What is an ETF?
There are a few different ways to approach investing in the stock market.
One involves investing directly in individual stocks like The Home Depot or Walmart. This method involves investing in one company at a time, with the price of the stock fluctuating as the company’s performance changes.
The other way is to buy a basket of securities—or a collection of different stocks—using exchange-traded funds (ETFs), which are somewhat like mutual funds and index funds, except they can be traded throughout the day like other securities.
Keep reading to learn more about how ETFs work, the different types of funds available, and the pros and cons of adding them to your portfolio.
How an ETF works
ETFs track specific sectors or market indexes with the goal of increasing investors’ returns based on the performance of that group of securities (e.g., $SPY, which tracks the S&P 500 stock index).
Another example is the iShares U.S. Medical Devices ETF ($IHI), which tracks companies that build medical devices like patient monitoring solutions and heart valves.
When you invest in sector ETFs, you’re investing in many different companies simultaneously as opposed to just one institution. A fund owner sets up a fund based on an underlying asset and then sells ETF shares to investors through a brokerage.
How to invest in ETFs
Here’s a breakdown of how to invest in ETFs.
1. Open an investing account
Keep in mind that not all brokerage firms offer ETFs, so you’ll need to double-check before you open an account.
You can either invest in ETFs through a taxable brokerage account or a tax-friendly retirement account like a traditional IRA, Roth IRA, or 401(k).
2. Pick a specific ETF
The next step is to pick a specific ETF in which you want to invest. If you’re just starting out, you’ll probably want to avoid more complicated products, like an inverse ETF and leveraged ETFs, and just focus on funds that are more or less straightforward.
How to pick an ETF
Look at the various metrics associated with the ETF, like issuer, expense ratio, and assets under management. Make sure the metrics indicate solid growth and that the cost aligns with your budget. Some ETFs are very expensive but don’t produce great returns.
The next thing you should consider is the fund’s benchmark. A benchmark may be the S&P 500 index, the Dow Jones, or the Nasdaq Composite. ETFs can also track certain sectors like technology, blockchain, or precious metals.
Make sure you understand the underlying benchmark and how it works. The benchmark will directly impact the performance of the fund in which you ultimately invest.
It’s also important to assess the ETF’s tracking performance, which is the difference between the fund’s performance and the index performance. ETFs don’t always mirror the performance of an index. Sometimes they do better, and sometimes they do worse.
3. Buy the ETF
Once you find an ETF that seems like a solid fit, the next step is to log into your online brokerage account and place an order.
You can buy an ETF at any time during the trading day, the same way you’d buy a stock. ETFs trade throughout the day, and prices fluctuate based on supply and demand.
4. Track progress
ETFs are automated. Once you buy into a fund, your work is done. That said, ETFs aren’t something you should set and forget. It’s important to check in regularly to assess performance and make sure the fund is on track.
A solid broker should provide you with a wealth of data to track your ETFs and visualize progress.
5. Be patient
ETFs are designed to provide slow and steady growth. Over time, most will yield a strong profit. However, this may require some patience. You may go for a stretch of time without noticeable gains.
Make sure to assess each ETF’s history and try to get a sense of how it’s going to perform moving forward.
The last thing you want to do is bail on an ETF shortly after getting it because of sluggish performance. Keep your eye on it. But don’t make any hasty moves without understanding why the fund is moving slowly.
When it comes to investing, pretty much no one gets rich overnight. If your goal is financial freedom, you’ll need to trust the plan and stay patient.
ETFs vs. mutual funds
Investors often want to know if an ETF is a mutual fund. These are two different types of funds.
An ETF is typically a passive investment, meaning it merely tracks a benchmark. A mutual fund is actively managed by a fund manager, meaning it’s manipulated or changed to beat an index. However, some ETFs are actively managed, like Cathie Wood’s ARK funds ($ARKK and $ARKW).
Generally speaking, mutual funds tend to be more expensive than ETFs, with higher fees. They also don’t tend to perform quite as well as ETFs, which is one of the benefits of ETF investing.
The pros and cons of ETFs
Like any other investment vehicle, there are pros and cons associated with ETFs. As such, it’s a good idea to have an understanding before you start investing.
ETFs are a great way to diversify your asset allocation. A single investment can open the door to many different companies in a particular index or sector.
As such, ETFs are great for beginner investors and experienced investors alike. If you don’t know what you’re doing, you can invest in an ETF and buy shares in a broad range of companies, reducing risk and exposing you to higher earning potential.
While the IRS treats ETFs and mutual funds the same from a tax perspective (investors need to pay capital gains taxes and dividend taxes), ETFs are more tax-friendly. As such, ETFs provide tax advantages to investors, who end up paying less when they sell than they’d pay if they sold a comparable mutual fund.
ETFs are fairly easy to liquidate, as you can sell them at any time during normal trading hours. You don’t have to worry about locking your money in with ETF shares.
Commissions and fees
ETFs can come with high trading costs, eating into profits when making trades. It’s necessary to read each fund’s prospectus to understand exactly what the broker charges. Otherwise, you could be in for a rude awakening when you go to make a trade and wind up with less than you initially thought you would receive.
ETFs are typically a less risky investment than stocks. But investors are still exposed to market volatility. They are not entirely risk-free, and you could potentially lose money by investing in ETFs.
At the same time, some ETFs are way more volatile than others. Do your due diligence before making an investment to make sure you take on a level of risk you can stomach.
Funds do not last forever. If the fund can’t cover administrative costs, it could shut down. This could force investors to sell prematurely… and possibly take a loss.
Tips for buying ETFs
Do your research
Make sure you do your research before buying ETFs and avoid rushing in without understanding the investment.
It’s critical you understand the benchmark the fund is tracking as well as the fund’s history and forward-looking outlook. You should also make it a point to look into the ETF to find out which stocks, specifically, you’re buying slices of.
Don’t overlook index funds
An index fund is similar to an ETF, as they are both passively managed and track specific indexes and sectors. The main differences are the way they’re bought and sold.
ETFs are bought and sold throughout the day like stocks, whereas index funds are bought and sold based on the price set at the end of the trading day.
Don’t overlook index funds when building a portfolio. Most investors choose to mix in a healthy variety of index funds and ETFs, along with a few mutual funds.
Remember that balance is key when building a financial portfolio. It’s best to avoid going too heavy in any one particular type of investment or fund.
Make sure you’re in a position to invest
As an investor, it’s a good idea to assess your overall portfolio before buying any ETFs and determine if you should be investing at all.
You may not be in a position to take on any risk. Or, you could be in a great position to do so.
Every investor is different, which is why it’s important to understand your personal situation before diving into the market.
ETFs to monitor for 2021
Now that you have a basic understanding of how ETFs work, here are some of the top funds to consider for 2021.
Vanguard Growth ETF (VUG)
The Vanguard Growth ETF, which tracks the U.S. large-cap growth index, has an expense ratio of 0.04% with a dividend yield of 0.7% and $70.6 billion worth of assets under management at the time of writing.
Vanguard Real Estate ETF (VNQ)
Vanguard also offers the VNQ, a real estate-focused ETF filled with U.S. REITs. This one has a higher expense ratio of 0.12%, but it has a healthy dividend yield of 3.77%.
Transformational Data Sharing ETF (BLOK)
Amplify offers the BLOK ETF, which invests roughly 80% of its net assets in blockchain technology use and development. So, if you buy into the hype surrounding blockchain, this is definitely something worth looking into.
BLOK offers an expense ratio of 0.71%, with an annual dividend yield of 1.31%. It also has $1.2 billion worth of assets under management at the time of writing.
Frequently Asked Questions
Are ETFs tax efficient?
ETFs offer tax efficiency when compared to mutual funds. They are also extremely tax-efficient when used with a tax-friendly retirement account like an IRA.
Are ETFs expensive?
ETFs can be expensive depending on which funds you’re looking at and how they’re structured. As such, it’s important to look at their expense ratio when buying them.
The general rule of thumb with expense ratios is to avoid funds that run higher than 1.5%. Anything less than that is reasonable.
In short, an expense ratio indicates how much of the fund goes towards the investor versus administrative or management costs. Simply put, low expense ratios are better than high ratios. This is one of the most important pricing metrics for an ETF.
What are the best types of ETFs?
Every ETF is different. It’s important to look at the underlying benchmark and the specific holdings in each account. For example, it’s possible to have two different ETFs based on a similar benchmark that have entirely different holdings. Analyze each ETF and judge each one on an individual basis.
What are bond ETFs?
Bond ETFs are stock exchange-traded funds that invest in fixed-income securities. For example, bond ETFs may invest in Treasuries. They may also invest in corporate bonds (e.g., $VTC).
You may also want to look into commodity ETFs, which track different commodities (e.g., $SLV).
The Bottom Line
If you’re investing in the U.S. stock market, ETFs can be a great investment strategy, and they’re one of the most popular asset classes. Instead of buying into one company, you buy into several, spreading risk around. Just keep in mind they’re usually better for long-term growth than short-term growth.
It’s also a good idea to consider reinvesting dividends so you can increase the number of shares in your portfolio. This is especially a good idea if you’re investing through a retirement account and are focused on long-term growth.
Many ETFs are low-cost. Just watch out for management fees and do your best to snag ETFs at the best market price when buying them (this is where the dollar-cost averaging strategy can really pay off). You’ll also want to make sure you have a solid understanding of the underlying index or sector the ETF tracks.
At the end of the day, you need to determine your overall investment objectives and invest in securities that help you achieve those goals. Start small and throw some cash into a few ETFs and let it ride. Before you know it, you’ll find out why more and more seasoned investors are filling their portfolios with ETFs.