There are many advantages to investing in ETFs. Not only can ETFs provide you with diversification across a market, or specific market sector, ETFs can also be incredibly liquid – allowing you to buy and sell the ETF with ease. If you’re wondering what an ETF is, or how to invest in ETFs, read on. We’ll cover everything you need to know about this powerful investing tool.
What Is an ETF?
Let’s review the basics like what an ETF is. Simply put, an ETF is an Exchange Traded Fund. These funds track the performance of a market index, a specific commodity, or a specific sector of the market – such as technology, retail, or healthcare. An ETF will be an aggregate of numerous individual companies or securities.
Below are some common terms and definitions:
- Ticker Symbol: The ticker symbol is a security’s unique identifier. Ticker symbols apply to individual stocks, mutual funds, commodities, cryptocurrencies, REITS and ETFs.
- Price: The price of an ETF is how much it would cost you to purchase a single share. Similar to a stock, the price displayed on a quoting platform (the TV, Yahoo Finance, Google Finance, or a brokerage) is the price you must pay to own a share.
- Order Type: An order type is how you want your order executed. Do you want to buy the current security at the current market price? If so, submit a market order. Do you want to buy the security when the price reaches a certain level? If so, submit a limit order.
- Number of Shares: The number of shares typically refers to the number of shares outstanding/available for purchase on the open market. Alternatively, the number of shares can refer to how many shares you actually purchased, or plan on purchasing.
- Commission: The commission refers to how much your brokerage will charge you to execute a trade. Online brokerages, such as TD Ameritrade, allow you to execute trades without paying a commission.
- Volume: The volume highlights how many shares are exchanged at any given moment. You can follow the volume by the minute, by a specific time block (such as 5, 10, 20, 30 minutes), by the hour, or by the day/week/month. The more volume a security has, the more liquid the investment is.
- Performance: The performance of a security indicates what its previous return was for a specific period of time. Performance records are between a quarterly, and multi-year timeline.
- Holdings: Holdings refers to what stocks or securities make up a specific ETF, mutual fund, or portfolio. For example, if you are investing in SPY, the holdings are the 500 companies in the S&P 500.
- Expense Ratio: An expense ratio is relevant to REITS, mutual funds, and ETFs. Simply put, an expense ratio is how much you’ll pay for the management fee of the investment.
Difference Between an ETF and Mutual Fund
An ETF and Mutual Fund are closely related. The main differences are:
- Mutual funds are typically under active management by a fund manager. The fund manager is actively selecting which securities make up the specific fund, and they are making manual buying and selling decisions.
- Due to the active management, mutual funds typically have a higher fee associated with them.
- A mutual fund will often have a minimum investment requirement. This can be a few thousand dollars!
- More often than not, a mutual fund charges a trading commission. Trading commissions, and fund fees, can erode the overall profitability of your performance.
Whereas with an ETF, an investor will appreciate:
- Lower fees, both in terms of commission and management fees
- No minimum investment requirement. For example, you can buy one share of SPY, or 20,000 shares of SPY.
- High liquidity. The right ETF can provide a great deal of liquidity, which is important for active traders.
With that said, a mutual fund and an ETF are aligned in the sense that they both provide a wide range of diversification. Unlike hand selecting which stocks belong in your portfolio, you can buy a wide range of stocks when you invest in a mutual fund and ETF.
For example, purchasing the SPY ETF gives you access to the 500 companies in the S&P 500. The SPY ETF essentially tracks the performance of the S&P 500; so if the S&P 500 is up 2% in a week, SPY will also be up 2% for that week.
Pros & Cons of Investing in ETFs
Without question, every investment comes with unique pros and cons that you need to consider before making an investment decision. Here are the most common pros and cons of investing in an ETF.
- The diversification of an ETF is a tremendous benefit. Instead of hand selecting a wide range of stocks, you can invest in a single ETF that has all the diversification you’ll ever need ‘built into it’.
- There are plenty of investment options. There are currently over 2k ETFs you can choose from!
- Generally speaking, an ETF is passively managed. What does that mean? The fee for investing in an ETF is minimal, and often free!
- Live time pricing. ETFs are priced second by second throughout the trading day.
- High liquidity. If you’re trading, or moving a lot of money, liquidity is of top importance. ETFs are often incredibly liquid, trading millions upon millions of shares per day.
- You may be able to generate a greater return if you personally managed your account, and/or if you had a mutual fund manager manage your account.
- If you’re investing in an ETF to gain more international market exposure, you really need to understand the companies of the international ETFs you invests in. For example, you may believe Germany is primed for success, and the country will experience strong economic growth. You decide to invest in a German based ETF. That ETF may be made up of companies that are based out of Germany, but generate their sales and revenue from other countries. Tracing something back to the source is often time consuming but, what you see is not always what you get.
5 Steps to Invest in ETFs
By now you may be questioning how to invest in ETFs. This can be complete in 5 simple steps!
Step 1: Research ETFs & Select a Brokerage
First and foremost, you’ll want to research which ETFs you want to invest in, and select a brokerage to facilitate the trade. Here are some of our recommendations.
|Brokerage||Why This Brokerage?||ETF Options|
|Vanguard||Vanguard is an icon in the investing world, and has a wide range of investment options.||Vanguard provides their customers with a wide range of investment options, including numerous ETF choices. A list of available ETFs can be found here.|
|Fidelity||Fidelity provides commission free trading, strong customer service, and online/mobile apps.||Fidelity also has commission-free ETF investing, which range from active equity ETFs, factor ETFs, sector ETFs, stock ETFs and even ETFs for bonds.|
|TD Ameritrade||TD Ameritrade is a world class online brokerage that provides outstanding customer service, strong technical analysis tools, and countless hours of educational materials.||Similar to Fidelity, TD Ameritrade provides an incredibly wide access to numerous ETF types. Their website offers great insight into all their ETF offerings.|
|E*Trade||E*Trade is a low cost, and often free, online brokerage.||E*Trade also provides access to a wide ETF offering. From market ETFs to drilling down on specific sectors, there is certainly no shortage of options.|
|Charles Schwab||Charles Schwab purchased TD Ameritrade for $22B in 2020. Without question, Charles Schwab is one of the biggest names in the investing world.||Considering Charles Schwab purchased TD Ameritrade, all the ETFs found in TD can be purchased through Schwab as well. Additionally, Charles Schwab has over 25 ETFs that are directly managed by the Charles Schwab Investment Management Group.|
Step 2: Determine Which Type of Account to Open
Now that you know what brokerage you plan on using, and which ETF you find most appropriate for your goals, it’s now time to determine your account type.
- General Investment Account: A general investment account allows you to make both long and short term investments. You can actively trade with these accounts, or you can take a more ‘set it and forget it’ approach.
- UTMA/UGMA: These accounts are set up for minors and controlled by the guardian. Once the child reaches a certain age, this account will be 100% in the child’s name and control. These are common accounts for college savings.
- Retirement Account (Traditional or Roth IRA, SEP-IRA): Retirement accounts provide numerous tax benefits. You can invest in a retirement account today, but defer taxes until you retire. Common options include a ROTH IRA, a SEP-IRA, or simplified employee pension. Tax nuances differ between any IRA option.
- Other Accounts: There are numerous other account types you can open. You may want to open a joint account with your spouse that you both contribute a certain amount of income to from each paycheck. Investing in ETFs within this account can help you save money, while limiting your downside risk.
Step 3: Add Funds to Your Account
Once your account is set up, it’s time to fund your account! Typically there is a fund clearing period of 24-72 hours before the funds can officially be used within the account.
You can fund the account via ACH, a debit card, or writing a check.
Step 4: Place an Order for Your Chosen ETF
Once your money has cleared, you are free to begin placing orders for your ETF, or any other security for that matter. Determine which type of order you want to use (market, limit, good to cancel, etc.), and execute the trade!
Step 5: Monitor Your Investments Periodically
Monitoring your performance is important. If you are an active trader, you’ll be monitoring your performance frequently – even numerous times an hour. If you are a value investor, you do not need to look at your performance each day, in fact, it’s encouraged not to.
With that said, find a period of time that you’re comfortable with, and stick to monitoring the performance at that time frame.
ETFs Are Incredibly Useful and Powerful
Now with a better understanding of what an ETF is or how to invest in ETFs, it should be clear how useful this investment option can be for your portfolio. ETFs provide a great deal of diversification, which can help you limit your downside, or reap the benefits of a market rally, without taking on a great deal of risk.
Additionally, ETFs can apply to just about any market, and just about any sector. Ultimately, working with a professional financial advisor is your best option if you want to take your finances to the next level.
Financial advisors are well educated on the various securities available to you in the market, and can help you identify which security, or ETF, is aligned with your goals. Financial advisors will help you establish a budget, and will help you navigate the complexities of financial management.
Frequently Asked Questions
An ETF is a great investment option for a beginner considering the low cost, low risks, and diversification an ETF provides.
An ETF is far more liquid than a mutual fund or piece of real estate. You can sell an ETF on the open market during market hours.
ETFs provide more divierification than a single stock, as an ETF is an aggregate of numerous stocks! One could view this as being safer than stocks, but that isn’t always 100% true.