Etfs: Smart Small-Amount Investing For Beginners

Exchange-traded funds (ETFs) are an increasingly popular investment vehicle for both active and passive investors. They are similar to mutual funds but trade like stocks, allowing investors to gain broad exposure to the market without choosing individual stocks. ETFs are a great way to invest small amounts of money as they have a low barrier to entry, are easy to buy and sell, and are tax-efficient.

ETFs are also highly diversified, low-cost, and provide access to a wide range of asset classes, industry sectors, and international markets. They are traded on major exchanges such as the NYSE and Nasdaq, and their prices fluctuate throughout the trading day.

However, it is important to note that ETFs are not immune to volatility and potential liquidity issues. Additionally, they may be subject to commission fees and could result in taxable income.

Overall, ETFs are a great option for those looking to invest small amounts and build a well-diversified portfolio with minimal effort.

ETFs vs. Mutual Funds

Exchange-traded funds (ETFs) and mutual funds are similar in that they are both professionally managed collections or "baskets" of individual stocks or bonds. They are both less risky than investing in individual stocks and bonds and offer a wide variety of investment options. However, there are some key differences between the two.

• Management: While they can be actively or passively managed, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds come in both active and indexed varieties, but most are actively managed.
• Trading: ETFs trade like stocks and are bought and sold on a stock exchange, with price changes throughout the day. Mutual fund orders are executed once per day, and all investors receive the same price.
• Minimum Investment: ETFs do not require a minimum initial investment and are purchased as whole shares. Mutual funds have minimum initial investments that are normally a flat dollar amount.
• Tax Efficiency: ETFs can generate fewer capital gains for investors since they may have lower turnover and can use the in-kind creation/redemption process to manage the cost basis of their holdings. A sale of securities within a mutual fund may trigger capital gains for shareholders.
• Control: ETFs allow investors more hands-on control over the price of their trade through real-time pricing and more sophisticated order types. Mutual funds are simpler, as the price is calculated after the trading day is over, and all investors who bought and sold that day receive the same price.
• Automatic Transactions: You can set up automatic investments and withdrawals into and out of mutual funds, but you can't do this with ETFs.
• Actively Managed Funds: People invest in actively managed mutual funds in the hopes that they will surpass their benchmarks. ETFs are usually passively managed and track a market index or sector sub-index.
• Fees: ETFs tend to have a lower expense ratio than mutual funds, as their costs are lower by design. Mutual funds may carry other fees, such as sales loads or early redemption fees.
• Suitability: If you make regular deposits, a no-load index mutual fund can be a cost-effective option. ETFs are a good choice if you want lower investment minimums, more control over the price of your trade, or an index fund.

Should I Invest Small Amounts in ETFs?

Investing small amounts regularly in ETFs is an option for those who save each month or with every paycheck. ETFs are similar to index mutual funds but tend to be lower-cost, more liquid, and tax-effective. They also have no minimum investment size, whereas mutual funds often have minimum initial investments of hundreds or thousands of dollars. ETFs can be a good way to gain broad exposure to the market without choosing individual stocks.

Pros and Cons of ETFs

Pros of ETFs:

• Lower costs: ETFs tend to have lower expense ratios than actively managed funds, and because they are passively managed, they don't require analysts, reducing operational expenses.
• Tax efficiency: ETFs are more tax-efficient than mutual funds as they realise fewer capital gains, and investors can control when they incur a taxable event.
• Diversification: ETFs can hold a wide variety of investments, including stocks, bonds, and commodities, reducing an investor's risk.
• Flexibility: ETFs can be traded throughout the day, giving investors more control over how and when they invest.
• Risk management: ETFs offer risk management opportunities such as market, stop-loss, and limit orders.

Cons of ETFs:

• Costs: While ETFs are more affordable than mutual funds, investors still incur trading fees when buying and selling, and expense ratios.
• Limited diversification: In some sectors or foreign stocks, investors might be limited to large-cap stocks, reducing their growth opportunities.
• Lower returns: While ETFs are less risky, they may offer lower returns than high-yielding stocks.
• Control: Investors don't have a say in the individual stocks in an ETF's underlying index, which can be an issue for those with moral conflicts or personal values.
• Intraday pricing: Intraday price movements could induce longer-term investors to trade unnecessarily.

How to Invest in ETFs

Investing in ETFs can be a great way to gain exposure to the stock market, especially for beginners. Here's a step-by-step guide on how to invest in ETFs:

• Open a brokerage account: You need a brokerage account to buy and sell securities like ETFs. You can choose between a traditional brokerage account or a robo-advisor, which builds and manages an investment portfolio for you, often using ETFs. Many brokerages have no account minimums, transaction fees, or inactivity fees.
• Find and compare ETFs: With thousands of ETFs available, you'll need to narrow down your options. Use screening tools offered by most brokers to filter ETFs based on criteria such as asset type, industry, performance, fund provider, etc. Look for ETFs with low expense ratios, no commissions, and strong historical performance.
• Understand the basics of ETF trading: ETFs trade like stocks, so you'll need to understand the basics of placing orders. Common order types include market orders, limit orders, stop orders, and stop-limit orders. Make sure you understand the ticker symbol, order type, number of shares, and price per trade before executing your order.
• Place your order: Navigate to the "trading" section of your brokerage's website and place your order. Double-check all the details before executing the trade.
• Monitor your investment: Congratulations, you've bought your first ETF! You don't need to constantly check its performance, but you can access that information through your brokerage's website or by searching the ticker symbol online.

• Diversification: ETFs offer inherent diversification, which can help safeguard your portfolio against market volatility. They allow you to invest across different industries, company sizes, geographies, and more.
• Tax advantages: ETFs have tax advantages over mutual funds. You may incur lower capital gains taxes with ETFs since they are not traded as frequently as mutual funds.
• Costs and fees: While ETFs typically have low expense ratios, there may be additional costs such as commission fees from brokers. Some brokers have dropped these commissions, so it's important to compare options.
• Liquidity: ETFs are generally liquid, but those that are not traded frequently can be harder to sell.
• Risk of closure: There is a risk that an ETF may close if it doesn't bring in enough assets to cover administrative costs. This can force investors to sell prematurely and incur tax burdens.

Understanding ETF Basics

An exchange-traded fund, or ETF, is a basket of investments such as stocks or bonds. ETFs are traded on exchanges and have unique ticker symbols that let you track their price activity. They are a type of investment fund that offers the best attributes of two popular assets: they have the diversification benefits of mutual funds while mimicking the ease with which stocks are traded.

ETFs let you invest in many securities all at once and often have lower fees than other types of funds. They are known for having very low expense ratios relative to many other investment vehicles. However, it's important to be aware that while costs are generally lower for ETFs, they can vary widely from fund to fund.

ETFs are bought and sold through online brokers and traditional broker-dealers, as well as in retirement accounts. Many online investing platforms, retirement account provider sites, and investing apps offer commission-free trading.

ETFs are made up of individual stocks and other investments. They are not the same as "ETF stock".

ETFs are sometimes focused on certain sectors or themes. For example, SPY is one of the ETFs that tracks the S&P 500, and there are fun ones like HACK for a cybersecurity fund and FONE for an ETF focused on smartphones.

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.

• Stock ETF: A basket of stocks that track a single industry or sector.
• Bond ETF: Used to provide regular income to investors.
• Industry or sector ETF: Funds that focus on a specific sector or industry.
• Commodity ETF: Invest in commodities like crude oil or gold.
• Currency ETF: Track the performance of currency pairs consisting of domestic and foreign currencies.
• Bitcoin ETF: Expose investors to bitcoin's price moves in their regular brokerage accounts.
• Inverse ETF: Earn gains from stock declines by shorting stocks.
• Leveraged ETF: Seeks to return multiples on the return of the underlying investments.

ETFs can be actively or passively managed. Actively managed ETFs have portfolio managers making decisions about which securities to include in the portfolio. They have benefits over passive ETFs but can be more expensive.

ETFs pay dividends if the underlying stocks held within the ETF pay dividends. These companies’ dividends are collected by the ETF issuer and distributed to investors.

When it comes to investing, some people opt for lump-sum investing, meaning they put their entire investment to work right away. Others prefer dollar-cost averaging, where the investment is spread out across equal monthly investments.

Understanding ETF Taxes

Exchange-traded funds (ETFs) are considered more tax-efficient than mutual funds. This is due to their structure, which allows them to defer taxable events until investors sell their shares. However, it's important to understand the specific tax implications of investing in ETFs to make informed decisions.

• Tax Efficiency: ETFs are known for their tax efficiency, which is a significant advantage, especially when compared to mutual funds. This efficiency is due to their low portfolio turnover, longer holding periods for underlying investments, secondary market transactions, and unique creation and redemption mechanisms.
• Capital Gains Taxes: ETFs held for under a year are subject to short-term capital gains taxes, while those held for longer periods qualify for more favourable long-term capital gains tax rates. Selling ETF shares is a taxable event, and investors should be mindful of the holding period to optimise their tax liability.
• Wash Sale Rule: If you sell an ETF and buy the same or a "substantially identical" ETF within 30 days, you may trigger the wash sale rule. This means you cannot offset other capital gains with the loss from the sale.
• Tax-Loss Harvesting: ETFs allow investors to take advantage of tax-loss harvesting strategies. By selling ETFs at a loss, investors can offset capital gains elsewhere, reducing their overall tax burden.
• Distribution of Dividends and Interest: Dividends and interest payments from ETFs are generally taxed as ordinary income or qualified dividends, depending on the underlying holdings. Qualified dividends are taxed at lower capital gains rates.
• ETF Structure and Taxation: The taxation of ETFs can vary depending on their structure and the underlying assets they hold. For example, ETFs backed by physical metals may be taxed as collectibles, while commodity ETFs using futures contracts may be subject to the "60/40" rule for capital gains treatment.
• Mutual Funds vs. ETFs: Mutual funds typically incur more capital gains taxes than ETFs due to their structure. Mutual funds pass on capital gains taxes to investors when they sell securities within the fund, whereas ETFs defer these taxable events until shares are sold.
• Tax Strategies: ETFs offer opportunities for tax planning, such as selling ETFs with losses before their one-year anniversary or using tax-loss harvesting strategies to offset gains.
• Tax-Advantaged Accounts: Investors can also consider holding ETFs in tax-advantaged accounts like IRAs or 401(k)s to further optimise their tax liabilities.

In conclusion, while ETFs offer tax advantages, it's important to understand the specific tax implications based on the type of ETF, its structure, and your individual circumstances. Consulting with a tax professional can help you make informed decisions about investing in ETFs and managing your tax liabilities effectively.

Frequently asked questions