Etfs: A Guide To Getting Started With 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 at any point during the market day. With over 2,000 ETFs currently on the market, ranging from funds that track stock indices to those focused on specific industries or emerging markets, investors have a wide array of options to choose from. While ETFs offer benefits such as flexibility and diversification, they also come with certain disadvantages, including annual expense ratios that can impact profits. Understanding the advantages and drawbacks of ETFs is crucial for investors looking to make informed decisions about their investment strategies.

How to choose the right ETF for your portfolio

With thousands of ETFs available, choosing the right one for your portfolio can be challenging. Here are some tips to help you select the right ETF:

Understand Your Investment Goals

Before selecting an ETF, it's crucial to have a clear understanding of the role you want it to play in your portfolio. Are you looking for a foundational building block, or do you want to target specific exposures or fill gaps? Knowing what you want to achieve will help you choose the right ETF.

Evaluate the ETF's Strategy

ETFs can have different investment strategies, such as active or passive management. Active ETFs aim to beat the performance of an index, while passive ETFs (or index ETFs) aim to track the performance of an index. Consider which strategy aligns better with your investment goals and risk tolerance.

Assess the Underlying Investments

Look into the underlying investments of the ETF. Understand what percentage of its portfolio is invested in various asset classes and segments to know exactly what you'll be investing in. This information can usually be found in the ETF's fact sheet or prospectus on the fund sponsor's website.

Consider the Expense Ratio

The expense ratio is the annual cost of investing in the ETF, expressed as a percentage of the assets managed. Compare the expense ratios of different ETFs to find the most cost-effective option. Keep in mind that lower expense ratios don't always mean better performance.

Diversification

Diversification is essential to reducing investment risk. Consider choosing ETFs that provide exposure to a diverse range of asset classes, sectors, or geographic regions. This can help spread your risk across different areas and potentially enhance your portfolio's overall performance.

Performance and Tracking Error

While past performance doesn't guarantee future results, it can give you an idea of how well the ETF has achieved its goals. Compare the ETF's performance relative to its benchmark to assess how closely it tracks the underlying index. ETFs with minimal tracking error are generally preferable.

Liquidity and Trading Volume

Consider ETFs with higher trading volumes, as they tend to be more liquid, making it easier to buy or sell your investment when needed. Avoid ETFs with low trading activity, as they may have poor liquidity and wide bid-ask spreads.

Asset Level

Look for ETFs with a minimum level of assets. ETFs with assets above a certain threshold, such as $10 million, tend to have higher investor interest, better liquidity, and tighter bid-ask spreads.

Socially Responsible ETFs

If aligning your investments with your values is important to you, consider socially responsible ETFs. These funds invest in companies that prioritize environmental, social, and governance (ESG) factors. Many of these funds have performed impressively and offer returns comparable or better than their traditional counterparts.

Use Screening Tools

To narrow down your options, utilize ETF screeners provided by brokerage platforms or third-party services. These tools allow you to filter ETFs based on various criteria, such as asset class, expense ratio, performance, and more, making it easier to find ETFs that match your specific requirements.

The pros and cons of investing in ETFs

Pros

ETFs, or Exchange-Traded Funds, have become an increasingly popular investment vehicle since their introduction in the 1990s. They offer investors a range of benefits, including:

• Diversification: ETFs provide access to a basket of stocks or other securities, allowing investors to diversify their portfolios and reduce risk. This diversification is often broader than what could be achieved by investing in individual stocks or mutual funds.
• Trading flexibility: Unlike mutual funds, which are traded once a day after markets close, ETFs can be bought and sold during normal market exchange hours, offering greater flexibility for investors to make timely investment decisions.
• Lower costs: ETFs generally have lower expense ratios and trading fees compared to mutual funds, and some brokers offer low- or no-commission trades on ETFs. Additionally, some ETFs have lower expenses because they track an index, requiring less time and resources from fund management.
• Tax efficiency: ETFs are considered more tax-efficient than mutual funds as they tend to realise fewer capital gains.
• Liquidity: ETFs can be easily bought and sold on major exchanges, providing investors with high liquidity and allowing them to retrieve their money without much difficulty.
• Transparency: As ETFs trade on public exchanges, investors have access to real-time pricing information and can make trades through their individually owned accounts or low-cost smartphone apps.
• Wide range of options: There are thousands of ETFs available on the market, offering exposure to various assets, including stocks, bonds, commodities, currencies, and even cryptocurrencies.

Cons

Despite their many advantages, ETFs also have some potential drawbacks that investors should consider:

• Higher management fees: Actively managed ETFs, which aim to outperform the market, often come with higher fees that can offset returns over time, especially if the ETF underperforms.
• Less control: When investing in an ETF, you buy a basket of stocks aligned with the fund's objectives, which may not match your own investment preferences. This gives you less control over your investments compared to buying and selling individual stocks and bonds.
• Potential for lower returns: While ETFs provide diversification, they may also dilute potentially high returns. Individual stocks or a carefully curated portfolio of stocks may provide higher returns, especially for investors with the time and expertise to manage their investments wisely.
• Commissions and trading costs: Frequent trading of ETFs can result in higher commissions and trading costs, which can erode investor returns over time.
• Limited diversification: Some ETFs, especially sector-specific or thematic funds, may lack broad diversification and concentrate on a small number of stocks within a particular industry or theme.
• Unknown index factor: Many ETFs are tied to relatively unknown or newly created indexes that may lack a track record of performance, posing a risk to investors.
• Limited access to private investments: Due to their structure and low-cost nature, ETFs generally do not provide access to private securities such as private equity or venture capital, which may offer higher returns and further diversification opportunities.

How to buy and sell ETFs

Open a Brokerage Account

Before you can start buying and selling ETFs, you'll need to open a brokerage account. The type of account you choose will depend on your investment goals. Here are some common types of brokerage accounts:

• Taxable accounts: These are regular accounts without special tax advantages, making them ideal for short-term goals. You have flexibility when selling investments but need to consider taxes on gains and dividend payments.
• Retirement accounts: These tax-advantaged accounts, like traditional or Roth IRAs, allow investments to grow tax-deferred or tax-free. However, the IRS imposes contribution limits and withdrawal requirements.
• 529 accounts: If you're saving for college, a 529 account is a good option as money grows tax-free and isn't taxed on withdrawal for qualified educational expenses.
• Custodial accounts: These accounts let you invest and manage money on behalf of a child beneficiary with broader usage than 529s. While there are no tax benefits, the first $2,000 of investment income is taxed at the child's lower rate.

When choosing a broker, consider factors like fees, minimum deposits, types of assets offered, customer service, and special features like tax-loss harvesting or portfolio rebalancing.

Decide on Your ETF Investment Strategy

Determine your asset allocation, or the percentage of each type of investment security, based on your goals and risk tolerance. Generally, you'll want to split your investing dollars between conservative bond ETFs and aggressive stock ETFs. Stock ETFs offer greater growth potential but may fluctuate more in the short term, so adjust your allocation based on your timeline and risk appetite.

Research Your ETFs

Use ETF research tools provided by your brokerage or third-party databases to find ETFs that align with your desired asset allocation. Consider indexes like the S&P 500, NASDAQ, or Dow Jones Industrial Average for the stock component of your portfolio. For the bond-based part, look at indexes like the Barclays Capital U.S. Aggregate Bond Index or focus on Treasury-backed securities for lower risk. Compare expense ratios across providers and choose ETFs with low operating fees, as these fees can eat into your returns.

Fund Your Account and Place Your Order

Transfer cash into your brokerage account to fund your ETF purchases. Then, search for the ETF by its ticker symbol and enter the number of shares you want to buy. Keep in mind that you generally can't buy fractional shares of ETFs, so you may not be able to invest all your available funds at once. Finally, confirm your order, usually by placing a "market order" to buy at the current ETF price.

Set Up a Purchase Plan

Investing in ETFs is often an ongoing process, so consider setting up a regular purchase plan. Arrange for automatic transfers from your checking account to your investment account, and instruct your brokerage to buy as many shares as possible with the available funds. This strategy, known as dollar-cost averaging, can help you pay less per share over time.

Decide on Your Exit Strategy

While you may hold your ETF investments for the long term, it's essential to have a plan for selling your shares. Work with a financial advisor to minimize capital gains taxes through strategies like tax-loss harvesting or tax-efficient withdrawals from retirement accounts.

Buying and Selling ETFs: Key Points

• Buying and selling ETFs is similar to trading stocks. You can trade ETFs through a full-service or online investment dealer during market hours.
• ETFs have ticker symbols and daily trading volumes, just like stocks. However, unlike stocks, low trading volume in ETFs does not necessarily indicate low liquidity.
• When buying ETFs, consider factors like volume, liquidity, and bid/ask spread. You can use an ETF Screener to find ETFs that match your criteria or search for a specific ETF by its name or symbol.
• When selling ETFs, remember that you can do so at any time during the trading day, providing flexibility. However, there is no guarantee that you will get the same price you originally paid.

How to identify the best ETFs for your portfolio

Exchange-traded funds (ETFs) are a great way to invest in a collection of stocks or other assets in just one fund, usually with low expenses. There are thousands of ETFs to choose from, so how do you identify the best ones for your portfolio? Here are some key factors to consider:

• Investment Objective: Start by understanding your investment goals and risk tolerance. Are you investing for retirement, saving for a child's education, or something else? Each goal will have a different time horizon and risk profile, which will impact your choice of ETFs.
• Asset Allocation: Determine the right mix of stocks, bonds, cash, and other investments for your portfolio. This will depend on factors such as your investment timeline, risk capacity, and financial goals. Core holdings should make up the majority of your portfolio and be broadly diversified, low-cost funds covering major asset classes.
• Performance and Fees: Compare the performance of similar ETFs and consider their expense ratios. While past performance doesn't guarantee future results, it can give you an idea of how the ETF has fared over time. Also, watch out for notable differences in fees, as these can eat into your returns.
• Liquidity and Trading Volume: Look for ETFs with sufficient assets under management (AUM) and high trading volume, as these tend to be more liquid. This will make it easier to buy and sell shares without significantly impacting the price.
• Underlying Index or Asset: Consider the underlying index or asset class that the ETF tracks. For diversification, it may be preferable to choose an ETF based on a broad, widely followed index.
• Tracking Error: While most ETFs closely track their underlying indexes, some may deviate. Choose ETFs with minimal tracking error to ensure they stay true to their stated style.
• Sector and Industry Focus: ETFs can focus on specific sectors or industries, such as financials, healthcare, technology, or consumer staples. Choose sectors that are largely uncorrelated to diversify your portfolio effectively.
• Robo-Advisors: If you're unsure how to identify the best ETFs for your portfolio, consider using a robo-advisor. These platforms can build all-ETF portfolios based on your investment goals and risk tolerance.

Remember, the best ETFs for your portfolio will depend on your individual circumstances and investment objectives. It's always a good idea to consult with a financial advisor to get personalized advice before investing.

The different types of ETFs

Exchange-traded funds (ETFs) are a good type of investment because of the benefits they deliver to investors. They can generate significant returns if the right funds are selected. ETFs provide several benefits to investors, including the ability to buy multiple assets in one fund, the risk-reducing benefits of diversification, and generally low costs to manage the fund.

Equity ETFs provide exposure to a portfolio of publicly traded stocks and may be divided into several categories by where the stock is listed, the size of the company, whether it pays a dividend, or what sector it's in.

Stock ETFs tend to be more volatile than other kinds of investments such as CDs or bonds but are suitable for long-term investors looking to build wealth.

Top U.S. market-cap index ETFs give investors broad exposure to publicly traded companies listed on American exchanges using a passive investment approach that tracks a major index such as the S&P 500 or Nasdaq 100.

International ETFs can provide targeted exposure to international publicly traded companies broadly or by more specific geographic areas, such as Asia, Europe, or emerging markets.

Industry ETFs give investors a way to buy stock in specific industries, such as consumer staples, energy, financials, healthcare, and technology.

Dividend ETFs allow investors to buy stocks that pay a dividend. Dividend ETFs are usually passively managed, mechanically tracking an index of dividend-paying firms. This kind of ETF is usually more stable than a total market ETF and may be attractive to those looking for investments that produce income, such as retirees.

Bond ETFs provide exposure to a portfolio of bonds, often divided into sub-sectors depending on bond type, issuer, maturity, and other factors, allowing investors to buy exactly the kind of bonds they want.

Long-term bond ETFs are most exposed to changes in interest rates, so if rates move higher or lower, these ETFs will move inversely to the direction of rates.

Short-term bond ETFs give exposure to bonds with a short maturity, typically no more than a few years. These bond ETFs won't move much in response to changes in interest rates, making them relatively low risk.

Total bond market ETFs give investors exposure to a wide selection of bonds, diversified by type, issuer, maturity, and region.

Municipal bond ETFs focus on bonds issued by states and cities, and interest on these bonds is typically tax-free. Muni bonds have traditionally been one of the safest areas of the bond market.

Balanced ETFs own both stocks and bonds and target a certain exposure to stock, which is often reflected in their name. These funds allow investors to have the long-term returns of stocks while reducing some of the risk with bonds, which tend to be more stable.

Commodity ETFs give investors a way to own specific commodities, including agricultural goods, oil, and precious metals, without having to transact in the futures markets.

Currency ETFs give investors exposure to a specific currency by simply buying an ETF rather than accessing the foreign exchange (forex) markets.

Real estate ETFs usually focus on holding stocks classified as REITs (real estate investment trusts). REITs are a convenient way to own an interest in companies that own and manage real estate, and they typically pay out substantial dividends, making them popular among those who need income.

Volatility ETFs allow investors to bet on the volatility of the stock market through what are called volatility ETFs. Volatility usually rises when the market is falling and investors become uneasy, so a volatility ETF can be a way to hedge your investment in the market.

Leveraged ETFs go up in value more rapidly than the index they're tracking, and a leveraged ETF may target a gain that's two or even three times higher than the daily return on its index.

Inverse ETFs go up in value when the market declines, and they allow investors to buy one fund that inversely tracks a specific index such as the S&P 500 or Nasdaq 100.

Bitcoin ETFs allow you to buy a stake in the cryptocurrency through a share in a fund, making it easy to buy in virtually any amount. These ETFs will track the spot price of Bitcoin directly, so a one percent move in the crypto translates into a one percent move in the fund.

Frequently asked questions