How to Invest in ETFs
Investing In ETFs
When it comes to investing, mutual funds and stocks tend to get all of the attention. But, over the last two decades, there’s been another financial product that’s been exploding in popularity. The best part: It combines some of the best features of mutual funds and stocks together into one investment.
It’s called an exchange-traded fund or “ETF” for short. Since their introduction back in 1993 with the S&P 500 Trust ETF “SPDR” (or spider as it’s better known), investors have really taken to ETF’s for a variety of reasons.
Here’s what makes ETFs so great and how you can start investing in them.
What Is An ETF?
Similar to mutual funds, an ETF is a collection of other securities such as stocks, bonds, etc. The fund provider decides what assets to buy, creates a fund to track its value, and then offers ownership of the fund by selling shares to investors. Because each share represents several different securities, investors can easily diversify without having to go through the trouble of buying each and every one individually.
Just like stocks, ETF shares can be bought and sold in the open market. This means their price is free to fluctuate throughout the day. That’s different from mutual funds where the value is only calculated at the end of the day after the markets close.
Currently, the ETF industry is valued over 6 trillion dollars (USD) and consists of nearly 7,000 different funds worldwide. In some places around the world (such as Canada), ETF’s have even managed to outsell mutual funds.
ETFs vs Mutual Funds
At first glance, you might wonder why anyone would want to buy an ETF instead of a mutual fund.
While it’s true that both products share a lot of similarities, some very important differences may influence you to pick one over the other.
Market Fluctuation And Risk
Since ETFs are constantly being traded, their value is free to fluctuate as the market rises and falls. This means at times the price of an ETF share may or may not reflect the underlying value of the assets it holds.
Similar to stocks, that can either be good or bad depending on the situation. If you buy the share at a discount and it goes up in price, then you’ll make a gain. But if you’re the one selling the share at a discount, then you’ll risk taking a loss.
When you buy and sell ETFs, you pay a commission just like you do with stocks. A commission is a fixed fee your broker charges you to make the trade.
Today, most discount brokers charge anywhere from $5 to $30 per trade. Some are even offering $0 trades for an introductory period or if you maintain a certain account balance.
Lower Expense Ratios
In addition to commissions, ETFs also carry an expense ratio (just like a mutual fund). An expense ratio is an annual percentage-based fee that the fund charges you for maintaining its operation. Since many ETFs are simply some variation of an index fund, you can expect the expense ratio to be much less than what a typical mutual fund charges.
Because ETFs trade like stocks, they are generally not taxable until you trade them. In general, this means if you held the ETF for less than one year, you’ll pay a short-term capital gains tax. If you owned the ETF for longer than one year, then you will pay a lower, long-term capital gains tax.
ETF’s can be viewed as more tax-efficient than mutual funds because they are not constantly rebalancing and reallocating their assets to the shareholders.
Any dividends you earn from an ETF will be taxed the same they would be with a mutual fund.
Types Of ETFs
Just like most financial products, ETF’s come in all shapes and sizes. Whatever it is that you like to invest in, there’s likely an ETF that’s right for you.
Here are some of the more popular types of ETF’s:
- Stock ETFs – Consists of equities (generally from U.S. based companies) that replicate major market benchmarks (such as the S&P 500 index).
- Sector ETFs – Focuses on stocks from specific industry sectors (like technology or pharmaceuticals).
- Foreign market ETFs – Invests in foreign stocks and benchmarks (for example Asia or Europe).
- Bond ETFs – Consists of fixed income assets such as government and company debt.
- Style-Based ETFs – Designed to cater to certain investment preferences (i.e. those who seek value or growth).
- Commodity ETFs – Invests in regularly used commodities such as gold and oil.
- Currency ETFs – Consists of foreign currency that can be used as a hedge against when the dollar depreciates.
- Real Estate ETFs – Lets you own various types of real estate through REITs (real estate investment trusts).
- Derivate ETFs – Contains derivate contracts that are frequently sold in relation to equities such as futures and options.
How To Buy ETFs
Buying an ETF is a relatively straight-forward process. If you’ve ever purchased shares of stocks or mutual funds, then buying ETFs will basically be a similar process.
If you’re just getting started with investing, then here’s what to do:
1-Setup Your Brokerage Account
Find a reputable discount broker and set up an account. Go with a well-known financial company like Fidelity or E-Trade.
You can choose to set up a regular taxable brokerage account or a tax-advantaged retirement account such as a Roth or traditional IRA. Because IRAs are used to build your retirement savings, taxes on your capital gains and dividends are often deferred or even eliminated altogether depending on which type of account you decide to open.
2-Research Your Options
After setting up your account, the next thing to do is to look through the various ETFs and pick out which ones you’d like to invest in.
It’s important to choose an ETF that fits your tolerance for risk vs reward. Are you investing to make more money or for growth? Or maybe you’re investing for retirement? If you’re after growth, for example, then you can choose ETFs that specialize in small-cap or foreign securities. If you’d rather not see your investments fluctuate in value so much, then maybe a good bond or large-cap U.S. index fund ETF is right for you.
Be sure to also compare the expense ratio of each fund you’re considering. Remember: The lower the fees, the more money for you!
3-Build Your Portfolio
With your funds picked out, its time to hit the “buy” button. Take a look at your brokerage account to ensure that the money from your bank account has transferred and is now available to use.
After buying your ETFs, check in on your investments from time to time and make sure they are performing the way you want them to. If any of the funds you picked turn out to be duds, then perhaps its time to do your research again and trade up for some different ETFs.