A Beginner's Guide To Etf Investing

Exchange-traded funds (ETFs) are a great way to get started with investing in the stock market. They are a collection of hundreds or thousands of stocks or bonds, managed by experts, in a single fund that trades on major stock exchanges. ETFs are a low-cost way to invest in a diverse range of stocks, bonds, and other assets. They are also more liquid and easier to buy and sell than mutual funds.

ETFs can be purchased through a brokerage account, and many online brokers now offer commission-free trades. When choosing an ETF, it is important to consider the expense ratio, which is the cost to operate and manage the fund, as well as the fund's performance history and holdings.

ETFs provide a simple and low-cost way to gain exposure to a wide range of investments, making them a great option for beginner investors.

Choose a brokerage account

You'll need a brokerage account to buy and sell 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. The process 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).

• TD Ameritrade
• ETrade
• Schwab

When choosing a brokerage account, you should compare each broker's features and platform. If you're a new investor, it might be a good idea to choose a broker that offers an extensive range of educational features.

Understand ETF basics

An exchange-traded fund (ETF) is a pooled investment security that can be bought and sold like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of securities. They can even be designed to track specific investment strategies.

ETFs are a collection of hundreds or thousands of stocks or bonds, managed by experts, in a single fund that trades on major stock exchanges, like the New York Stock Exchange, Nasdaq, and Chicago Board Options Exchange.

ETFs offer diversification, low costs, and the ability to trade shares live during the trading day. They are also more liquid (easy to buy and sell) than mutual funds.

There are two basic types of ETFs: passive and active. Passive ETFs (also known as index funds) simply track a stock index, such as the S&P 500. Active ETFs hire portfolio managers to invest their money. Passive ETFs want to match an index's performance, while active ETFs want to beat it.

ETFs charge fees, known as the expense ratio. You'll see the expense ratio listed as an annual percentage. For instance, a 1% expense ratio means that you'll pay $10 in fees for every $1,000 you invest.

Most ETFs pay dividends. You can choose to have your ETF dividends paid to you as cash or automatically reinvested through a dividend reinvestment plan (DRIP).

ETFs are available on most online investing platforms, retirement account provider sites, and investing apps.

Understand ETF taxes

If you buy ETFs in a standard brokerage account (not an IRA), you should know that they could result in taxable income. Any gains you make from selling an ETF will be taxed according to capital gains tax rules, and any dividends you receive will likely be taxable as well.

ETFs have two major tax advantages over mutual funds. Firstly, if you invest in a mutual fund, you may have to pay capital gains taxes (or, the profits from the sale of an asset, like a stock) through the lifetime of your investment. This is because mutual funds, particularly those that are actively managed, often trade assets more frequently than ETFs. Most ETFs, on the other hand, only incur capital gains taxes when you go to sell the investment. This means you'll pay less tax on your ETF investment overall.

Secondly, as mutual fund managers are actively buying and selling investments, they incur capital gains taxes along the way, and the investor may be exposed to both long-term and short-term capital gains tax. If you're invested in an ETF, you get to decide when to sell, making it easier to avoid those higher short-term capital gains tax rates.

Because ETF share exchanges are usually treated as in-kind distributions, ETFs are the most tax-efficient among all three types of financial instruments (the other two being mutual funds and stocks).

Of course, if you invest in ETFs through an IRA, you won't have to worry about capital gains or dividend taxes. In a traditional IRA, money in the account is only considered taxable income after it is withdrawn, while Roth IRA investments aren't taxable at all in most cases.

Compare costs

ETFs are a great way to get exposure to a wide variety of stocks, bonds, and other assets, usually at a low cost. However, there are some costs to keep in mind when investing in ETFs.

Firstly, ETFs charge fees known as the expense ratio, which is an annual percentage of your investment in the fund that covers operating expenses. For example, a 1% expense ratio means you pay $10 in fees for every $1000 invested. Lower expense ratios save you money, so it's important to compare the ratios of different ETFs before investing.

Another cost to consider is the brokerage account you need to buy and sell ETFs. While some brokers offer commission-free trades, others may charge a fee, so be sure to review their commission and fee schedules.

Additionally, ETFs may be subject to commission fees from online brokers, though many have dropped these commissions to zero.

It's also worth noting that while ETFs don't have minimum investment requirements, they trade on a per-share basis. So, unless your broker offers fractional shares, you'll need the current price of one share to get started.

Finally, if you buy ETFs in a standard brokerage account (not an IRA), any gains from selling and dividends received will likely be taxable.

Choose your first ETFs

There are a few key steps and considerations to keep in mind when choosing your first ETFs.

Determine your investment focus

Before selecting a specific ETF, it's important to first decide on your investment focus. This involves choosing an asset class, such as equities, bonds, or commodities, and determining what percentage of your portfolio will be allocated to each class. You should also consider your diversification strategy. Do you want to spread your wealth across an asset class, or focus on unique market segments?

Select an index

Next, you'll need to choose an index for your ETF to track. A good index covers a large portion of the market you want to follow. Broad market indices are best for diversification, whether you're investing in a single ETF or building a portfolio of multiple ETFs.

Evaluate ETF selection criteria

When selecting an ETF, there are several objective and subjective criteria to consider:

#### Objective criteria:

• Performance and tracking difference: The perfect ETF would deliver the same return as its index. Evaluate an ETF's performance over various timeframes and compare it with its benchmark index and similar ETFs.
• Ongoing charges: ETFs are known for their low costs compared to other investments. The Total Expense Ratio (TER) or Ongoing Charge Figure (OCF) measures the approximate annual charge for holding an ETF and is an important factor to consider.
• Fund size: A fund size of more than £100 million indicates profitability and lowers the risk of liquidation.
• Fund age: It's easier to compare ETFs with at least one year of performance data, but three to five years is better for long-term investments. Older ETFs also allow you to assess the risk of timely closure.
• Trading costs: Order fees are incurred when buying an ETF, and the cost depends on the broker.
• Liquidity: Liquidity refers to how efficiently you can trade an ETF on the stock exchange. Broad market ETFs are usually very liquid, and higher liquidity can lead to lower transaction costs.
• Tax status: Ensure your ETFs have reporting fund status to avoid unexpected tax complications in the future.

#### Subjective criteria:

• Sustainability: Consider whether you want to invest in companies that meet certain sustainability, social, and governance (ESG) standards.
• Replication method: There are three main methods: full physical replication, sampling (partial physical replication), and synthetic replication using derivatives. Each method has its own advantages and risks.
• Income treatment: Distributing ETFs pay income directly into your account, while accumulating ETFs reinvest income back into the product.
• ETF provider: Evaluate ETF providers based on their transparency, accessibility of information, and clarity of important details.
• Fund currency and domicile: While these factors may not significantly impact your ETF selection, it's important to be aware of potential tax complications and regulations associated with different fund currencies and domiciles.

Narrow down your options

With thousands of ETFs available, screening tools can help you narrow down your options based on various criteria such as asset type, geography, industry, trading performance, and fund provider.

Consider your financial goals and risk tolerance

Ask yourself: What are my financial goals? How much risk can I tolerate? How much exposure do I want to a particular sector or asset? These questions will help guide your ETF selection and ensure it aligns with your investment strategy.

Understand the costs

When investing in ETFs, there are typically two types of costs: transaction fees, which occur when buying or selling, and the fund's expense ratio, which is calculated annually.

Know when to trade

ETFs can be traded anytime during the exchange's trading hours, providing flexibility and liquidity. However, markets tend to be more volatile near the open and close of trading hours, so consider trading after the first and before the last 20 minutes of the trading day.

Work with a financial advisor

If you need further guidance, consider consulting a financial advisor. They can help you determine which ETFs are right for your portfolio and provide advice on investment strategies and trade execution.

Frequently asked questions