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, you contribute money to a pool fund that invests in certain assets when you invest in an ETF, and shares are traded on national stock exchanges. An ETF must register with the U.S. Securities and Exchange Commission as either a unit investment trust or an open-ended investment company.
You must go through a stockbroker to buy or sell an ETF, and they charge a commission unless the ETF is part of a special deal the broker has worked out with the sponsor of the ETF.
ETFs aren't lottery tickets, nor are they magic. They come with advantages and disadvantages that must be carefully weighed in light of your personal financial circumstances, investing goals, and your investing strategy.
ETF Investing In Volatile Economic Times
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 to buy and sell. The trader sets criteria on their selected trades called limit orders, which set limits on the buy and sell prices for the stock being traded.
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The way your ETF makes money depends on the type of investments it holds.
An ETF might invest in stocks, bonds, commodities such as gold or silver, preferred stock, or a famous index such as The Dow Jones Industrial Average or the S&P 500. How you make money from an ETF will depend on the underlying investments of that ETF over time.
- You'll hopefully make money 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 high-dividend stocks
- You're hoping to make money from interest income if you own a bond fund ETF
- You're hoping to make money from the underlying rents, capital gains on property sales, and service income generated by the apartments, hotels, office buildings, or other real estate owned by the real estate investment trusts (REITs) in which the ETF has made an investment if you own a real estate ETF
Three keys can help you increase your returns from ETF investing over time.
Understand Your ETFs
Don't invest in ETFs that you don't understand. Read both the ETF's summary prospectus and its full prospectus. Have a handle on its historical performance, investment strategies, and risks. Some ETFs utilize super leverage and short stocks, while others concentrate heavily in specific sectors or industries.
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 like 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 other 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'll see periods like 2007 through 2009 when your ETF holdings are down 20%, 30%, 50%, or even more on paper.
There's no guarantee the future will look like the past, but time has historically ironed out most of that volatility and investors have been well-rewarded. The thing to remember is that ETFs are like any other investment in that they won't solve all of your problems. They're a tool—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.
U.S. Securities and Exchange Commission. "Exchange-Traded Funds (ETFs)." Accessed April 5, 2020.
U.S. Securities and Exchange Commission. "Mutual Funds and ETFs A Guide for Investors." Pages 13-14. Accessed April 5, 2020.
Vanguard. "Vanguard Global ex-U.S. Real Estate ETF Prospectus." Page 2. Accessed April 5, 2020.
U.S. Securities and Exchange Commission. "Exchange-Traded Fund (ETF)." Accessed April 5, 2020.
U.S. Securities and Exchange Commission. "Mutual Funds and Exchange-Traded Funds (ETFs) – A Guide for Investors." Accessed April 5, 2020.