Exchange-traded funds are portfolios that trade on a stock exchange, like an ordinary stock. With one purchase, you can gain access to a multitude of different types of investments. For example, you can buy a gold ETF, if you want to invest in a basket of stocks in that particular industry only, or you can buy the SPY ETF, which tracks the entire S&P 500 index. To help you get the most out of your investments, we asked Vanguard for some help answering questions about ETFs.
1. Invest in ETFs Anytime
You might be nervous about jumping into a market seemingly making new highs every day, but the truth is that nobody can time when the market will stop rising and start falling. With so many types of ETFs available, you can find funds that profit in down or up markets. According to Vanguard, “With over 2,000 ETFs listed in the U.S., there is an ETF to fit almost any investment view. If an investor is set with a good long-term plan and objectives, any time is a good time to start investing and saving, particularly given the widespread availability of low-cost advice and investments now available.”
2. Take Advantage of ETF Tax Structure
Exchange-traded funds are tax-efficient in comparison to active mutual funds. “It is more due to the fact that most ETFs — and 98% of ETF assets — employ an indexing strategy,” according to Vanguard. “Indexing is a low-turnover way to manage a portfolio, and lower turnover can lead to fewer realized capital gains to distribute.”
If you’re looking to maximize your tax efficiency with ETFs, look to ETFs that track indexes, like the S&P 500.
3. ETFs Are Passive Investments
“First, I would consider the basics — my objectives for the investment, including time horizon and goals,” Vanguard stated. “I would think through which types of accounts I’d be using, such as taxable or tax-deferred, and which asset class mix I’d be targeting. Then, I’d consider my preference for an active or passive strategy, weighing considerations such as cost, diversification and opportunity to outperform the market — keeping in mind that ETFs are typically passive investments.”
4. Understand ETFs vs. Mutual Funds
Exchange-traded funds and mutual funds share many similar characteristics. Notably, each takes a pool of money contributed by investors and assigns one or more money managers to allocate those funds according to the stated investment objectives of the fund. An important distinction between the two is that mutual funds continually offer their shares to investors via an investment management company, and those shares can only be bought or sold once per day — after the market closes. Exchange-traded funds, on the other hand, trade like stocks on an exchange and can be bought or sold any time the market is open. When choosing between ETFs and mutual funds, Vanguard suggests that investors consider whether or not they require the trading flexibility inherent in an ETF.
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5. Decide What Type of ETF You Need
When it comes to choosing the right ETF, Vanguard noted that you should analyze ETFs just like you would any other investment: “A reasonable starting point for long-term investors is broadly diversified, low-cost ETFs, as these fit well within a strategic asset allocation plan.”
6. Be Aware ETFs Might Close
While the sheer volume of available ETFs gives investors lots of choices, the economics of the business means that some ETFs will inevitably close. Exchange-traded funds can close for many reasons, but a primary reason is that the asset base is so low that continuing to manage the fund becomes economically unfeasible for a company. Vanguard reminds us that while over 30 ETFs closed in the first half of 2017, 99 percent of all ETF assets are invested in ETFs with over $100 million in assets.
“Anything is possible,” according to Vanguard. “But you’re likely not invested in an ETF at risk of closing if you stick to the larger, well-established funds. An investor in an ETF that is closing would receive their investment back in cash, which could result in a capital gain. That might require some tax planning and due diligence to seek out a replacement investment.”
7. Take a Portfolio Approach
While ETFs are typically diversified portfolios, they usually invest in a specific industry or sector of the market. Even ETFs that track major swaths of the market, such as S&P500 index funds, should be considered single investments. As Vanguard explained, “Don’t look at ETFs as wholly different mutual funds. Similar to mutual funds, they are essentially just diversified portfolios of stocks or bonds. If you are considering investing in ETFs, take the same careful and thoughtful approach to building your portfolio as you would with other investments. Consider your goals, objectives and desired strategy first — then plan to arrive at the question of whether an ETF is the right investment vehicle for you.”
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8. Choose Broad Exposure If You Want to Buy and Hold
Purchasing broadly focused ETFs with low expense ratios is a good first step in establishing a buy-and-hold portfolio. If you’re a buy-and-hold investor, ETFs might be a perfect match. However, if this is your investment strategy, be careful to avoid ETFs with too narrow of a focus, as you might be more inclined — and it might even be more prudent — to buy and sell those ETFs with more regularity.
Vanguard emphasized that “ETFs make great long-term investments. If your goal is to avoid market timing, aim for broad exposure. Vanguard Total Stock Market ETF (VTI) or Vanguard Total Bond Market ETF (BND) offer complete exposure to the U.S. equity and investment-grade taxable markets, respectively, for only 0.04% and 0.05% in expense ratio per year.”
9. Consider the ETF Provider, Not Just the Investment
When it comes time to buy an ETF, don’t just think about the investment itself – think about where you’re buying it from. As Vanguard suggests, as an investor, you should “…consider your comfortability with your brokerage provider and its fees and functionality.” Some brokerage houses, including Vanguard, Fidelity and Charles Schwab offer a number of ETFs that are commission-free.
Be prepared to understand trading nuances, such as bid-ask spreads and order types, in addition to trading costs.
10. Listen to Warren Buffett
Legendary investor Warren Buffett put it bluntly in the 2016 annual report of his company, Berkshire Hathaway: “Both large and small investors should stick with low-cost index funds.”
While many investors want to be stock-buying heroes — or over-diversify due to the abundance of specialized ETFs — perhaps following the wisdom of such a well-known investor as Warren Buffett can help you be successful and make the most on ETFs.