As the investing landscape changes, there are a growing number of investment tools available to individual investors than ever before. Due to innovations such as the exchange-traded fund (ETF), even small and less-established investors can access good investing options.
An ETF bundles many investments together to be bought and sold in one neat and tidy package. The purchase of one ETF provides exposure to dozens or even hundreds of different investments at once.
What Is an ETF?
An ETF is an investment fund that you can buy and sell like a stock, but that pools together different assets, such as stocks, bonds, commodities, or currencies, and then divides its ownership up into shares.
This means that with just a few clicks, it is possible to buy one fund that provides exposure to hundreds or thousands of investment securities. ETFs are often heralded for helping investors gain diversified exposure to the market for a relatively low cost.
This is important to understand—the ETF is simply the suitcase that packs investments together. When you invest in an ETF, you are exposed to the underlying investment. For example, if you are invested in a stock ETF, you are invested in stocks. If you are invested in a bond ETF, you are invested in bonds.
Most ETFs are passive, which means to track an index. Their aim is to provide an investor exposure to some particular segment of the market in an attempt to return the average for that market. If there’s a type of investment that you want broad, diversified exposure to, there’s probably an ETF for it.
Though less popular, there are also actively-managed ETFs, where a person or group makes decisions about what securities to buy and sell within the fund. Generally, these will charge a higher fee than index ETFs, which are simply designed to track an index or segment of the market.
How Do ETFs Work?
Most ETFs track a particular index that measures some segment of the market. For example, there are multiple ETFs that track the S&P 500 index. The S&P 500 index is a measure of the stock performance of 500 leading companies in the United States.
Therefore, if you were to purchase one share of an S&P 500 index fund, you would be invested in all 500 companies in that index, in their proportional weights.
What Is the Difference Between an ETF and a Mutual Fund?
ETFs are similar to mutual funds. Both provide access to a wide variety of investments through the purchase of just one fund.
But there are also several differences between ETFs and mutual funds:
• ETFs trade on an open market exchange (such as the New York Stock Exchange) just as a stock does, so it is possible to buy and sell ETFs throughout the day. Mutual funds trade only once a day, after the market is closed.
• ETF investors buy and sell ETFs to and from other ETF investors, not the fund itself, as you would with a mutual fund.
• ETFs are typically “passive” investments, which means that there’s no investment manager making decisions about what should or should not be held in the fund, as with mutual funds. Instead, they aim to provide the average return in the market for which they are invested. For example, an ETF for technology stocks would mimic the returns of technology stocks overall.
What Are the Advantages of ETFs?
There are a number of benefits of ETFs in an investment portfolio—notably:
ETFs are traded on the stock market, with prices updated by the minute, making it easy to buy and sell them throughout the day. Trades can be made through the same broker an investor trades stocks with. In addition to the ease of trading, investors are able to place special orders (such as limit orders) as they could with a stock.
ETFs often have low annual fees (called an “expense ratio”)—typically lower than that of mutual funds—and no sales loads. Brokerage commissions, which are the costs of buying and selling a stock within a brokerage account, do apply, though they are typically less than 0.25% per year.
Using exchange traded funds is one way to achieve relatively cheap and easy diversification within an investment strategy. With the click of a button, an investor can own hundreds of investments in their portfolio.
Investors should be able to find what they want and build a diverse portfolio across all markets. The broad range of ETFs covers stocks, bonds, commodities, real estate, and even hybrids that offer a mix.
What Are the Disadvantages of ETFs
There are some potential downsides to trading ETFs, including:
Trading Might Be Too Easy
With pricing updated instantaneously, the ease of ETF trading can encourage investors to get out of an investment that’s supposed to be a long term.
Even if ETFs average lower fees than mutual funds, a brokerage might still charge commissions on trades. Commission fees plus fund management fees can potentially make trading ETFs pricier than trading standalone stocks.
ETFs can be great for investors looking for exposure to a broad market, index, or sector. But for an investor with a strong conviction about a particular asset, investing in an ETF that includes that asset will only give them indirect exposure to it—and dilute the gains if it shoots up in price relative to its comparable assets or the markets as a whole.
What Are the Most Common Types of ETFs?
The ETF market is very diverse today but much of it reflects its roots in trying to capture a broad swathe of large public equities. The first US ETF was the “Standard & Poor’s Depository Receipt,” known today as the SPDR. It was launched on the American Stock Exchange in 1993—and today ETFs that cover the S&P 500 are one of the largest sectors of the industry.
Since the SPDR first debuted, the ETF industry has gotten more diverse as ETF trading and investing has gotten more popular with individual investors and institutions. But even so, market or index ETFs play a major role.
These are some of the most common types of ETFs.
These provide exposure to a representative sample of the stock market, often by tracking a major index. An index, like the S&P 500, is simply a measure of the average of the market it is attempting to track. (In this case, U.S. stocks. The S&P 500 is a measure of the average performance of the 500 “leading” stocks in the U.S.)
These ETFs track a sector or industry in the stock market, such as healthcare stocks or energy stocks.
These track a particular investment style in the stock market, such as a company’s market capitalization (large cap, small cap, etc.) or whether it is considered a value or growth stock.
Foreign Market ETFs
These ETFs provide exposure to international markets, both by individual countries (for example, Japan) and by larger regions (such as Europe or all “developed” countries except the United States).
Bond ETFs provide exposure to bonds, such as treasury, corporate, municipal, international, and high-yield.
Commodity ETFs track the price of a commodity, such as a precious metal (like gold), oil, or another basic good.
Real Estate ETFs
These ETFs provide exposure to real estate markets, often through what are called Real Estate Investment Trusts (REITS).
In addition, there are inverse ETFs, ETFs for alternative investments, and actively-managed ETFs. (While most ETFs are passive and track an index, there are a growing number of managed ETFs.)
ETFs designed for the modern investor.
Distributor, Foreside Fund Services, LLC
What Is ETF Trading?
ETF trading is the buying and selling of ETFs. To know how to trade ETFs, it helps to understand how stocks are traded because ETF trades are very similar to stock trades.
Stocks trade in a marketplace called an “exchange”, open during weekday business hours, and so do ETFs. It is possible to buy and sell ETFs as rarely or as frequently as you could a stock. You’ll be able to buy ETFs through whomever you buy or sell stocks from, typically a brokerage.
That said, many investors will not want to trade ETFs frequently; a simple ETF trading strategy is to buy and hold ETFs for the purpose of long-term growth.
Whether you choose a buy and hold strategy or decide to trade more often, the ease of trading ETFs makes it possible to build a broad, diversified portfolio that’s easy to update and change.
When it comes to trading flexibility, ETFs can be used in different, more innovative ways than mutual funds. For example, advanced investors might choose to leverage or short markets using ETFs. ETFs also trade in such a way as to avoid short-term capital gains taxes, giving investors more control over their annual taxes.
3 Steps to Invest in ETFs
1. Do Your Research
Are you looking to get exposure to an entire index like the S&P 500? Or a sector like technology that may have a different set of prospects for growth and returns than the market as a whole? Those decisions will help narrow your search.
2. Pick an ETF
For any given market, sector, or theme you want exposure to, there is likely to be more than one ETF available. One consideration for investors is the fees involved with each ETF.
3. Find a Broker
If you’re already trading stocks, you’ll already have a broker that can execute your ETF trades. If you don’t have a broker, finding one should be easy. You can sign up for a brokerage account in minutes. Once your account is funded, you can start trading stocks and ETFs.
How to Build an ETF Portfolio
Are you willing to take more risk to attempt more growth? How will you handle market volatility? Investment strategies vary based on criteria like personal risk tolerance and age. Once you have determined your desired asset allocation—that proportional mix of different asset classes—ETFs can help fulfill the exposure to those markets.
For example, if you decide that you would like to invest in a traditional mix of stocks and bonds at a ratio of 70% and 30%, you could buy one or several stock ETFs to gain exposure to the stock market with 70% of your money and another few ETFs to fulfill your 30% exposure to the bond market.
For diversification purposes, some investors like to have both U.S. and foreign stock ETFs in their portfolios, as well as both government and corporate bond ETFs. Some investors also add alternative assets to their investment strategy: gold and other commodities, emerging markets, and ETFs that invest in real estate.
Once you’ve determined your desired allocation strategy and purchased the appropriate ETFs, upkeep throughout the year is necessary. This could mean rebalancing your funds once a year or utilizing a more active approach. ETFs provide the flexibility to pursue any number of investment styles, philosophies, and techniques.
There’s practically an ETF out there for every investor, whether you’re looking at a particular market, sector, or theme. ETFs offer the bundling of a mutual fund, with the trading ease of stocks.
Though a DIY approach to investing using ETFs is doable, many investors prefer to have the help of a professional who can provide guidance throughout the investment process.
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