A Beginner's Guide To Us Etf Investing

Exchange-traded funds (ETFs) are a popular investment vehicle that combines the flexibility and convenience of trading individual stocks with the diversification offered by index funds or professionally managed mutual funds. ETFs are traded on public stock exchanges, allowing investors to buy and sell throughout the day, unlike mutual funds, which can only be traded at the end of the trading day. They provide exposure to a wide range of assets, including stocks, bonds, commodities, and specific sectors or industries.

ETFs have become attractive to investors due to their low costs, diversification benefits, and ease of trading. However, it's important to consider the disadvantages, such as annual expense ratios and potential liquidity issues.

When investing in ETFs in the US, it's essential to open a brokerage account, compare different ETFs using screening tools, place your order, and monitor your investment. This process can be done through online brokers or robo-advisors, depending on your preferences.

Choosing an ETF: Diversification, fees, and performance

When choosing an ETF, investors should consider diversification, fees, and performance. Here are some key factors to keep in mind:

Diversification

Diversification is a crucial aspect of investing in ETFs. By investing in a diverse range of assets, investors can reduce their risk and improve their long-term returns. ETFs offer an easy way to achieve diversification by providing exposure to various asset classes, sectors, and geographical regions.

When selecting an ETF, look beyond the name and analyze the top holdings of the fund. Two ETFs with similar names or themes may have different approaches and focus on different types of assets. For example, water-related ETFs may include utilities or infrastructure stocks as their top holdings. Understanding the underlying assets of the ETF is essential to making an informed decision.

Additionally, consider the level of diversification within your overall investment portfolio. Choose ETFs that cover different asset classes, sectors, industries, and geographical regions to minimize risk and maximize returns.

Fees

ETFs are known for their low fees, but it's important to compare expense ratios across different funds. High fees can significantly impact your long-term returns, so opt for ETFs with lower expense ratios whenever possible. Passively managed ETFs, which aim to replicate a specific index, tend to have lower fees than actively managed funds.

Performance

While past performance doesn't guarantee future results, it's worth comparing how similar ETFs have performed over time. Look at the long-term track record of the ETF and how closely it has tracked its benchmark or index. Also, consider the overall performance of the asset class or sector in which the ETF invests.

In addition to performance, consider the level of risk associated with the ETF. Riskier assets, such as stocks, generally require a longer investment horizon, while less risky assets, such as bonds, may be more suitable for short-term investment goals.

Other Factors

• Liquidity: ETFs are generally liquid and can be easily bought and sold on exchanges, but it's important to consider the daily average volume and bid/ask spread to ensure you can enter and exit positions without significant impact on the price.
• Assets Under Management (AUM): An ETF with low AUM may be at risk of liquidation, so opt for funds with higher AUM for added stability.
• Tax Efficiency: Some ETFs are more tax-efficient than others, depending on the type of assets they hold and the country of investment. Consider the tax implications of the ETF to minimize your tax burden.
• Rebalancing: Determine a rebalancing strategy for your portfolio to maintain your desired asset allocation. This can be done at fixed time intervals or when the portfolio deviates from the target allocation by a certain threshold.

By carefully considering these factors, you can choose ETFs that align with your investment goals, risk tolerance, and time horizon. Diversification, fees, and performance are key aspects to evaluate when selecting ETFs to build a robust and well-rounded investment portfolio.

Opening a brokerage account

You’ll need a brokerage account to buy and sell securities like ETFs. If you don’t already have one, you can open one online, and many brokerages have no account minimums, transaction fees or inactivity fees. Opening a brokerage account is not a difficult process and is similar to opening a bank account.

If you’d rather have someone do the work of investing for you, you might be interested in opening an account with a robo-advisor. Robo-advisors build and manage an investment portfolio for you, often out of ETFs, for a low annual fee (typically 0.25% of your account balance).

To screen and invest in the specific ETFs you want, you’ll need a brokerage account at an online broker.

Buying and selling: How to place an order

Once you've found a broker that suits your needs, you can place an order to buy ETFs. Here's a step-by-step guide:

• Decide on the amount you want to invest: Determine how much money you can invest in the ETF. Consider the price of the ETF, as you will usually need to buy at least one whole share. However, some brokers offer fractional shares, allowing you to invest any amount.
• Choose your desired ETF: Research and select the specific ETF you want to purchase. You can use an ETF screener or brokerage platform tools to narrow down your options based on criteria like trading volume, expense ratio, past performance, holdings, and commission costs.
• Place the order with your broker: Log in to your brokerage account and place the trade using the ETF's ticker symbol. If you don't have sufficient funds in your account, deposit the necessary amount and then place the trade when the money clears.
• Confirm the order: Review the order details, including the number of shares you want to buy, and confirm the purchase. In most cases, you will place a "market order," which means buying the ETF at the current market price.
• Set up a regular purchase plan: Investing in ETFs is often a long-term strategy. Consider setting up automatic investments at regular intervals to build your position over time. This approach is known as dollar-cost averaging and can help you pay less per share overall.
• Monitor your portfolio: While ETFs are generally designed to be maintenance-free investments, it's a good idea to periodically check your portfolio to ensure it aligns with your desired asset allocation. Experts recommend reviewing your portfolio every six to twelve months and making adjustments if necessary.

Costs: Expense ratios and commissions

Expense ratios are typically expressed as a percentage of a fund's average net assets and can include various operational costs and annual fees. The operating expenses of an ETF directly impact the value of your investment. The average expense ratio for index ETFs is usually lower than that of index mutual funds. When choosing from the thousands of US-listed exchange-traded funds (ETFs), cost is a central focus as high costs erode portfolio returns.

The expense ratio of an exchange-traded fund reflects how much it costs to operate an ETF. The expense ratio is usually expressed as a percentage of a fund's average net assets and can include various operational costs and annual fees. For example, if you invest $10,000 in an ETF with an expense ratio of 0.04%, you'll pay $4 to the fund's manager that year. As the value of your investment grows, the amount you pay will also grow, which is why a fund's expense ratio can significantly impact your returns over time.

The gross expense ratio is the fund's total annual operating expense ratio, gross of any fee waivers or expense reimbursements. The net expense ratio represents the ETF's expenses after any expenses have been waived and/or partially absorbed by the fund manager. The expense ratio doesn't include brokerage commissions, transaction fees, and other fees to financial intermediaries that you may pay for purchases and sales of ETF shares on the secondary market.

The average expense ratio for index ETFs is typically lower than that of index mutual funds, historically 0.52% for ETFs versus 0.85% for mutual funds. Importantly, the higher costs of mutual funds can add up and impact portfolio returns over the long run. Fortunately, ETF average expense ratios have been falling for many years. From 2008 to 2023, average index equity ETF expense ratios declined by 15%, and average index bond ETF expense ratios fell by 30%. In 2023, the average expense ratio for index equity ETFs declined by 1 basis point to 0.41%. The average expense ratio for index bond ETFs declined by 1 basis point to 0.21% in 2023.

When it comes to investing in mutual funds or ETFs, one of the most important factors to consider is the expense ratio. An expense ratio measures how much you'll pay over the course of a year to own a fund. A high expense ratio can significantly impact your returns, and it pays for things like the management of the fund, marketing, advertising, and any other costs associated with running the fund. Both mutual funds and ETFs charge an expense ratio.

The expense ratio is the cost of owning a mutual fund or ETF. Think of it as the management fee paid to the fund company for the benefit of owning the fund. The expense ratio is measured as a percentage of your investment in the fund. For example, a fund may charge 0.30%, meaning you'll pay $30 per year for every $10,000 you have invested in that fund. You'll pay this on an annual basis if you own the fund for the year.

It's important to note that many investors choose to invest in funds with high expense ratios if it's worth it for them in the long run. The good news is that expense ratios have been declining for years, and many passive funds have expense ratios below 0.10%, or $10 annually for every $10,000 invested. A few funds even have expense ratios of 0%, which is great for investors.

To determine if an expense ratio is good, you can measure it against the simple average of all funds to see how it ranks overall, or against the asset-weighted average of all funds to see if you're getting a better price than most other investors. Ultimately, you should aim for a fund that falls below the asset-weighted average as lower costs are preferable.

Actively managed funds tend to have higher expense ratios than passive, index-tracking funds. ETFs that invest in foreign securities generally cost more to manage than funds that invest in US Treasury bonds. As an ETF's assets increase, its fixed costs likely represent a smaller percentage of its net assets, meaning its expense ratio often decreases.

In addition to expense ratios, there are other costs to consider when investing in ETFs, such as trading and holding costs. These costs can accumulate significantly and have a larger impact on the total cost of ownership than any expense ratio difference between two ETFs.

Mutual funds may also charge a sales load, which is a commission for buying the fund and can be very pricey. This is a different kind of fee and should be avoided as much as possible. Major brokers offer many mutual funds without a sales load and with very low expense ratios.

Risks: Liquidity, closure, and market volatility

Liquidity risk, closure risk, and market volatility are three key risks that investors should consider when investing in ETFs in the US. Here's a detailed overview of each:

Liquidity Risk

Liquidity is a crucial aspect of ETFs, as it determines how easily shares can be bought and sold without significantly impacting the ETF's market price. An ETF with high liquidity allows for swift transactions at prices that closely reflect the intrinsic value of the underlying assets. The primary factors influencing an ETF's liquidity are its composition and the trading volume of its constituent securities.

However, it's important to note that low-volume ETFs may still have adequate liquidity. The concept of liquidity in ETFs goes beyond the traditional understanding of individual stocks and involves both the dealer and secondary markets. The unique creation and redemption mechanisms in the primary or dealer market allow for adjustments in the ETF's supply to meet investor demand, maintaining price stability.

The secondary market liquidity, visible through metrics like trading volume, market depth, and the bid-ask spread, is also essential. High trading volumes and narrow bid-ask spreads often indicate good liquidity, making it more cost-effective for investors to trade.

Closure Risk

ETF closures happen regularly, as many ETFs fail to generate sufficient revenue to cover their costs. While investors usually don't lose their investment when an ETF closes, closures can be inconvenient and costly. A closure creates reinvestment risk and may lead to unexpected capital gains taxes.

To identify ETFs at high risk of closure, investors can consider factors such as low assets under management (AUM), the strength of the ETF issuer, and the fund's rank in its segment. However, it's worth noting that funds with low AUM do not always equate to high closure risk, as there may be other factors at play.

Market Volatility Risk

Market volatility refers to the speed and magnitude of price changes in the market. ETFs that track market volatility, such as VIX ETFs, are highly risky and complex. These products are often used to speculate on or hedge against future market moves. While they can be lucrative, they are not suitable for long-term investment due to their extreme volatility.

Additionally, leveraged ETFs, which aim to amplify the performance of a specific index, carry high risks. While they can be profitable, they can also lead to significant losses if the market shifts unexpectedly. Leveraged ETFs are generally recommended only for short-term traders.

In summary, investors considering ETF investments in the US should carefully evaluate the liquidity, closure risk, and market volatility associated with their chosen ETFs. Understanding these risks is crucial for making informed investment decisions and managing potential downsides effectively.

Frequently asked questions