One of the biggest challenges of investing involves familiarizing yourself with the type of assets you can invest in. Should you stick with stocks? Buy some bonds? An exchange-traded fund will let you invest in both, and more. Trading with ETFs means trading within a $3.8 trillion industry. Its popularity is such that in 2017, Bloomberg reported that stocks were not even the most commonly traded asset class on the stock market; ETFs were. And yet, a GOBankingRates survey revealed that only 17% of respondents knew most about an ETF versus other assets.
So, what is an ETF? Does an ETF align with your investment goals? Why choose an ETF over another security? Did you already forget what ETF stands for?
Check out GOBankingRates’ guide to ETFs to help you answer those questions and more.
In this guide you will learn:
- What Is an ETF?
- Different Types of ETFs
- ETF Advantages
- ETF Disadvantages
- ETFs vs. Mutual Funds vs. Stocks
- How To Invest In ETFs
An ETF is a collection of securities packaged as one that tracks an underlying index. These securities can include stocks and bonds (or both), which can number as few as 10 or in the thousands. Although most ETFs focus on either a pool of stocks or bonds, they can also include other assets, such as commodities.
Unlike stocks, ETFs aren’t beholden to a single company or entity, and unlike mutual funds, are not sold directly sold to investors. Rather, brokers trade ETFs on national stock exchanges, such as the New York Stock Exchange or Nasdaq. You still buy “parts” of the ETF — that is, shares of the ETF created and redeemed by financial institutions classified as “authorized participants.” Because ETFs are traded on an exchange, they also have their own tickers. An ETF fund will align its market price with its underlying securities by continuously issuing and redeeming ETF shares.
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Explore the different types of ETFs to see which ones align with your investing goals or style. Depending on your investment portfolio and goals, you might discover a new security to incorporate into your investing strategy. Here’s a breakdown of the different types of ETFs.
An index ETF seeks to track the performance of an index, such as the S&P 500. It accomplishes this by constructing a portfolio that reflects whatever the index benchmark is via investing in the securities within that index, or at least a portion of them. If the index falls by a certain percentage, the fund will likely reflect a similar devaluation. And when the index rises, the fund will likely also gain value.
Bond ETFs expose your fund to other types of bonds, which can include floating-rate bonds, international treasury bonds and many others. These ETFs only hold bonds, rather than a variety of securities. However, because bond ETFs are traded on stock exchanges, you can still trade them even if the underlying bonds are not being traded at that time.
If you have an interest in commodities, such as metals, oils or agriculture, commodity ETFs might be the right investment for you. The commodity market space offers a few different ways for investors to give their funds exposure, with the most direct being the physical commodity ETF. These ETFs actually own the commodity in question, as opposed to an equity-based commodity ETF, which invests through companies that touch the commodity via production, transportation or storage.
Why limit yourself to one country when amplifying your portfolio? International ETFs allow you to profit off of economies from around the globe. These funds hold securities from different countries, and you can even select your ETF based on developing and emerging markets. International ETFs can include multiple countries.
Currency ETFs concentrate on currency futures contracts, which specify the purchase of an asset at a predetermined date using a specific currency. Like international ETFs, these funds require a bit more monitoring because you’ll have to track the strength of a foreign currency against the dollar — or the inverse, depending on how you fund it. These funds are generally used by experienced traders due to their exposure to higher risk.
You’d think with a name like inverse ETFs they’d called them FTEs, but no, inverse ETFs are equivalent to shorting stock, only you’re shorting ETFs. According to Investor’s Business Daily, “When you short an ETF, you borrow the shares you’re selling now at a presumably higher price. The goal is to buy them later at a lower price and profit from a market decline in the meantime.” The Securities and Exchange Commission even refers to inverse ETFs as “short funds” that “seek to deliver the opposite of the performance of the index or benchmark they track.”
Inverse ETFs can more simply be understood as moving in the opposite direction of the index they’re tracking; if the index moves down, the ETF moves up.
ETFs with leverage can double, triple, quadruple, quintuple (you get the idea) the gains on your investment. The caveat: These types of ETFs are reset daily, so that compounding return is meant to be achieved on a daily basis, and not for long-term investments. These types of ETFs can help bolster gains in an upward trending market while mitigating potential losses in a downward trending market.
Actively Managed ETFs
A fund manager specifically selects the securities that go into this ETF, versus the fund’s usual passive investment strategy of tracking the market. This can be crucial in a volatile market, as whoever manages the ETF can adapt to market shocks. Most ETFs are designed with passivity in mind, as they track an index, but an actively managed ETF will attempt to outperform the index itself. The benefit of an active manager can incur higher investment fees.
ETFs and ETNs both trade on the stock market, and both track an underlying asset. However, an ETN is an unsecured debt security issued by a bank, as opposed to an ETF which holds a number of assets within itself. Barclays Bank initially developed ETNs to give investors easier access to complicated assets such as commodities and currencies.
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ETFs offer investors some alluring perks over their investment relatives. Keep reading to see if any of these benefits stand out to you. CEO of Robo-Advisor Pros Barbara Friedberg thinks the benefits of trading with ETFs can be “profound.”
“Because they trade on major exchanges, like a stock, they can be bought and sold throughout the day at the market price,” Friedberg said. “ETFs are so popular that you can find an ETF to match your investment strategy. Index fund investors can invest in both equal weight and market cap weight low fee ETFs from Vanguard, Wisdom Tree, iShares, Shwab and more. Tactical investors can target sector ETFs such as international equities or commodities. Many fund companies offer commission-free ETFs as well. You can even create an ETF portfolio and get free investment management and rebalancing through popular robo-advisors like M1 Finance and Schwab Intelligent Portfolios, while Fidelity recently launched zero-management-fee ETFs.”
Because ETFs are traded on the market, they enjoy the same trading fluidity as individual securities. If your fund didn’t kill it during the workday, you might be able to take another shot when you trade it after-hours. A mutual fund, on the other hand, can only be traded once a day, and at the next available value, whereas an ETF can react more quickly to market change. This is especially useful when you consider an ETF’s value can change minute by minute, like a stock’s can.
A diversified portfolio can weather a volatile market more easily than if your investments rely on one kind of security. An ETF accomplishes this by taking different securities and putting them in one basket, producing an entirely new asset with gains that are realized from others. You can further divvy up your ETF by diversifying the assets themselves: For example, the stock portion of your bond could deal with large- and small-cap stock. Even if you only trade with stock ETFs, those could weather a bad trading day more easily than if you just invested in one company.
That said, you might want to heed the “don’t put your eggs in one basket” advice for ETFs themselves and avoid building an ETF-only portfolio. If your ETF is stocks-only and the companies are in the same industry, a hit in that market sector might cause all those stocks to dip.
ETFs are already on the right track for risk management thanks to inherent diversification. But one of the other market security features of ETFs includes professional management. Because you have investment companies building the funds, you can at least be sure that crucial market analysis will have gone into the ETF to determine which assets it holds.
Furthermore, you can use ETFs to offset risk in another investment. If you have an asset in a high-risk sector but cannot diversify that risk due to restrictions or other reasons, you can use an ETF to short that sector or industry.
Potentially Lower Costs
ETFs generally have lower fees than mutual funds. This is due to ETF operation costs — portfolio management fees, custody costs, administrative expenses, marketing expenses, etc. — being billed to the brokerage firms that oversee the ETFs in customer accounts. Lower costs are associated with higher returns, to say nothing of investing funds you have at hand, so cost is an important question to consider when weighing different asset options. Another cost-cutting factor for ETFs is that unlike mutual funds, they have no redemption fee — which is charged to an investor when shares are sold from a fund.
Did you invest in ETFs in 2018? If so, you might’ve gotten to enjoy some of the tax benefits that come along with them. Mutual funds generally incur a larger capital gains tax than ETFs. Plus, a capital gains tax is only triggered by the sale of an ETF by the investor, regardless of how long the investment was held. Mutual funds, which are considered less tax-efficient, will hit you with a capital gains tax throughout the life of the investment.
“ETFs are more tax-efficient than mutual funds,” said Mark Wilson, founder and president of Founder & President at MILE Wealth Management. “Mutual funds are forced to distribute gains they realize each year; these capital gain distributions can be substantial (sometimes as high as 30% or more). The ETF structure allows virtually all funds to avoid making these distributions. For the taxable investor, this can make a big difference.”
ETFs are a solid choice to diversify your investment portfolio, but it’s best to know the risks associated with ETF investment.
“Not without their drawbacks, some ETFs charge higher management fees and track obscure investment strategies,” said Friedberg. “Additionally, if you’re considering dollar-cost-averaging, and purchasing a set dollar amount of an ETF regularly, make sure to choose a commission-free fund. Otherwise, the low-fee ETF could end up costing a lot.”
Inexperienced traders especially need to be more aware of the instrument’s pitfalls and design. Keep reading to understand the disadvantages of investing in an ETF.
Potential for Higher Costs
Although ETFs might save you money in the long run, they still come with their own set of costs. They don’t carry a load fee like mutual funds do, but because they are traded like stocks, you can expect a commission fee whenever you buy or sell shares. Plus, when you compare ETF fees with a specific stock, the cost is likely higher, as there are no management fees with stocks. Inexperienced investors may wind up frequently trading ETFs to the point that the commission costs erase the management benefits.
ETF investors might find themselves limited to what they can invest in, depending on the sector or stock. This is due to limited equities on the market index. Furthermore, if your scope is international, you might have trouble finding a beneficial foreign ETF.
The spread between an ETF’s share price — the ask — and the price a share could be sold for — the bid — can be quite high. ETFs have multiple underlying assets with trade values that might not necessarily align with the market price of the ETF shares. In this instance, you can fall into the trap of buying high just to wind up selling low.
Andrew Aran, a partner with Regency Wealth Management, notes that “trades in ETFs are best avoided in early and late trading periods as volatility can be greater and liquidity lesser in those periods.”
Because ETFs exist within intraday trading, the values of their underlying securities also change daily. No investment is a guarantee, but long-term investors should note that the value of an ETF can frequently change, and keeping track of the multiple underlying assets, especially if the ETF is passively managed, can be a negative for investors in itself.
ETFs pay dividends, but probably at a lower rate than if you invest in exclusively stocks. Because multiple people own shares of an ETF, and since ETFs are comprised of multiple assets, any stock dividends that would otherwise be distributed to an individual shareholder are instead distributed across the ETF shareholders.
When buying and selling assets, brokers usually point out the differences between three of the more commonly traded assets. Here’s an overview of the similarities and differences among ETFs, mutual funds and stocks.
|ETFs vs. Mutual Funds vs. Stocks|
|Asset Class||ETFs||Mutual Funds||Stocks|
|Description||A basket of securities, usually passively managed, that trades like stocks||A pool of money from different investors which is then used to purchase stocks, bonds and other assets to use in a portfolio||A market share of a company that you own|
|When You Can Trade||During trading hours and after-hours trading||Once a day||During trading hours and after-hours trading|
|Maintenance Costs||Yes (varies with broker)||Yes (varies with broker but always includes a load fee)||No|
|Commission Fees||Yes||Load Fee||Yes|
|Underlying Assets||Yes (with index tracking)||Yes (can include indexed funds)||No|
|Holdings||Disclosed on a daily basis||Usually disclosed monthly but varies from company to company||Individual security but investor can own multiple shares|
|Built-In Diversification||Yes: Stocks, bonds, commodities and other assets||Yes: Stocks, bonds, commodities and other assets||No: Individual security|
|Risk of Capital Gains Tax||Low: ETFs offset the capital gains risk because their structure results in fewer capital gains distributions, as ETFs use creation units to approximate securities.||High: Because a mutual fund manager is constantly restructuring the fund by selling securities, this exposes shareholders to more capital gains taxes.||Low-High: A stock’s value, and its payout, depends entirely on the value of the company you’re investing in, so exposure to a capital gains situation could go either way.|
These choices represent “The Big Three” in American investments. According to a GOBankingRates survey, 46% of respondents invest in stocks, while 44% put money in investment funds, which include mutual and exchange-traded funds.
One note about the fees: If you’re limited on funds to invest with, consider a broker that offers commission fee-free ETFs. For example, TD Ameritrade offers more than 300 commission-free ETFs for investors if you don’t want to pay its flat commission fee if $6.95. Research the costs associated with each broker’s investment products before you invest.
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ETFs vs. Mutual Funds
GOBankingRates had experts weigh in on the debate surrounding ETFs versus mutual funds, two investing vehicles that are often compared with each other because they’re structured similarly but trade rather differently.
“The main differences between mutual funds and ETFs concerns liquidity,” said Robert Johnson, chairman and CEO at Economic Index Associates. “ETFs are more liquid than mutual funds. An ETF trades like a stock, and the price remains fluid throughout the trading day. Mutual funds, by contrast, are priced once a day — at the end of the trading day — and trade at a mutual fund’s net asset value. The trades for investors who place orders to buy or sell shares of a mutual fund on a specific day all occur at the mutual fund’s net asset value, which is computed at the end of the trading day. Thus, investors can day-trade ETFs but not mutual funds.”
However, some investors call out when mutual funds are preferable.
“Personally, I do not use ETFs to cover the bond portion of portfolios,” said Wilson, who noted that he’s been personally and professionally using ETFs for nearly two decades. “I use mutual funds here. Large pools of bonds are harder to trade efficiently than large pools of stocks — this has led to ‘premiums/discounts’ in bond ETF pricing that mutual funds have avoided. In my mind, the pricing and tax-efficiency advantages are not enough to make up for this potential.”
Timothy Hooker, co-founder of Dynamic Wealth Solutions, said, “One risk [for ETFs] is that you have a stop limit and an event like Aug. 24, 2015 happens. Investors who had stops in place took unnecessary losses when the mini flash crash occurred because of technical exchange errors. These types of pricing errors do not happen with mutual funds.”
David G. Dietze, president of Point View Wealth Management, Inc., had perhaps the harshest words for ETFs: “We are not big fans of ETFs… Particular pitfalls to be avoided are thinly traded ETFs, where bid ask spreads can be large; less liquidity can make prices less likely to reflect [net asset value]. Less popular ETFs could also be terminated, potentially exposing you to a taxable event not of your own choosing.”
Learn More: ETF vs. Mutual Funds
So now you know what an ETF is, what kinds there are, and the advantages and disadvantages of investing with one. But how do you actually go about adding this type of investment to your portfolio? In a few steps, here’s how to start investing in ETFs:
1. Find a Brokerage Account
Brokerage accounts allow investors to trade and buy on the stark market through a brokerage firm. Some examples of brokerage firms include Fidelity and E-Trade. Opening any kind of wealth management account, be it a checking or brokerage account, requires that you provide personal information, which includes your Social Security number, address and employment information, if applicable.
Selecting a brokerage account involves figuring out what the broker offers that suits your investment goals. Different brokers offer customers different costs associated with maintaining an account, and some firms might even offer a set amount of commission-free trades to entice potential investors.
2. Understand Fees
Before you begin trading ETFs, understand that you have to spend money to make money. Brokers charge a commission for every trade you set up, and this cost can vary depending on how you execute the trade. TD Ameritrade’s commission fee is $6.95 flat per ETF trade if done over the internet. But that figure shoots up to $44.99 if you require a broker-assisted trade.
Also note if your broker requires any annual fees, and understand any potential penalty fees you could incur.
3. Build a Diversified ETF Portfolio
Now that you’ve got your brokerage account set up and have an idea of how to navigate fees, it’s time to build your portfolio. ETFs themselves already offer investors a nifty way to diversify their portfolio given that they draw upon different securities to make up one fund. However, because those assets are mostly similar, you still need a way to vary your ETFs. Holding ETFs that draw upon different investments is a good way to capitalize off of different markets at once. You could also invest in pre-diversified ETFs.
Diversified portfolio ETFs offer investors exposure to multiple asset classes through one ticker, according to ETFdb.com.
4. Determine How To Keep Adding To Your ETF Holdings
You should budget enough money to make the trades you want, and always consider the commission fee. Exploring different ETFs with different holdings is homework in itself, and also requires a constant assessment of the securities you want to invest in. This is the most personalized part of investing in an ETF, but there are some questions you can ask to help guide yourself:
- What is the financial health of the company I’m buying the ETF from?
- Do any other assets in my portfolio complement this ETF?
- What is the health of the assets included within the ETF?
- What are the underlying assets included in the ETF?
- What is the expense ratio associated with the ETF?
- Is this ETF available as a commission-free fund?
- How many trades can I make per month?
- Can I avoid capital gains tax?
- What is the bid-ask spread?
- What is my cost limit?
Crunching the numbers and developing a financial plan goes a long way in ensuring that your ETF investment works for you.
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