If you’re new to investing, you’re probably familiar with the most basic investments: stocks and bonds. But it’s also important to understand exchange-traded funds (ETFs). ETFs are a particularly good choice for new investors, because they provide you with a diverse portfolio right from the get-go, and they also tend to be less risky than purchasing individual stocks.
So, what are ETFs, and how can you take advantage of them? Here’s a guide on how to invest in ETFs, including some of the best funds for new investors.
What Is An Exchange-Traded Fund (ETF)?
An ETF is similar in many respects to a mutual fund. Investors pool their assets, which are then invested into stocks, bonds, or other financial instruments. However, ETFs are traded on the stock exchange, whereas you have to invest in a mutual fund directly.
Most ETFs are designed to track a particular stock index, industry sector, or commodity. Some invest in U.S. assets only, while others focus on other countries and regions, and some will invest in any country. The share prices will fluctuate throughout the day as the fund’s underlying assets change in value. This is yet another difference between ETFs and mutual funds, which only change value once per day at close of market.
Understanding Exchange-Traded Funds
The reason ETFs are called “exchange-traded funds” is because they’re traded on an exchange, like a stock. This is the reason share prices will fluctuate throughout the day. As people buy and sell them on the open market, the price will naturally change. On the other hand, mutual funds aren’t traded on an exchange. You have to buy them directly or purchase them through a financial institution. Fund shares are priced at the end of the market day, after recalculating the value of the fund’s assets. Trades are then executed based on the recalculated value.
At the same time, ETFs are different from buying individual stocks. When you purchase a regular stock, you’re purchasing shares in a particular company. This can be risky since your fortunes are entirely dependent on a single company’s performance. If you’re wealthy, you can hire a financial advisor to invest in a variety of stocks. If you’re a hardcore market enthusiast, you can even invest enough money to diversify your own assets. This spreads out the risk. Since the market as a whole tends to go up, your odds of success go up the more diverse your investments are.
But for most people, diversifying your own assets is a significant challenge. An ETF takes care of that for you, by investing in dozens, hundreds, or even thousands of stocks, bonds, commodities, and other assets. Some are focused on companies of different sizes, and some focus on particular industries. Some even focus on commodities markets, such as rare earth elements.
Here are some more important things to understand about ETFs:
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Passive ETFs vs. active ETFs: Passive ETFs simply track a stock index, and don’t require any complex financial management. Active ETFs hire financial managers to pick and choose specific investments.
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Expense ratios: The expense ratio is an annual fee you pay, which funds the ETF’s operations. This fee will be a percentage of your total investment; the lower the number, the less you pay.
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Dividends: If your ETF pays a dividend, you’ll be asked to decide what to do with that money. You can take an annual cash payment, or you can use a dividend reinvestment plan (DRIP), to put the money back into the ETF.
Understanding ETF Taxes
If you’re purchasing your ETFs through an ordinary brokerage account, your gains will be subject to capital gains taxes. This is true for gains from selling shares at a profit and any dividend payouts you receive.
The exception to this is if you’re investing in an ETF through a retirement account. With an IRA or 401(k), the money you take out in retirement will be considered ordinary income, not capital gains. If you’re investing through a Roth IRA, you won’t be subject to any taxes at all.
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Types Of ETFs
ETFs come in a number of varieties. Some are designed to be more conservative, while others are geared towards more aggressive investors. Let’s look at some of the different varieties.
Passive & Active ETFs
ETFs fall into two main categories: passively-managed and actively-managed. A passively-managed ETF is designed to match the performance of a particular stock index, sector, or region. For example, an ETF might focus on large-cap companies in emerging markets or American tech stocks. Many simply invest in stocks from an index like the S&P 500.
An actively-managed ETF is designed to outperform a particular stock index or sector. A professional financial advisor researches individual companies and buys and sells them with an aim to maximize gains. These funds can sometimes have advantages, but they also charge higher fees.
Bond ETFs
Bond ETFs are designed to provide a steady stream of income. Exactly how much income they provide depends on the bonds they invest in. Most funds will focus on U.S. government bonds, AAA-rated corporate debt, and other conservative investments. These funds provide the most reliable income, but at the lowest rates. Some funds will focus on riskier bonds, and some will buy junk bonds. These represent riskier investments, but the potential rewards are substantial.
Stock ETFs
The most common type of ETFs invest in stocks. The idea is to provide a broad, diverse portfolio even to small investors. If you want to invest in a mutual fund, you may need to invest thousands of dollars at a time. If you just want to put away a few dollars a week, that’s not a viable option. With an ETF, you can build a similarly-diverse portfolio for a smaller benefit.
Industry/Sector ETFs
Industry ETFs and sector ETFs put their money into a single industry or sector. For instance, a financial ETF might focus its investments on the financial industry. The tech sector is particularly popular right now, due to the historically high levels of growth. Different sectors and industries will represent different levels of risk and reward.
Some funds will invest in two or more complementary industries. For example, an energy ETF could invest in both petroleum stocks and green energy stocks. When market events negatively impact the petroleum stocks, the green energy stocks are likely to benefit, and vice-versa. The fund can then move its assets around based on market conditions.
Commodity ETFs
Commodity ETFs are a unique opportunity for small investors to buy commodities. Because you’re not buying the commodity itself, you don’t have to worry about storage and insurance expenses. These types of ETFs tend to have lower returns, but they also tend to perform better during recessions. As a result, they’re a good way to hedge your portfolio against a downturn.
Currency ETFs
Currency ETFs invest your money into various foreign currencies. If those currencies go up in value against the dollar, your investment will grow, and if the currencies lose value compared to the dollar, your investment will shrink. Some ETFs even invest in cryptocurrencies like Bitcoin.
Inverse ETFs
Inverse ETFs try to earn money by shorting stocks. In short-selling, an investor borrows a stock and sells it. They then repurchase it later at a lower price and return the share. The price difference is kept as a profit. Inverse ETFs are another good hedge against market downturns, because the faster stocks are plummeting, the more of a windfall short-sellers are making.
Be aware that many so-called inverse ETFs are actually ETNs. An ETN is an exchange-traded note, which works a little bit differently. Talk to your financial advisor to see if an ETN would be appropriate for your portfolio.
Leveraged ETFs
Leveraged ETFs invest into derivatives and options. Without getting too far into the weeds, these are mechanisms that allow investors to bet on the price of future stocks. This can enable funds to return a multiple on the return for a given exchange.
Leveraged ETFs are a higher-risk, higher-reward investment than ordinary ETFs. For example, if the S&P 500 returns 4% on the year, a 2x-leveraged ETF returns 8% – a healthy profit. But if the S&P 500 loses 4%, the same 2x-leveraged fund loses 8%.
How to Invest in ETFs
Because ETFs are traded on the stock exchange, you trade them like you would an ordinary stock. As a result, the investment process is fairly easy; all you have to do is open a brokerage account and make your investment. Some brokerages even allow you to purchase partial shares!
Let’s take a closer look at the investment process.
1. Find an Investing Platform
Step 1 is finding a platform to make your investments. In the old days, this meant going to a stock broker in person. Nowadays, you can join any number of online brokerages that provide the same service much more conveniently. Not only that, but smartphone apps like Robinhood allow you to trade directly from your smartphone.
Which option is best will depend on your needs. Brokerages charge fees, but they also provide educational content and guidance to help you make more informed decisions. Apps are often free, but you’ll be on your own when it comes to advice.
2. Open a Brokerage Account
Once you’ve chosen a platform, the next step is to open an account. This can be done online, and most brokers these days will not charge inactivity fees or require account minimums. Check ahead of time to be sure. You will, however, need to provide some basic “know your customer” information. This will include some personal information, such as your Social Security number.
Once your account is set up, you’ll be ready to start investing. If you’d rather not go through the trouble of choosing an ETF or making your own trades, it can be worth considering a robo-advisor. A robotic advisor will build your portfolio for you and execute all your trades, for a modest fee of 0.25%.
3. Decide Which ETF to Buy
If you haven’t already researched which ETFs to buy, it’s important to do that now. There are many options to choose from, so it can help to decide what sector, index, or company size to invest in. This can help you narrow down your choices. After that, there are some other things you should think about:
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Expense ratios – ETFs charge an annual fee, which covers their administrative expenses. This fee, or expense ratio, averages around 0.12% for a passively-managed fund. Because actively-managed funds have higher expenses, their expense ratios can be considerably higher.
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Commissions – Traditionally, brokers have charged a commission on individual trades. With the advent of online trading, this has become rare. Make sure your broker doesn’t charge any commissions on ETF trades.
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Performance – Look at an ETF’s past performance. This is no guarantee of future performance, but it’s certainly worth considering.
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Volume – Volume is the measure of how many individual shares have been traded in a particular time period. The higher the volume of a given fund, the more popular it is.
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Price – Unless your trading platform allows you to buy fractional shares, you’ll need to be able to afford at least one share of the ETF in order to buy it.
4. Place a Trade
Now that you know what ETF you’re purchasing, it’s time to execute a trade. In the context of stocks, bonds, and ETFs, a “trade” can refer either to a purchase or a sale. Go to the trading screen on your trading app or brokerage website, and search for the ETF’s ticker symbol. This is a series of all-caps letters, like “VOO,” that’s unique to a particular ETF. Make sure to double-check the ticker symbol before you complete the trade.
Two factors will determine the current share price. The first is the “bid,” the highest price that people are currently willing to pay. The second is the “ask,” which is the lowest price people are willing to sell for. The average of these numbers is the sticker price, but your actual purchase or sales price can be different.
There are a few ways you can place an order for ETF shares. Here are the most common ways you’ll be able to buy:
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Market order – Immediately purchase shares at the best available price.
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Limit order – Purchase shares, but only if they’re available below a certain price.
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Stop order – Purchase shares when the price drops or rises to a certain point, and execute the full order, even if some shares must be purchased outside of the limit.
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Stop-limit order – Purchase shares when the price drops or rises to a certain point, but only buy as many shares are available within the limit.
5. Let Your ETFs Work for You
That’s it! You’ve now purchased shares in an ETF. This is a great first step in your investment journey. Now, you can continue to invest, and diversify your investments by putting your money into different stocks and funds. The best thing is that you don’t need a ton of advanced tools to monitor your performance. Many apps will show you your investments’ current value on a nifty chart.
Pros & Cons of ETF Investing
Now that we know what ETFs are and how to invest in them, what makes them desirable – or not – for your portfolio? Here are some of the benefits and drawbacks of ETF investing.
Advantages of ETF Investing
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Reduced cost – If you wanted to buy all the stocks in an ETF by yourself, it would be absurdly expensive. You’d need enough cash on hand to buy hundreds, or even thousands, of shares. With an ETF, you’re getting wide diversification even from a single share. ETFs typically have lower trading costs and expense ratios, as well.
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Diversification – Instead of buying a single stock, you spread your risk across an entire industry, or even an entire index.
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Liquidity – Unlike with a mutual fund, you don’t have to go through a complex dog-and-pony show just to sell your shares. If you decide to cash out, all you have to do is open your app and sell your shares. You can then spend the cash, or invest it in a different asset.
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Disclosure – Because ETFs are publicly-traded, you get up-to-date information on their holdings. Mutual funds only report their holdings on a monthly or quarterly basis.
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Variety – No matter what market or industry you want to invest in, there’s almost certainly an ETF that focuses on it.
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Bond ETFs are easy – Investing directly in bonds is a headache, but casual investors can still profit by purchasing a bond ETF.
Disadvantages Of ETF Investing
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Liquidity and diversification – Some ETFs trade at low volumes, and can be difficult to sell. Along the same lines, while most ETFs are very diverse, some focus on niche industries and are decidedly not diverse.
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Fund closure – If the fund doesn’t have enough money to cover its administrative costs, it could be forced to close down. In this case, investors have no choice but to cash out their shares. This could mean taking major losses, and even if you cash out at a profit, you’ll be forced to pay capital gains tax.
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Reduced upside – While ETFs have less risk than investing in individual stocks, they also provide less potential reward. You won’t see the same kind of growth as people who invested in Tesla or Amazon.
10 Best ETFs to Invest in
Here are some of the best ETFs to invest in for 2022. Remember, nobody has a crystal ball, and even the best-performing funds can experience losses. That said, these funds are well-diversified, and should show strong performance in the long term.
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Vanguard S&P 500 ETF (VOO) – Tracks the S&P 500 index, which are larger U.S. companies.
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Schwab U.S. Mid-Cap ETF (SCHM) – Invests in mid-cap U.S. companies.
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Vanguard Russell 2000 ETF (VTWO – Invests in small-cap U.S. companies.
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Invesco QQQ Trust (QQQ) – Tracks the Nasdaq-100 index, a high-growth index with a lot of tech companies.
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Schwab International Equity ETF (SCHF) – Invests in large-cap non-U.S. companies.
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Vanguard High-Dividend ETF (VYM) – Invests in companies that pay large dividends.
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Schwab Emerging Markets Equity ETF (SCHE) – Invests in companies based in developing countries.
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Schwab U.S. REIT ETF (SCHH) – Invests in real estate investment trusts.
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Schwab U.S. Aggregate Bond ETF (SCHZ) – Invests in a variety of U.S. bonds, with different terms and ratings.
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Vanguard Total World Bond Fund (BNDW) – Similar, but invests in bonds from all over the world, including the U.S.
Summary
Learning how to invest in ETFs is just as easy as investing in stocks and bonds. All you have to do is open a brokerage account, choose an ETF, make your investment, and watch your money grow. Along the way, you won’t have to pay the kinds of fees you’ll pay with a mutual fund. For first-time investors in particular, this can represent an excellent value.
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FortuneBuilders is not registered as a securities broker-dealer or an investment adviser with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority (“FINRA”), or any state securities regulatory authority. The information presented is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing provided shall constitute financial, tax, legal, or accounting advice or individually tailored investment advice. This information is for educational purposes only is not meant to be a solicitation or recommendation to buy, sell, or hold any securities mentioned.
