Finding The Right Etfs: A Guide To Smart Investing

Exchange-traded funds (ETFs) are a great way for beginners to get into investing. They are simple to understand and can generate impressive returns without requiring much expense or effort.

ETFs are a pooled investment security that can be bought and sold like an individual stock on an exchange. They can be structured to track anything from the price of a commodity to a large and diverse collection of securities. ETFs can even be designed to track specific investment strategies.

ETFs are available on most online investing platforms, retirement account provider sites, and investing apps like Robinhood. Many of these platforms offer commission-free trading.

1. Open a brokerage account: You will need a brokerage account to buy and sell securities like ETFs. Many brokers have no account minimums, transaction fees or inactivity fees.

2. Choose your first ETFs: You can buy ETFs that track broad market indexes, such as the S&P 500. You can also use screening tools to narrow down your ETF options based on criteria such as asset type, geography, industry, trading performance or fund provider.

3. Let your ETFs do the hard work for you: ETFs are generally designed to be maintenance-free investments. Avoid checking your portfolio too often and making emotional, knee-jerk reactions to major market moves.

ETF screener tools

• Brokerage Platforms: Most brokerage trading platforms offer free asset screener tools that can help investors find ETFs based on various factors such as cost, asset class, or index. These tools are easily accessible if you already have a brokerage account.
• Subscription-based Services: For more advanced screening capabilities, investors can opt for subscription-based services that provide comprehensive ETF screening and analysis. These services often come with a fee but offer more sophisticated features and data.
• Fundamentals and Performance: When using screener tools, it's important to consider key fundamentals such as the level of assets, trading volume, and the underlying index. A well-diversified ETF with a high level of assets and trading volume is generally more liquid and has tighter bid-ask spreads.
• Expense Ratios: The expense ratio of an ETF is an important factor to consider, as it represents the annual fees associated with the fund. Lower expense ratios are generally preferable as they maximise returns by minimising fees.
• Trading Prices and Volume: ETF screener tools allow investors to filter ETFs based on their current trading prices, helping them identify funds that fit within their budget. Additionally, volume, which indicates the popularity of a fund, can be a useful metric for assessing investor interest.
• Holdings: Screener tools often provide insights into the top holdings of an ETF, allowing investors to understand the individual companies the fund invests in and make more informed decisions.
• Performance History: While past performance doesn't guarantee future results, comparing the long-term performance history of similar funds can provide valuable context. Look beyond one-year returns and consider three-year, five-year, or even ten-year performance for a more comprehensive understanding.
• Customisable Criteria: Some screener tools offer customisable criteria to tailor your search. For example, you can screen ETFs based on specific sectors, investment themes, or geographic regions. This flexibility helps investors find ETFs that align with their interests and goals.
• Comparison Features: Many screener tools facilitate side-by-side comparisons of multiple ETFs, allowing investors to evaluate key metrics and make informed decisions about which funds best suit their investment strategy.

By leveraging the features of ETF screener tools, investors can efficiently narrow down the vast array of available ETFs and make more informed investment decisions. These tools empower investors to consider various factors, from fees and performance to diversification and investment objectives, ultimately helping them build well-constructed portfolios.

ETF pros and cons

Exchange-traded funds (ETFs) are a powerful type of investment that can be a perfect way for beginners to get started investing. They can generate impressive returns without requiring much expense or effort for investors.

Pros:

• ETFs provide exposure to a variety of stocks, bonds, and other assets, typically at a minimal expense.
• They take the guesswork out of stock investing and allow investors to match the market's performance over time, which has historically been quite strong.
• ETFs are more liquid and easier to buy and sell than mutual funds.
• They make it extremely easy to invest in individual bonds.
• They are considered low-risk investments because they are low-cost and hold a basket of stocks or other securities, increasing diversification.
• ETFs tend to have much lower expense ratios compared to actively managed funds.
• Dividends can be immediately reinvested.
• ETFs can be more tax-efficient than mutual funds.
• They can give investors exposure to many stocks from a particular industry, investment category, country, or a broad market index.
• The most popular ETFs trade with more liquidity than most stocks, meaning there are always plenty of buyers and sellers and narrow bid-ask spreads.

Cons:

• ETFs still have costs to consider, including trading costs and expense ratios.
• Investment mixes may be limited.
• Partial shares may not be available.
• Intraday pricing might cause unwise trading.
• Costs could be higher compared to investing in a specific stock.
• Lower dividend yields.
• There is a risk the ETF will close.

How to invest in ETFs

Exchange-traded funds (ETFs) are a great way to get started with investing. They are fairly simple to understand and can generate impressive returns without requiring much expense or effort.

Open a brokerage account

You will need a brokerage account to buy and sell securities like ETFs. Many brokerages offer commission-free stock and ETF trades, so cost need not be a major consideration. When choosing a broker, compare each broker's features and platform. If you are a new investor, consider choosing a broker that offers an extensive range of educational features.

Choose your first ETFs

For beginners, passive index funds are generally the best way to go. Index funds are cheaper than their actively managed counterparts, and most actively managed funds don't beat their benchmark index over time.

• Vanguard S&P 500 ETF (VOO) -- Large U.S. companies
• Schwab U.S. Mid-Cap ETF (SCHM) -- Midsize U.S. companies
• Vanguard Russell 2000 ETF (VTWO) -- Smaller U.S. companies
• Schwab International Equity ETF (SCHF) -- Larger non-U.S. companies
• Vanguard High-Dividend ETF (VYM) -- Stocks that pay above-average dividends
• Schwab U.S. REIT ETF (SCHH) -- Real estate investment trusts

Let your ETFs do the hard work for you

It's important to remember that ETFs are generally designed to be maintenance-free investments. Avoid checking your portfolio too often and making emotional, knee-jerk reactions to major market moves.

Factors to consider when choosing an ETF

Given the number of ETF choices available to investors, it's important to consider the following factors:

• Level of Assets: An ETF should have a minimum level of assets, with a common threshold being at least $10 million.
• Trading Activity: Trading volume is an excellent indicator of liquidity. Generally, the higher the trading volume, the more liquid the ETF.
• Underlying Index or Asset: Consider the underlying index or asset class the ETF is based on. For diversification, it may be preferable to invest in an ETF based on a broad, widely followed index.
• Tracking Error: While most ETFs track their underlying indexes closely, some do not. An ETF with minimal tracking error is preferable.
• Market Position: Avoid ETFs that are imitations of an original idea.

Advantages of ETFs

• ETFs provide exposure to a variety of stocks, bonds, and other assets, typically at minimal expense.
• They take the guesswork out of stock investing and allow investors to match the market's performance over time.
• ETFs are more liquid and easier to buy and sell than mutual funds.
• Bond ETFs make the fixed-income portion of your portfolio very easy to manage.

Potential drawbacks of ETFs

• Since ETFs own a diverse assortment of stocks, they don't have as much return potential as buying individual stocks.
• ETFs are often low-cost but not free. If you buy a portfolio of individual stocks on your own, you won't have to pay any management fees.

ETF types

Exchange-traded funds (ETFs) are a type of index fund that tracks a basket or collection of securities, such as stocks, bonds, commodities, or currencies. They can be traded like an individual stock on an exchange.

• Equity ETFs own stocks in companies that can be headquartered anywhere in the world, or they may focus on companies in the United States only. Some ETFs allow companies of all styles and sizes, while others are more specific.
• International ETFs own stocks in companies headquartered outside of the United States.
• Sector ETFs own stocks in companies pursuing similar types of business or offering similar products and services.
• Dividend ETFs own stocks in companies that have a history of paying dividends to shareholders.
• Market-cap index ETFs select and weight stocks based on the size of each company's market capitalization—the total value of its shares.
• Smart beta, factor-based, and fundamental ETFs track an index based on a strategy other than a traditional market-cap-weighted index.
• ESG ETFs (environmental, social, and corporate governance) incorporate these considerations into their investment approach.
• Bond/fixed-income ETFs provide regular income to investors and distribution depends on the performance of underlying bonds.
• Commodity ETFs invest in raw materials (e.g., agricultural goods, energy, and precious metals). These tend to be higher in risk and are not suitable for all investors.
• Currency ETFs track the performance of a single currency or a basket of multiple currencies.
• Real estate investment trust (REIT) ETFs are attractive in terms of yield, despite increased volatility compared to bonds.
• Inverse ETFs profit when a particular index does poorly.
• Leveraged ETFs can double or triple the returns of a particular index by using leverage.

ETF taxes

The tax efficiency of exchange-traded funds (ETFs) is a significant part of their appeal. ETFs are generally more tax-efficient than mutual funds due to their structure, which allows them to avoid triggering capital gains taxes until investors sell their shares. This is because ETFs create and redeem shares using in-kind transactions, which aren't considered sales and, therefore, don't trigger taxable events.

However, selling your shares in an ETF is a taxable event, and the tax implications will depend on how long you've held the ETF and the type of ETF. Here's an overview of the tax rules for different types of ETFs:

• Long-term profits on the sale of ETF shares: If you've held the ETF for more than a year, you'll pay long-term capital gains taxes, which are currently up to 20% plus a 3.8% net investment income tax (NIIT) for high earners.
• Short-term profits on the sale of ETF shares: If you've held the ETF for less than or equal to one year, you'll pay short-term capital gains taxes, which are taxed at ordinary income rates (up to 37%) plus the 3.8% NIIT.
• ETF dividends and interest: Dividends and interest payments from ETFs are taxed like income from the underlying stocks or bonds they hold. Most ETF dividends are considered "qualified dividends" and are taxed at lower capital gains rates, while interest payments are ordinary dividends taxed at ordinary income rates.
• Commodity ETFs: These ETFs invest in commodities such as oil, corn, or aluminum through futures contracts. Gains and losses on the ETF's futures are treated as 60% long-term and 40% short-term capital gains or losses, regardless of how long the ETF held the contracts. This is known as the 60/40 rule.
• Precious metals ETFs: ETFs focused on precious metals such as gold and silver are treated as "collectibles" for tax purposes. Long-term gains are taxed at a rate of up to 28%, while short-term gains are taxed as ordinary income.
• Currency ETFs: Most currency ETFs are structured as grantor trusts, and profits from the sale of these ETFs are taxed as ordinary income, regardless of how long you've held them.
• Crypto ETFs: Spot crypto ETFs that hold actual cryptocurrency are taxed as ordinary income, while crypto ETFs invested in futures contracts are subject to the 60/40 rule.

It's important to note that the tax treatment of ETFs can vary depending on the investor's jurisdiction and other factors. Additionally, the tax laws and regulations surrounding crypto ETFs are relatively new and may change over time.

When comparing the tax efficiency of ETFs to mutual funds, studies have shown that ETFs offer a slight advantage. For example, a study by Villanova and the University of Pennsylvania found that the average annual after-tax advantage of ETFs was 0.92%. This advantage is due to the lower number of "taxable events" in ETFs compared to mutual funds. Mutual fund managers often buy and sell securities within the fund, triggering capital gains taxes for investors, while ETF managers can create and redeem shares without triggering these taxes.

However, it's worth noting that mutual funds have taken steps to reduce their turnover rates and compete with ETFs on tax efficiency. As a result, the difference in tax efficiency between ETFs and mutual funds may have narrowed in recent years.

Frequently asked questions