Brokers And Etfs: Do You Need A Middleman?

Exchange-traded funds (ETFs) are a popular investment option, offering an easy way to begin investing. They are similar to stocks in that they can be traded throughout the day when the market is open, but they are also similar to mutual funds in that they are a collection of securities. To invest in ETFs, you need a brokerage account. While you can invest in ETFs without a broker, it is not recommended as brokers provide access to a diverse range of ETFs and offer important tools for creating a well-diversified portfolio. Brokers also offer other benefits such as commission-free trades, extensive research capabilities, and educational resources.

What is a brokerage account?

A brokerage account is a type of investment account that allows you to buy and sell a variety of investments, such as stocks, bonds, mutual funds, and ETFs. It is typically used to build future financial security or invest for long-term goals. You can open a brokerage account with a brokerage firm, which will then execute investments at your request.

There are several benefits to opening a brokerage account. Firstly, there are no limits on how much you can contribute or what you can do with the money. Secondly, you can usually open an account with no upfront deposit, and there are no fees to open and maintain your account. Thirdly, you can use the account to save for any goal and take your money out at any time without early withdrawal penalties. Finally, you can use your brokerage account to gain access to investment research, tools, and strategies.

There are two main types of brokerage accounts: individual brokerage accounts, which have only one account owner, and joint brokerage accounts, which have two or more account owners.

When choosing a brokerage platform, it is important to consider cost-efficiency, the variety of offerings, and the availability of advanced research tools. It is also crucial to understand the risks involved in investing in ETFs, as well as the potential taxes and fees associated with brokerage accounts.

What are the best brokers for ETFs?

Fidelity

Fidelity is our overall best broker for ETFs. It offers more than 2,500 commission-free ETFs, industry-leading ETF research capabilities, fractional ETF shares to buy, in-depth screening capabilities, and a customised managed ETF basket called the Portfolio Builder. It also has multiple account types, no account maintenance fees, and superb ETF screening. However, it has limited branch locations and higher broker-assisted trade fees.

Interactive Brokers

Interactive Brokers (IBKR) provides a powerhouse of investment and research tools, from screeners with scores of factors to tools for fundamental and technical investors. The platform caters to the global investor and also delivers multiple account and order types, including options and derivative ETF investing. Most ETF commissions are free, although some trades levy low fees. However, the TWS platform can be intimidating to learn, and there is no in-platform backtesting.

Charles Schwab

Charles Schwab presents an easy-to-use ETF screener with roughly 100 screening characteristics. With commission-free trading and multiple account types, ETF investors can quickly and accurately find the best funds for their specifications. The platform also has pre-built screens, comparison tools, and extensive factor screeners. However, the ETF quote and information page lack the details of some competitors, and there is no in-depth or third-party ETF research or fractional shares for ETFs.

Vanguard

Vanguard is best known for being a low-cost fund provider. It offers screening tools, including the ability to compare ETFs based on factors such as expense ratios, management style (active or passive), average annual return and many more. Vanguard ETFs are great for buy-and-hold investors seeking a well-diversified, core ETF portfolio. However, Vanguard only screens proprietary Vanguard ETFs, and the platform has limited capabilities and features, making it unsuitable for intermediate and advanced ETF traders and investors.

E-Trade

E-Trade offers a competitive slate of ETFs and risk-based and customisable pre-built portfolios. Certain ETFs trade 24 hours a day, five days a week. It also has a solid screener, a list of all-star ETFs, and extended hours and overnight trading. However, there is a $2,500 minimum for pre-built portfolios, no fractional shares available, and a low-interest rate for uninvested cash.

Other notable mentions include Public, J.P. Morgan Self-Directed Investing, and Firstrade.

Do I need to pay taxes on ETFs?

The short answer is yes, you do need to pay taxes on ETFs. However, the amount of tax you pay depends on several factors, including the type of ETF, the length of time you held it, and your income. Here is a more detailed breakdown of the tax implications of ETFs:

• Long-term capital gains taxes: If you hold an ETF for more than a year before selling, you will typically pay long-term capital gains taxes. The maximum tax rate for long-term capital gains is 20%, but this can increase to 23.8% if you include the 3.8% Net Investment Income Tax (NIIT) for high earners.
• Short-term capital gains taxes: If you sell an ETF within a year of purchasing it, any gains will be taxed at the ordinary income rate, which can be up to 40.8%.
• Qualified dividends: Dividends from ETFs that meet certain criteria are considered "qualified dividends" and are taxed at the lower capital gains rate.
• Non-qualified dividends: Dividends that do not meet the criteria for qualified dividends are taxed at the ordinary income tax rate.
• Commodity ETFs: ETFs that invest in commodities like oil, corn, or aluminium often use futures contracts. These ETFs may be structured as limited partnerships and will report your income on a K-1 form instead of a 1099 form. Gains or losses from selling these ETFs are taxed at a blended rate of 60% long-term gains (up to 23.8%) and 40% short-term gains (up to 40.8%).
• Precious metals ETFs: ETFs that invest in precious metals like gold and silver are often structured as grantor trusts. These ETFs are treated as investments in collectibles, with a maximum long-term capital gains rate of 31.8% and short-term gains taxed as ordinary income.
• Currency ETFs: The taxation of currency ETFs depends on their structure. Currency ETFs structured as open-end funds are taxed at the long-term rate of up to 23.8% or the short-term rate of up to 40.8%. Currency ETFs structured as grantor trusts are taxed as ordinary income, while those structured as limited partnerships use the 60/40 blended rate.
• Wash sales: If you sell an ETF and buy the same or a "substantially identical" ETF within 30 days, you may be subject to the wash sale rule. This means you cannot offset other capital gains with the loss from the sale of the ETF.
• Net investment income tax (NIIT): High-income individuals may be subject to an additional 3.8% tax on investment income, including gains from ETF sales.

It's important to note that these tax rules apply to ETFs held in taxable accounts. If you hold ETFs in a tax-deferred account like an IRA, you generally won't be taxed until you make a withdrawal. Additionally, the specific tax treatment may vary depending on your jurisdiction and other factors. Consulting a tax professional is always recommended to understand your specific tax situation.

What are the pros and cons of ETFs?

Pros of ETFs

ETFs, or exchange-traded funds, are a powerful type of investment with certain advantages over other types of investments such as individual stocks or mutual funds. Here are some of the pros of investing in ETFs:

• Lower costs: ETFs tend to have lower costs than other types of investments, such as mutual funds, due to their structure. Most ETFs try to mimic an index, which means the investment managers are fairly hands-off and don't actively manage the fund. This passive management style results in lower fees for investors.
• Diversification: ETFs typically offer diversified investments, with some aiming to provide exposure to the total stock market. This diversification is important because it spreads out investment risk and reduces the impact of any single company's performance on the overall portfolio.
• Tax efficiency: ETFs are more tax-efficient than mutual funds because they are focused on passive or index investing, resulting in fewer trades and lower capital gains taxes for investors.
• Flexibility: ETFs are traded on exchanges throughout the day, similar to stocks, giving investors more control over how and when they invest. This flexibility is advantageous for those who want to time the market, although this is generally not advised for long-term investors.
• Risk management: ETFs offer risk management opportunities such as market, stop-loss, and limit orders, which can help investors manage their risk exposure.
• Accessibility: ETFs provide access to a wide range of investments, including stocks, bonds, currencies, and commodities. They also allow investors to gain exposure to various market segments, industries, investment categories, and countries.

Cons of ETFs

While ETFs have many advantages, there are also some potential drawbacks to consider:

• Costs: Although ETFs tend to have lower costs than mutual funds, investors still incur trading fees when buying and selling ETFs, similar to stocks. These costs depend on the brokerage firm and type of ETF.
• Limited diversification: In some cases, ETF investors might be limited to large-cap stocks due to a narrow group of equities in the market index. This limitation could result in fewer growth opportunities, especially for investors who cannot access mid- or small-capitalization companies.
• Lower returns: While ETFs provide diversification and lower risk, they may also offer lower returns compared to investing directly in individual stocks. The returns of ETFs may be lower than those of high-yielding stocks, particularly in the case of dividend-paying ETFs.
• Challenges for hands-on investors: ETFs may not be ideal for investors who want to be very hands-on with their investments or have specific investment goals or values. It can be challenging to find ETFs that align with personal values or avoid certain asset classes or companies.
• Shutdown risk: ETFs have a minor risk of shutting down, which means shareholders would need to reinvest their money and potentially incur unexpected fees or capital gains taxes.

How do I open a brokerage account?

Opening a brokerage account is a simple process that can be done online. It is the first step to begin investing. You can open a brokerage account by following these steps:

Step 1: Decide on the type of brokerage account

You can choose between a margin account and a cash account. A margin account allows you to borrow money to invest, whereas a cash account only lets you invest the money you have.

Step 2: Evaluate how the brokerage can help you reduce risk

Look at the tools and features offered by the broker to help you manage risk. This includes research tools, educational resources, and investment options.

Step 3: Choose the best online brokerage account

Compare different brokers based on their features, investment products, and your specific needs. Some factors to consider are account minimums, fees, and investment options.

Step 4: Start the application process

Provide basic identification, tax, and income information to the broker. This usually includes your Social Security number, tax information, and employment details.

Step 5: Fund your account

After your application is approved, transfer funds from your bank account to your brokerage account. You can do this through electronic funds transfer, wire transfer, or check deposit.

Step 6: Practice trading

Before you start investing with real money, it is recommended to practice your investing activities. You can use simulated trading accounts or virtual trading platforms to learn the basics and gain experience without risking your own money.

By following these steps, you can open a brokerage account and start investing towards your financial goals.

Frequently asked questions