Etfs: A Smart First Investment Choice?

Exchange-traded funds (ETFs) are an excellent entry point for new investors into the stock market. They are cheap and typically carry lower risk than individual stocks since a single fund holds a diversified collection of investments. ETFs are also ideal for beginning investors due to their many benefits, which include low expense ratios, instant diversification, and a multitude of investment choices.

ETFs are fairly simple to understand and can generate impressive returns without much expense or effort. They allow investors to buy multiple stocks or bonds at once, offering simplicity and broad market exposure. ETFs trade just like stocks on major exchanges such as the NYSE and Nasdaq.

ETFs are not free, however, and if you buy a portfolio of individual stocks on your own, you won't have to pay any management fees. Additionally, investors need to be aware of some disadvantages, such as commissions and expenses, underlying fluctuations and risks, and capital gains distributions.

Overall, ETFs are a great option for first-time investors looking to build a well-diversified portfolio.

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. Both are overseen by professional portfolio managers and can be actively or passively managed.

However, there are some key differences between the two. ETFs trade like stocks and are bought and sold on a stock exchange, with prices fluctuating throughout the day. Mutual funds, on the other hand, are priced once per day and are typically bought for a set dollar amount. ETFs do not require a minimum initial investment and can be purchased for the price of one share, while mutual funds usually have a flat dollar amount minimum investment. ETFs are usually passively managed and track a market index, while mutual funds can be actively or passively managed, with most being actively managed. Mutual funds also tend to have higher fees and expense ratios due to their higher operations and trading costs.

When deciding between ETFs and mutual funds, consider your investment goals and risk tolerance. ETFs are a good choice if you want intraday trades, limit orders, or other features not available with mutual funds. They also tend to be more tax-efficient. Mutual funds may be a better option if you invest frequently or want to set up automatic investments or withdrawals. Actively managed mutual funds may be preferable if you're looking for a fund that could potentially outperform the benchmark index.

Pros and cons of ETFs

Pros of ETFs

• ETFs are a low-cost investment option with lower expense ratios than other types of investments such as individual stocks or mutual funds.
• They are traded on exchanges throughout the day, similar to stocks, offering more control over how and when you invest.
• ETFs provide a diversified investment option, reducing the risk of losing everything in the event of a market swing.
• They are tax-efficient, with fewer taxable events and lower capital gains taxes compared to mutual funds.
• They are flexible, allowing investors to wager on declining markets by short-selling.
• ETFs are more liquid and economical than mutual funds.
• They are simple to understand and can generate impressive returns without much expense or effort.
• ETFs are considered safer than stocks due to their inherent diversification.
• They are great for stock market beginners and require less research than investing in individual stocks.

Cons of ETFs

• ETFs have costs associated with buying and selling, such as trading fees and expense ratios.
• They might duplicate low-volume indexes, increasing the bid/ask spread, and in such cases, buying the actual stock might be a better option.
• ETFs may have limited diversification in some cases, especially for sectors or foreign stocks, where investors might be limited to large-cap stocks.
• The returns and dividends from ETFs may be lower than those from high-yielding stocks.
• ETFs may not be ideal for hands-on investors who want to select specific companies or sectors to invest in based on personal values and sustainability issues.
• There is a risk that an ETF will close if it doesn't bring in enough assets to cover administrative costs, which can lead to unexpected costs and taxes for investors.

How to start investing in ETFs

Exchange-traded funds (ETFs) are an easy and effective way to begin investing. They are fairly simple to understand and can generate impressive returns without much expense or effort.

An exchange-traded fund allows investors to buy many stocks or bonds at once. Investors buy shares of ETFs, and the money is used to invest according to a certain objective. For example, if you buy an S&P 500 ETF, your money will be invested in the 500 companies in that index.

ETFs are similar to mutual funds but trade like stocks. They are priced continuously throughout the trading day and you choose how many shares you want to purchase.

Open a brokerage account

You’ll need a brokerage account to buy and sell securities like ETFs. The majority of online brokers now offer commission-free stock and ETF trades, so cost shouldn't be a major consideration. 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.

Choose your first ETFs

For beginners, passive index funds are generally the best way to go. Index funds are cheaper than their actively managed counterparts, and most actively managed funds don't beat their benchmark index over time.

• Vanguard S&P 500 ETF (VOO) -- Large U.S. companies
• Schwab U.S. Mid-Cap ETF (SCHM) -- Midsize U.S. companies
• Vanguard Russell 2000 ETF (VTWO) -- Smaller U.S. companies
• IShares Core S&P Total U.S. Stock Market (ITOT) -- Broad exposure to over 3,000 stocks
• Vanguard Small Cap ETF (VB) -- Focus on smaller companies

Let your ETFs do the hard work for you

ETFs are generally designed to be maintenance-free investments. Avoid checking your portfolio too often and making emotional, knee-jerk reactions to major market moves. Once you buy shares of some great ETFs, leave them alone and let them produce excellent investment growth over long periods.

How do ETFs help with diversification?

ETFs, or Exchange-Traded Funds, are a great way to diversify your portfolio. They are baskets of individual securities, much like mutual funds but with two key differences. Firstly, ETFs are traded on exchanges like stocks, while mutual fund transactions only occur once the market closes for the day. Secondly, ETFs have lower expense ratios.

ETFs are a simple way to invest in a variety of stocks, bonds, and other assets, usually at a low cost. They are more liquid and transparent than other funds as they trade throughout the day like stocks. This means that you can buy and sell ETFs any time the market is open.

ETFs are also a great way to reduce risk. By investing in an ETF, you gain exposure to a wide range of companies or assets, rather than putting "all your eggs in one basket" by investing in a single company. This means that if some stocks within the ETF fall, the overall impact on your investment will be reduced.

ETFs can also give your portfolio exposure to alternative asset classes, such as commodities, currencies, and real estate. This can be a great way to further diversify your investments and reduce risk.

When choosing an ETF, it's important to look beyond the name and analyse the top holdings of the fund. Two ETFs with similar names may have very different approaches and therefore very different returns. It's also important to compare the performance of similar ETFs, though past performance does not guarantee future results.

ETFs are a great option for beginners as they are simple to understand and can generate impressive returns without much expense or effort. They are also a good choice for investors who want a more hands-off approach, as they are generally designed to be maintenance-free investments.

ETF taxes

The tax efficiency of ETFs is one of their main selling points, but it's important to understand the nuances of how they are taxed. Here's a detailed look at ETF taxes:

Taxation of Capital Gains

ETFs generally offer better tax efficiency than mutual funds when it comes to capital gains. This is mainly because ETFs passively track an index, leading to less frequent buying and selling of securities. As a result, they tend to distribute fewer capital gains. When you sell an ETF, any gains are taxed based on how long you owned it. In the US, if you hold an ETF for more than a year, it's considered a long-term capital gain and taxed at a lower rate than short-term capital gains (held for a year or less). High earners may also be subject to the 3.8% Net Investment Income Tax (NIIT) on ETF sales.

Dividends and Interest Payments

Dividends and interest payments from ETFs are taxed as ordinary income or qualified dividends, depending on the type of dividend and how long you've held the ETF. Qualified dividends are taxed at lower capital gains rates, while ordinary dividends are taxed at higher ordinary income rates. Most ETFs pay dividends, and you can choose to reinvest them or receive them as cash.

Commodity ETFs and the 60/40 Rule

ETFs that invest in commodities like oil, corn, or metals do so through futures contracts. These ETFs often structure themselves as limited partnerships, and any gains or losses are treated as 60% long-term gains and 40% short-term gains, regardless of how long you've held the ETF. This is known as the 60/40 rule.

Precious Metals ETFs and Collectibles Tax Rate

ETFs that invest in precious metals like gold and silver are treated as collectibles for tax purposes. This means that long-term capital gains are taxed at a higher rate of up to 28%, while short-term gains are taxed as ordinary income.

Currency ETFs

Most currency ETFs are structured as grantor trusts, and profits are taxed as ordinary income, regardless of how long you hold the ETF.

Exchange-Traded Notes (ETNs)

ETNs are debt securities linked to an index, and they don't distribute dividends or interest. When you sell an ETN, you may be subject to short-term or long-term capital gains taxes.

Wash Sale Rule

It's important to note that if you sell an ETF and buy the same or a "substantially identical" ETF within 30 days, you may be subject to the wash sale rule. This means you can't offset other capital gains with the loss from the sale, as it's seen as an attempt to artificially book a loss without changing your investment position.

Tax Strategies

One strategy to optimize taxes with ETFs is to sell those with losses before the one-year mark to take advantage of short-term capital loss treatment. Conversely, you can hold ETFs with gains past the one-year mark to benefit from the lower long-term capital gains tax rates. Additionally, you can sell an ETF with a loss and buy a similar but different ETF to maintain exposure to the same sector while still being able to claim the loss for tax purposes.

Frequently asked questions