Etfs: A Smart Investment Strategy For Your Money?

Exchange-traded funds (ETFs) are a popular investment choice, especially for beginners. They are similar to stocks but offer more diversification. ETFs are collections of assets, often stocks, bonds, or a mix of the two, and they trade on stock markets. When you buy a share of an ETF, you get an indirect stake in all the stocks held by the fund, which can be dozens or even hundreds of stocks. This provides instant diversification, reducing your risk and increasing your returns. ETFs are also more flexible than traditional open-end funds, as they can be bought and sold during market hours, and they often have lower operating costs and better tax efficiency. However, ETFs may underperform individual stock investments, and there are management fees to consider. When deciding whether to invest in ETFs, it's important to understand their advantages and disadvantages and how they fit into your overall investment strategy and goals.

ETFs vs. Stocks

When it comes to investing, there are many options to consider, each with its own advantages and disadvantages. Two of the most popular investment options are individual stocks and exchange-traded funds (ETFs). So, what's the difference between the two, and which is the better option?

Stocks

A stock represents fractional ownership in a company. When you buy a stock, you're investing in the success of that specific company and no other. Stocks are typically traded on exchanges such as the New York Stock Exchange (NYSE) or Nasdaq.

#### Pros of Stocks:

• Very high returns: A single stock can potentially return much more than an ETF, as you receive the performance of that individual company.
• Dividends: Some companies pay dividends to shareholders, meaning they pass on a percentage of their profits.
• Zero commissions: Many brokers charge no fees for buying and selling stocks.
• Lower capital gains tax rates: If you hold a stock for more than a year, you may benefit from lower capital gains tax rates.

#### Cons of Stocks:

• Volatility: Stocks can fluctuate significantly from day to day and month to month, and you may need to sell at a loss.
• Risk: If the company you've invested in performs poorly, you could lose all your money.
• Time-intensive: Analysing and valuing individual stocks requires a lot of time and effort.

ETFs

On the other hand, ETFs are collections of assets, often stocks, bonds, or a mix of both. When you buy a share of an ETF, you own an indirect stake in all the stocks or other assets held by the fund. ETFs are bought and sold on major stock exchanges and can be traded at any time during the trading day.

#### Pros of ETFs:

• Diversification: ETFs provide exposure to dozens or even hundreds of stocks or other assets in one packaged security, reducing risk and increasing returns.
• Lower fees: ETFs have lower expense ratios than mutual funds, and some brokers offer commission-free ETF trading.
• Less volatile: ETFs that track an index of stocks generally have less pronounced price movements than individual stocks, providing more stable returns.
• Simplicity: ETFs require less expertise to invest in compared to stocks.
• Tax efficiency: ETFs have a tax advantage over mutual funds, as capital gains tax is only incurred when the ETF is sold by the investor.

#### Cons of ETFs:

• Lack of control: ETF investors cannot choose the specific stocks held in the fund.
• Potential underperformance: While ETFs provide stable returns, they may underperform the best-performing individual stocks.
• Fees: ETFs charge an expense ratio, which is an incremental cost for owning the fund.

The choice between investing in ETFs or stocks depends on your financial goals, risk tolerance, and knowledge of the market.

ETFs are a good option for those who want instant diversification without spending a lot of time and effort on investing. They are also suitable for those who want to invest in a specific trend or industry without picking individual winners.

On the other hand, stocks are better for those who enjoy analysing and following individual companies and have the time to devote to investing. Stocks can also be a good option for those who want to find outperformers, such as Amazon or Microsoft, and beat the market.

Ultimately, many investors choose to blend these two strategies, holding a portfolio that consists mostly of ETFs with a small percentage of individual stocks.

Pros and cons of ETFs

Pros of ETFs

ETFs are a powerful type of investment with several advantages over other types of investments such as individual stocks or mutual funds. Firstly, they offer instant diversification, meaning your money is spread across different investments, reducing your risk and increasing your returns. Secondly, ETFs tend to have lower costs than other investments like mutual funds due to their passive management and lower expense ratios. Thirdly, ETFs are traded on exchanges throughout the day, offering more flexibility and control compared to mutual funds, which only trade once per day. Fourthly, ETFs are tax-efficient as they incur fewer capital gains taxes than mutual funds since they are passively managed and have fewer trades. Finally, ETFs provide risk management opportunities and are suitable for both long-term and short-term investors.

Cons of ETFs

Despite their advantages, ETFs have some drawbacks. Firstly, ETFs incur costs such as trading fees and expense ratios, which can add up over time. Secondly, not all investments are available through ETFs, especially in emerging markets or for unique assets like collectible cars or art. Thirdly, ETFs might offer limited diversification in certain sectors or foreign stocks, where investors may be restricted to large-cap stocks only. Fourthly, ETFs may not be ideal for hands-on investors who want to choose specific companies or asset classes based on their values and sustainability preferences. Lastly, while ETFs are generally less risky than individual stocks, the potential returns may be lower, and investors might earn more by taking a chance on stocks.

How to get started with ETFs

Exchange-traded funds (ETFs) are a great option for beginners looking to invest. They are similar to stocks but offer much more diversification. ETFs are also a more liquid investment and have a very low investment threshold.

Set up an online account:

You will need to open an account with a broker or trading platform. This is where you will buy and sell ETFs.

Fund your account:

Once your account is set up, you will need to deposit money into it. This can be done through various methods, such as a bank transfer or credit card.

Purchase ETFs:

When you are ready to invest, you can purchase ETFs using their ticker symbol and indicating how many shares you want. The number of shares you buy will depend on the current pricing and your financial situation. ETFs offer entry-level access, allowing you to buy as little as a single share or even fractional shares with some brokers.

Look for low or no transaction costs:

Fees vary by broker, but it is advisable to look for options with very low or no transaction costs. Many traditional brokerages now offer commission-free trading on ETFs.

Choose a diverse ETF:

ETFs are a great way to gain exposure to a variety of investments. Look for ETFs that track a broad market index, such as the S&P 500, or that provide exposure to different asset classes like bonds, currencies, and commodities.

Consider a robo-advisor:

If you don't feel confident choosing specific ETFs, consider using a robo-advisor service. These platforms will automatically invest on your behalf, often recommending low-cost ETF portfolios.

By following these steps, you can get started with ETFs and take advantage of their benefits, such as diversification, flexibility, and low costs.

Tax implications of ETFs

ETFs are considered more tax-efficient than traditional mutual funds. They are taxed in a similar way to mutual funds, but their structure means taxes are minimised for the holder. ETFs have fewer "taxable events" than mutual funds.

Mutual funds incur more capital gains taxes than ETFs because they trigger taxable events more often. Mutual fund managers need to constantly rebalance the fund by selling securities to accommodate shareholder redemptions or to reallocate assets. This creates capital gains for shareholders, even if they have an unrealized loss on the overall mutual fund investment. ETFs, on the other hand, accommodate investment inflows and outflows by creating or redeeming "creation units", baskets of assets that approximate the entirety of the ETF investment exposure. This means the investor is usually not exposed to capital gains on any individual security in the underlying structure.

ETFs are also more tax-efficient because they create and redeem shares using in-kind transactions, which aren't considered sales and therefore don't trigger taxable events. This is due to a section of the US Internal Revenue Code of 1986, which exempts the distribution of capital gains when the shares whose values appreciated are given in kind to redeeming investors.

However, selling your shares in an ETF is a taxable event. If you hold an ETF for more than a year, you will pay up to 20% in long-term capital gains tax, plus an additional 3.8% net investment income (NII) tax if your income is high enough. If you hold an ETF for less than a year, it is taxed as a short-term capital gain, at ordinary income rates of up to 37%, plus an additional 3.8% NII tax for some.

ETF dividends are taxed according to how long the investor has owned the ETF fund. If the investor has held the fund for more than 60 days before the dividend was issued, the dividend is considered a "qualified dividend" and is taxed anywhere from 0-20% depending on the investor's income tax rate. If the dividend was held for less than 60 days, the dividend income is taxed at the investor's ordinary income tax rate.

There are some exceptions to the general tax rules for ETFs. ETFs that invest in currencies, metals and futures have specific rules and follow the tax rules for the underlying assets, which are usually taxed as short-term gains.

ETFs for beginners

Exchange-traded funds (ETFs) are a collection of assets, often stocks, bonds, or a mix of the two. They are similar to stocks in that they are traded on a stock market, but they are also taxed at short-term or long-term capital gains rates. ETFs are bought and sold during market hours, and their pricing is continuous and varies based on the changing intraday value of the underlying assets in the fund.

ETFs are a good option for beginners as they are a more diversified and lower-risk investment than stocks. They are also more cost-effective and have a very low investment threshold. ETFs are also more liquid than stocks, meaning they can be easily bought and sold.

To start investing in ETFs, you need to set up an online account through a broker or trading platform and fund the account. When purchasing ETFs, you can use their ticker symbol and indicate how many shares you want. You can buy as little as a single share, and some brokers even allow you to buy fractional shares.

• Understand the basic structure and liquidity of ETFs: ETFs have an open-ended structure, which means that the supply of ETF units can be adjusted to cater to market demand. The liquidity of an ETF is determined by the liquidity of its underlying holdings rather than its fund size or daily volume traded.
• Know the Net Asset Value (NAV) and Indicative Net Asset Value (iNAV): The NAV is the net value of the ETF's underlying holdings, which can be used as a guide to determine the 'fair value' of the product. The iNAV is the estimated intra-day 'fair value' of the ETF, which updates in real time and can help determine a fair price to buy or sell.
• Consider currency hedging: If the ETF invests in international shares, consider whether it is "hedged" or "unhedged" in terms of foreign currency. A "hedged" ETF removes the impact of currency fluctuations, while an "unhedged" ETF includes the relative performance of the foreign currency in the investment.
• Understand bid and offer spreads: All ETFs are subject to bid and offer spreads, which is the difference between the NAV of the fund and the price at which it can be bought or sold. The spread is the market maker's compensation for the time and financial risk they bear.
• Know the difference between 'market orders' and 'limit orders': When placing an order, you can choose between a 'market order', where you accept the price the market is willing to pay, or a 'limit order', where you determine the price you are willing to bid.
• Time your purchases and sales: Avoid trading near the market open and close, as market makers may experience higher risk and wider spreads during these periods.

ETFs are a great option for beginners due to their diversification, low risk, and ease of use. However, it is important to understand the structure and potential risks of ETFs before investing. By considering the above factors, beginners can make more informed decisions when investing in ETFs.

Frequently asked questions