Everything You Need To Know About ETFs
/Exchange-Traded Funds, or ETFs for short, are in many ways similar to mutual funds, but they are listed on exchanges. Most ETFs own a basket of stocks, bonds, currency, commodities, or other assets. Like stocks, ETF shares can be traded throughout the day on an exchange via a brokerage firm.
ETF trading provides the ease of stock trading and the diversification benefits of mutual fund trading, meaning ETFs combine the best attributes of two popular assets: stocks and mutual funds.
A growing number of investors are using ETFs to diversify their portfolios. If you are considering investing in ETFs, here is everything you need to know about ETFs - how they work, how to buy them, and why you should buy them.
What are ETFs?
ETFs are baskets of securities, such as stocks, bonds, commodities, and currencies that can be traded on an exchange throughout the trading day. An ETF is a security that tracks an index, a commodity, or a basket of assets like an index fund, and can be bought or sold on stock exchanges or markets at real-time prices during trading hours.
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ETFs provide complete transparency as to what the fund holds on a daily basis, so you always know what kinds of shares you are holding when you own shares of an ETF.
When you buy or sell an ETF, you will likely have to pay a commission to your broker. Some brokers offer a sizable list of commission-free ETFs that you can buy and sell without paying a commission.
How do ETFs work?
Unlike regular mutual fund shares, ETF shares can be traded throughout the day on an exchange via a brokerage firm at prices that change in real-time based on supply and demand.
ETFs provide investors the ability to get returns on their investments as the markets move in their favor, i.e. when stock prices rise and fall. Investors can also benefit from companies that pay them dividends for holding their stocks. They may also get a residual value if the fund they have invested in is liquidated.
Types of ETFs
There are different kinds of ETFs. Here a few popular types of ETFs you can buy:
Market ETFs
When people think of ETFs, most people refer to market ETFs, also known as simple index funds. These are the most widely known ETFs that track a certain index fund like the S&P 500 or Nasdaq-100.
The S&P 500 is a list of 500 of the largest U.S. stocks. The Nasdaq-100 is the top 100 stocks on the Nasdaq exchange.
Bond ETFs
Bond ETFs provide exposure to different types of bonds, including U.S. Treasurys, municipal bonds, corporate bonds, and more. Investing in bond ETFs is a good way to diversify a portfolio and mitigate the market volatility associated with investing.
Sector ETFs
If you want to buy a basket of stocks in a specific industry, you can buy a sector ETF without having to research each individual company. For example, you can buy sector ETFs in (Real Estate Investment Trusts), Biotech (BBH), oil (OIL), financial services (XLF), etc.
Commodity ETFs
This is where you can buy gold, soybeans, crude oil (USO), natural gas (UNG), orange juice, etc. in commodity markets.
Foreign market ETFs
Foreign market ETFs can hold a basket of stocks that track a foreign exchange like the FTSE, the Nikkei, etc. A foreign market ETF can also hold a basket of stocks from different countries with similar economies, like emerging stock markets.
Alternative investment ETFs
These ETFs allow investors to gain exposure to a particular investment strategy, such as low market volatility, currency carry trade, or covered call writing. When you trade in ETFs during low market volatility, there are not a lot of ups and downs. Currency carry is when you invest in different currencies to earn a higher interest rate based on the difference in interest rates between different currencies. Covered call writing is a type of options trade designated to earn additional income on stock holdings in normal market conditions.
Actively managed ETFs
A fund manager actively manages the baskets of stocks. These ETFs generally have much higher fees.
How to invest in ETFs
You can invest in ETFs in a variety of ways. Folks usually do this by opening an account with one of the reputable online brokers to invest in ETFs. The number of ETFs you can buy and related fees will vary depending on the broker you choose to open your account with. You can also choose one of the robo advisors to invest in low-cost ETFs. With the advent of fintech and robo advisors, a growing number of investors are utilizing technology platforms to open up an ETF account.
Here are the steps to investing in ETFs:
Open a brokerage account
Choose your first ETFs
Leave your ETFs alone
You will need to open a brokerage account before you can buy or sell ETFs online. It does not take much to open an account online. You can open an ETF trading account in about 10 minutes online.
Some brokers such as Vanguard and Schwab offer commission-free ETF trades. Do your own homework to choose a broker that will let you buy their own ETFs commission-free. If you want to invest in ETFs, choose a broker that has the most of the ETFs you want available on their list commission-free.
Once you have opened up a brokerage account, you can buy shares of an ETF just like you can buy a stock. You can place a market order to buy shares at the market price at the time of buying those shares, or you can place a limit order to buy shares at or below a specific price.
When it comes to choosing your first ETFs, you may wish to invest in passive index funds. They are cheaper than their actively managed counterparts. Once you have bought some ETFs, simply leave them alone. Your investments will likely produce growth over long periods of time, if you allow your investment to sit and gain returns.
ETFs fees
There are costs to consider when it comes to investing in ETFs. These are operating expenses, commissions, and bid/ask spreads.
OERs are charged annually by the fund company. It is expressed as a percentage of a fund's average net assets. For example, a 1% expense ratio means that you will pay $10 in fees for every $1,000 you invest. A lower expense ratio will save you money. OERs cover the fund's management and other costs.
Your broker may charge you a commission each time you buy or sell an ETF online. When you buy or sell an ETF online, bid/ask spreads can also factor into your trade costs.
If the ETF is on the commission-free ETF list with your broker, you will pay no commission.
Advantages of ETFs
ETFs provide an easy way to invest in a well-diversified set of assets without having to research individual companies if you do not have the time, energy, or desire to do so. They also provide flexible trading options similar to other stock trading, as you can place several types of orders such as stop loss orders, limit orders, and buy on margin throughout the trading hours.
Other advantages include:
Low knowledge barrier to entry. Even if you do not know anything about investing in bonds, you could buy a bond-market ETF.
ETFs are more liquid than mutual funds.
It is super easy to buy and sell ETFs online. You can buy or sell an ETF with a simple click of the mouse.
ETFs provide an investor with easy exposure to a specific desired market segment such as style ETFs, industry ETFs, or commodity ETFs.
ETFs have lower capital gains taxes than mutual funds, as an investor incurs capital gains tax only upon the sale of an ETF whereas, mutual funds pass on capital gains taxes to an investor through the life of the investment.
Compared to mutual funds, ETFs are more tax efficient and more liquid.
Disadvantages of ETFs
Trading costs can be high, especially for individuals who invest small amounts. Fees can really cut into your returns where you invest small amounts.
With any investment, there are risks associated with it and you are not guaranteed a return.
In conclusion
Investing in ETFs is maintenance-free investments. Once you buy shares of some great ETFs, they can produce excellent investment growth over a long period of time. If you want to diversify your investments, then you might consider investing in ETFs.
Disclaimer: the content presented in this article is for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.
