If you’re looking for a way to create a diversified portfolio of stocks, investing in exchange-traded funds (ETFs) could fit the bill. ETFs are investment funds made up of multiple stocks and other assets that can be traded on a stock exchange. But how do they work, how do you invest in them and are they safe? Learn the answers before jumping into ETF investing.
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What is an ETF?
An ETF is a low-cost investment fund that can be traded on a stock exchange such as the New York Stock Exchange (NYSE) or the NASDAQ. These funds are created by ETF issuers and fund managers and are comprised of a basket of securities such as stocks, bonds and futures contracts.
Each ETF is allocated a ticker symbol and can be bought and sold by investors in the same way that you would buy and sell stocks. Unlike mutual funds — which you can only buy or sell at the end of a trading day — ETFs can be traded anytime during market hours. By investing in ETFs, you create a diversified portfolio and spread your investment across a wide range of asset classes, including US stocks, global stocks, fixed income, debt, foreign currencies, commodities and precious metals.
There are two main types of ETFs:
- Passive ETFs. Also known as indexed ETFs or index funds, these funds aim to replicate the returns of a specific index or benchmark. For example, you may want to invest in a fund that tracks the performance of the S&P 500 or the Dow Jones Industrial Average.
- Managed ETFs. Aim to outperform the market or a particular index to generate higher returns according to a human adviser’s investing strategy. These generally come with a higher level of risk and usually have higher management fees.
Quick steps to invest in ETFs
If you’ve researched the benefits and risks of investing in ETFs and you’re ready to get started, you’ll need to sign up for an online trading account:
- Compare and find the best online trading platform for you.
- Sign up for an account. You’ll need to provide personal details and proof of ID.
- Transfer money into your trading account.
- Log in to your account.
- Search for the ETF you want and place a buy order.
Compare online brokers that trade ETFs
ETFs are bought and sold just like regular stocks, so you’ll need to choose an online broker before you can invest.
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What is a stock index fund?
Index funds track a selection of stocks that make up an index. An index fund will try to match the returns of its underlying index. Here are a few examples of the most popular index funds:
- SPY. The SPDR S&P 500 ETF tracks the S&P 500 index, which holds 500 of the market’s top stocks and is often used to represent the American stock market.
- VTI. The Vanguard Total Stock Market ETF represents the entire stock market.
- QQQ. The PowerShares QQQ ETF tracks the tech-leaning NASDAQ 100, which holds the top 100 NASDAQ-listed stocks.
- VEA. The Vanguard FTSE Developed Markets ETF tracks the top non-US stocks from developed nations.
- VIG. The Vanguard Dividend Appreciation ETF tracks companies that have raised their dividends every year for 10 years or longer.
- IWM. The iShares Russell 2000 ETF tracks an index of the top 2,000 small-cap stocks in the US.
- DIA: The SPDR Dow ETF tracks the Dow, which holds 30 of the best blue-chip stocks on the market.
Other types of ETFs
Beyond ETFs that track index funds, there are a variety of other ETFs available for trade, including:
- Bond ETFs. These ETFs invest in fixed-income securities, like bonds. Interest is paid on a monthly dividend and capital gains are distributed through annual dividends. Notable funds in this category include the iShares Core U.S. Aggregate Bond ETF and the Vanguard Total Bond Market ETF.
- Industry ETFs. As the name implies, industry and sector ETFs track specific slices of the economy, like tech, gas and solar. Big funds in this category depend on the market sector you’d like to gain exposure to.
- Commodity ETFs. These funds track major commodities, like the SPDR Gold Trust for precious metals and the Invesco DB Oil Fund for crude oil.
- Currency ETFs. If you’re seeking exposure to international cash, opt for funds that track the performance of foreign currencies like the Invesco CurrencyShares Euro Currency Trust or the Invesco CurrencyShares Japanese Yen Trust.
- Inverse ETFs. Inverse ETFs — also called short ETFs or bear ETFs — short stocks in an attempt to earn a return from their decline. Notable examples include the ProShares Short S&P 500 and the Direxion Daily S&P 500 Bear 3X Shares.
You can always find the current top-performing ETFs listed here.
What are the benefits of investing in ETFs?
There are several reasons you may want to invest in ETFs, including often lower fees and general ease of access. A few other perks:
- Diversify your portfolio. Buying units in just one ETF allows you to invest in many stocks and asset classes at once. By spreading your money across asset classes, you can minimize your level of risk.
- Dividend income. If the underlying assets held by an ETF pay dividends, those dividends will be passed on to you.
- Relatively inexpensive. Creating a diversified portfolio through stocks and other traditional investment options usually requires a significant amount of capital. But if you invest in ETFs, you can get started with as little as a few hundred dollars at a time or less if you use a if you use a robo-advisor or a brokerage account that lets you invest in fractional shares.
- Tax-effective investment. Because most ETFs attempt to track the performance of a specific index, there is usually a low turnover of investments when compared to actively managed funds. This results in fewer capital gains tax liabilities for investors.
- Easy exit. Unlike other types of investments that lock you into a contract for a fixed term, ETFs are open-ended. This means that as long as there’s sufficient liquidity available, you can buy and sell ETFs whenever you choose. For example, if you need fast access to your funds for an emergency or opportunity, you can quickly liquidate your ETF holding.
- Full transparency. The complete list of all underlying holdings of an ETF is provided to the market each day, while the net asset value of the ETF is provided regularly. This means you can constantly monitor your risk exposure and invest with confidence.
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What are the risks of investing in ETFs?
ETFs are often advertised as being safer investments than directly buying stocks, but that’s not always the case. Always do your research before you invest. Here are some of the main risks to consider:
- Leverage. Some ETFs aim to multiply the returns of the underlying assets by as little as 1.5 times or as much as four times. To leverage their assets, they often utilize derivatives like options, so they’re rebalanced daily. That means that in times of high volatility, a big drop in the ETF price will lead to a shrinking of the net asset value (NAV) overnight. And an equally strong rebound the next day won’t bring the ETF back to where it started. Leveraged ETFs are designed for short-term trades only and shouldn’t be bought and held for the long term.
- Inverse returns. Confusion or misunderstanding about inverse ETFs, which aim to increase when the underlying asset’s value goes down or vice versa, can produce the opposite effect of what an investor intends. Make sure you know exactly what the ETFs you buy are designed for.
- Tracking errors. ETFs don’t always mimic the performance of the index they’re designed to track, with fees, taxes and other factors potentially resulting in lower-than-expected returns.
- Risks associated with individual ETFs. The underlying assets held by your ETF also come with their own risks. For example, if your ETF exposes you to investments that may be difficult to sell in certain market circ*mstances — such as commodities or emerging global markets — you’ll need to accept an increased level of risk.
- Currency risks. If you invest in an ETF that tracks the performance of overseas assets, fluctuations in the value of the currencies involved have an impact on the value of your investment.
Top tips when buying and selling ETFs
Like stock prices, the price of ETF units can fluctuate daily. However, many ETFs move up and down in line with the index they’re tracking. A few tips to keep in mind to help you get more out of your ETF investments:
- Compare the price. ETF issuers regularly provide net asset value (NAV) information, often in real time. This is commonly referred to as the indicative NAV (or iNAV). By comparing it with the buy and sell prices quoted by your ETF broker, you can determine whether you’ll get value for your money when buying or selling units.
- Keep an eye out for tracking errors. While many standard ETFs are designed to mimic the performance of a specific market index, they won’t exactly replicate what the index does. This is known as a tracking error and it occurs because fees, taxes and a range of other factors can influence the value of an ETF.
- Time your trades. In the first and last 30 minutes of the day’s trading, there tends to be much more volatility in ETF prices. This means the spread between the ETF offer (for buyers) and bid prices (for sellers) can be wider.
- Know the opening hours of the underlying market. Because spreads are wider to account for potential market volatility when an underlying market is not trading, it can be better to place buy and sell orders when the market for the underlying asset is open.
- Consider limit orders. The iNAV can change quickly throughout the day, as volatility in underlying markets drives it up or down. As a result, it’s safer to place limit orders rather than market orders when buying or selling.
What are the costs of investing in ETFs?
When you invest in an ETF, the most obvious cost is the ETF unit price. Other, less obvious costs you need to be aware of are the management fees and brokerage fees. While ETFs typically charge lower fees than mutual funds, this isn’t always the case.
Read the prospectus provided by the ETF issuer for full details of any fees that apply and how they’ll affect your investments. The main costs to take note of:
- Management fees. Sometimes referred to as the management expense ratio (MER). This fee is charged by the ETF issuer and is usually included in the unit price.
- Brokerage fees. Paid whenever you buy or sell ETF units. These fees vary depending on the online broker, and many have eliminated their commissions on ETFs as of fall 2019.
- The buy/sell spread. This is the difference between the highest price you’re willing to pay for an ETF unit and the lowest price at which a seller will sell.
Physical ETFs vs. synthetic ETFs
Most ETFs available on the market are physical ETFs. Since 2010, the SEC has blocked all new synthetic ETFs from being issued.
- Physical ETFs. Standard ETFs are commonly referred to as physical ETFs, and they work by purchasing the underlying assets — such as stocks — on the benchmark index that the ETF aims to replicate. This means that when you invest in an ETF, you don’t actually own the underlying assets — you own shares of the ETF.
- Synthetic ETFs. A little more complex, not only do they directly own the underlying assets the fund invests in, but they use derivatives to achieve their desired returns. Derivatives are instruments that derive their value from underlying assets such as stocks, commodities or futures contracts. The main advantage of synthetic ETFs is that they allow you to access investments that may otherwise be too expensive or simply impossible to buy.
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Synthetic ETFs have all the same risks as physical ETFs, but they also expose you to a few potential problems:
- Counterparty risks. Synthetic ETFs take out contracts with third parties, which are usually investment banks. If these third parties are financially unable to fulfill any commitments they make to the ETF, such as paying the return on the underlying index to the ETF, the performance of your investment will suffer.
- Commodities risks. Most ETFs that track the performance of commodities are synthetic ETFs that track the futures price of a commodity or index. However, in some circ*mstances, the price of futures differs from the price of the actual commodity, so it’s essential to be aware of whether a fund tracks current or futures commodity prices before you buy.
Bottom line
Before deciding whether ETFs are the best investment solution for you, make sure you’re fully aware of how they work and have an in-depth understanding of the risks involved. When you’re ready, compare online trading platforms to find the best fit for your ETF trades.
Frequently asked questions
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Synthetic ETFs must feature the word “synthetic” in the product name.
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Yes, ETFs collect dividends from their investment portfolios and then distribute those dividends to investors on a regular basis, usually quarterly.
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No. If the index is weighted, the number of stocks purchased by an ETF will reflect the importance of each stock to the performance of the index. For example, an ETF would hold more shares in a large company like Microsoft or Apple than it would in the smallest companies in the index.
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Yes, you can use a margin loan to fund the purchase of ETF units.
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You can purchase as little as one share in an ETF, unless you trade with a brokerage account that allows fractional investing. If fractional shares are enabled, you could invest as little as $1.
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