Retail investors are often recommended to park their money in exchange-traded funds, or ETFs. And individuals have heeded that advice: In the past decade, a net $900 billion has flowed out of stock mutual funds, while $1.8 trillion has gone into stock ETFs.
ETFs are tradable funds that investors can buy and sell on stock exchanges all day. They typically hold a basket of assets, such as stocks or bonds, and mirror the moves of another underlying index.
For example, the very first ETF that launched in 1993, the SPDR S&P 500 ETF Trust, known commonly as SPY, tracks the S&P 500 Index, a benchmark equity gauge. So when investors buy a SPY share, they get exposure to all 500 companies in the S&P 500, and the ETF’s price moves track the index’s price moves.
Since its start almost three decades ago, the ETF industry has taken the financial world by storm. There are about 7,600 ETFs worldwide and 2,200 such funds in the U.S. For beginner investors struggling to decide which ETFs to buy, here’s a handy guide.
How Do I Pick an ETF?
Investors can screen for ETFs for free using websites like ETF.com and etfdb.com . Registering a SoFi Invest® online trading account also gives individuals the ability to search for funds and follow them via a watchlist.
Step 1: Pick the Asset Class
Because the performance of an ETF is so closely tied to an underlying index, investors need to first decide which underlying asset class they want exposure to. The main asset classes are stocks, bonds, currencies, and commodities.
Risk is generally inversely correlated to return. So riskier assets have the potential to deliver greater returns, while safer assets tend to deliver reliable, albeit smaller, returns. Stocks are considered to be a riskier, more volatile asset class. Commodities even more so. Meanwhile, bonds tend to be safer but also deliver more muted returns.
Keep in mind, just because an investor buys an ETF that gives them exposure to one asset class, that doesn’t preclude them from buying another that invests in another market. In fact, it’s a healthy portfolio diversification strategy to allocate one’s money into different asset classes, a practice known as asset allocation.
Step 2: Narrow the Focus
Once an investor has chosen their asset class, they can dive deeper within that market. When it comes to stock ETFs, this usually involves picking an industry–like technology or financial–that they’d like to get greater exposure to. Equity ETFs may also focus on a specific attribute a stock can have. Take dividend ETFs, which hold shares of companies with regular payouts.
For bond ETFs, investors can decide between funds that invest in U.S. government-bond versus bonds issued by countries abroad, as well as investment-grade (higher quality) company debt versus high-yield (junk) bonds.
More recently, thematic ETFs have taken off. These are stock funds that tend to be much narrower than the traditional sector ETF. They can focus on a niche subsector, like robotics, electric cars or blockchain, or even modern trends, like the gig economy or working from home.
There are pros and cons to thematic ETFs: while they’re often marketed as a convenient way to wager on an investment story, they also tend to underperform the broader market. Thematic ETFs have also been criticized for being too narrow and not offering the wide breadth that ETFs were originally designed to offer.
Step 3: Explore Different ETF Strategies
ETFs began as a way to provide investors access to broad markets with a single investment. Since then however, the popularity of the industry has led to the creation of numerous different kinds of ETFs, some of which employ complex strategies.
Here are some of the different ETF types:
• Leveraged ETFs allow investors to make magnified bets on different assets or markets. So instead of replicating the move of the underlying index exactly, leveraged ETFs will produce a move that’s 2x or 3x. (Recommended: What Are Leveraged ETFs?)
• Inverse ETFs let investors wager against an asset, so shorting or betting that the price of a market will go down. So if on a given day, the underlying market goes down, the inverse ETF’s price will go up. (Recommended: What Is an Inverse ETF?)
• Actively Managed ETFs invest in assets without following an index. While ETFs are usually a form of passive investing–the strategy of tracking another index–actively managed ETFs are like stock-picking strategies packaged into a tradable fund. (Recommended: What Are Actively Managed ETFs?)
• Smart-Beta & Factor ETFs use a rules-based system–such as stock weightings, valuations, or volatility trends–to choose the investments in a fund. These funds are often considered a hybrid between passive and actively managed ETFs.
• Currency-Hedged ETFs are funds that let investors wager on a basket of overseas stocks, while mitigating the risk that stems from currency fluctuations.
• Cryptocurrency ETFs are a more nascent market. While crypto ETFs have existed in Europe for years and one recently launched in Canada, U.S. regulators have not approved one stateside. (Recommended: Are There Bitcoin ETFs?)
Step 4: Look at ETF Costs
A fundamental reason why ETFs have become so influential is their low cost. Low ETF fees have compressed costs across the board in asset management. The average expense ratio of all U.S. open-end funds and ETFs has tumbled to 0.45% in 2019 from 0.87% in 1999, data from Morningstar released in 2020 show.
Expense ratios are a percentage of assets subtracted each year. So an expense ratio of 0.45% means that the charge is $4.50 for every $1,000 invested each year.
Because the vast majority of ETFs tend to be passive, they tend to be much cheaper than mutual funds, many of which are still actively managed. Morningstar found that the average expense ratio of an actively managed fund in 2019 was 0.66%. For passive funds, it was 0.13%.
More complex ETFs like leveraged funds, or actively managed ones, tend to have higher expense ratios. But some passive ETF fees have hit rock-bottom levels.
Step 6: Other Ways to Analyze ETFs
What about how well an ETF has done? Should that matter? While profitability can make an investment look more attractive, it shouldn’t be the only factor investors use when determining which ETF to buy. That’s because in investing, past performance is not indicative of future results.
For ETFs, another key measure of performance is how well it tracks the underlying index. Tracking errors, when a move in the ETF veers from one by the market it’s designed to track, can come up from time to time, particularly in leveraged funds or ones that invest in stocks overseas.
Looking at the assets under management (AUM) can be a helpful way to pick an ETF. A larger AUM can signal an ETF’s popularity, which in turn makes it more likely that it’s liquid, or easy to trade without impacting prices.
How to Find ETF’s Holdings, Prospectus and Fact Sheet
Another touted perk of ETFs is their transparency. Investors can look up what’s exactly in a fund by going to the ETF provider’s website and searching for the fund. Contacting the ETF provider directly for this information is also possible. ETF providers are required to update this information regularly.
Securities and Exchange Commission (SEC) regulation also requires that ETF providers make easily available an ETF’s prospectus. The prospectus has information about the ETF including its investment objective, the risks, fees, as well as expenses. For investors interested in an ETF, one of the most important things they can do is research the fund by carefully reading the prospectus.
Meanwhile, ETF fact sheets act like quick summaries of the fund, giving key information like performance, the top holdings, and other portfolio characteristics. ETF providers typically produce fact sheets every quarter and make them available on their website.
Choosing an ETF from the thousands out there can seem daunting, but taking a step-by-step approach can help individuals sort through the multitude of options. A key step investors can take in researching ETFs is reading the fund’s prospectus, where they’ll find vital information on the investment objectives as well as potential risks.
Considerations include which asset class an investor wants to invest in; how broad or narrow of an exposure they want; costs–which are usually shown as expense ratios; and lastly, an ETF’s size can give clues on the popularity and liquidity of the fund.
One ETF, on its own, can provide some diversification. However, some people choose to use a number of ETFs as building blocks to assembling a well-balanced portfolio.
Ready to get started? SoFi Invest’s Active Investing platform offers an array of stock, bond, currency and thematic ETFs that individuals can choose from. Plus, with some ETFs, investors can buy fractional shares, or slices of a whole ETF. For those who want help building an ETF portfolio, SoFi also offers access to certified financial planners who can answer questions.
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