prices of those underlying assets may be different than the ETF prices are reflecting.
This means that investors should know the underlying assets their ETFs are based on and track the prices and performance of those assets to understand the net asset value (NAV) of their ETFs. This can also lead market makers (generally institutions that have buy and sell prices on stocks throughout a trading day) to use ETFs as a price discovery tool.
How Investors Make Money From ETFs
Making money from ETFs is essentially the same as making money by investing in mutual funds because they are operated almost identically. However, the main difference between the two is that ETFs are actively traded at intervals throughout a trading day, where mutual funds are traded at the end of the trading day.
ETF price fluctuations will be watched by the trader, who will pick price points at which to buy and sell. The trader sets criteria on their selected trades using limit or market orders.
The way your ETF makes money depends on the type of investments it holds.
An ETF might invest in stocks, bonds, or commodities such as gold or silver or it might attempt to mirror the performance of an index such as the Dow Jones Industrial Average or the S&P 500.
Warren Buffet is fond of advising investors to invest in an index, based on performance longevity and stability throughout turbulent markets. Returns can come from a combination of capital gains—an increase in the price of the stocks your ETF owns—and dividends paid out by those same stocks if you own a stock ETF that focuses on an underlying index.
Bond fund ETFs are comprised of holdings of Treasuries or high performing corporate bonds. These funds can be used as a way to minimize the amount of risk a portfolio has by diversifying with investments that traditionally yield gains when the stock market reverses.
Benefits and Drawbacks of ETFs
Decreased risk through diversity
Lower costs and fund expenses
Transparency through accountability
ETFs can be based on less volatile investments
Index tracking errors
ETFs allow traders to trade throughout a trading day vs.mutual funds, which trade at the closing price. This gives traders the ability to move quickly in and out of positions, making—or losing—money throughout a trading session or day.
When an ETF is purchased, a trader buys into a basket of funds rather than searching out individual stocks to purchase. If you are using a brokerage account, this can keep transaction costs down since one transaction expense is lower than multiple transactions.
Because an ETF consists of securities based on many underlying investments, when they are added to a trader's portfolio, that portfolio becomes more diversified. Diversifying a portfolio is a well-known technique for reducing the overall risk involved in trading.
Investments are taxed in different ways—ETFs generally have fewer capital gains than mutual funds, and are taxed only when the ETF is sold by the investor. Mutual funds capital gains, in comparison, are taxed throughout the lifetime of the fund—which increases the amount of taxes paid on the investment.
Liquidity is the ability to turn an asset into cash—in this case it is the ability to sell ETFs. Since ETFs can be traded throughout the day, they have high liquidity when compared to other investment types.
Actively managed ETFs are required by law to publish their holdings daily. This gives ETFs that have higher turnover rates within the fund more transparency than mutual funds and makes the ETF manager more accountable for the actions they take for the fund.
If an ETF pays dividends, they will be taxed as ordinary income unless they meet the requirements to become qualified dividends—the qualification of which is to be held by the trader "for more than 60 days during the 121 day period that begins 60 days before the ex-dividend date"—at which time they receive the lower tax rate of capital gains.
While there are a few ETFs that offer higher yields, by design they carry lower risk than individual stocks, so dividends are generally lower.
Prices throughout a trading day can rise and fall much more than in mutual funds, causing large bid and ask spreads—the difference between the prices a trader is willing to buy or sell at. Large spreads can cause traders to lose much more money than they anticipated, or have.
ETF index funds are designed to track the performance of a stock market index, such as the S&P 500. Tracking error is the difference between an index fund's performance and the performance of the index. Generally, this is caused by the fund's management because they are not managing the fund correctly. This mismanagement then leads to claims of performance by the fund's managers to continue to attract investors and traders.
Understand Your ETFs
You shouldn't invest in ETFs that you don't understand. ETFs are built around underlying assets, such as stocks. As you are looking for ETFs to purchase, be sure to read both the ETF's summary prospectus and its full prospectus.
Work to comprehend the historical performance and returns in different types of market conditions, look at different investment strategies, and understand the risks that the fund presents. Some ETFs utilize super leverage (high debt) and short stocks (borrowed to sell), while others concentrate heavily in specific sectors or industries.
Heavily concentrated ETFs come with higher risk—if the market or industry the ETF is concentrated in collapses or experiences downturns, the entire fund will be affected, with disastrous results.
As Warren Buffett is fond of saying, the first rule of making money is to never lose money. You should know the exact underlying holdings of each ETF you own.
Watch Your Expenses
Keep your ETF expenses reasonable. This generally isn't a major problem because ETFs tend to have expenses that are very affordable—it's one of the reasons they're frequently preferred by investors who can't afford individually managed accounts. But ETF expenses nonetheless include management fees, annual fees, and brokerage commissions, among other costs.
A financial planner, financial advisor, or do-it-yourself investor can cobble together a portfolio of reasonably diversified holdings, even picking up similar ETFs that focus on individual sectors or industries for an expense ratio in the neighborhood of 0.50% per annum.
Focus on the Long Term
ETFs should ultimately perform roughly in-line with their underlying holdings, short of some sort of structural problem or another low-probability event. This means that you might be subject to fairly horrific swings in market value in any given year if you hold an equity exchange-traded fund. You might see periods similar to 2007–2009 when ETF holdings drop by 20% or more.
There's no guarantee the future will look like the past, but time generally irons out most of the volatility, and investors have been well-rewarded. The thing to remember is that ETFs are like any other investment in that they are not golden eggs. They are investing tools that should be used to build a diverse portfolio while mitigating risk—nothing more, nothing less.
Disclaimer: Please note that The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.