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What Are ETFs?

In recent decades, exchange-traded funds (ETFs) have become an increasingly popular investment option. These versatile products have found a home in most portfolios, from institutional investors to individuals buying and selling single shares at a time. Keep reading to learn more about what ETFs are and how they could fit into your investment strategy.

Types of ETFs

Unfortunately, the choice isn’t quite as simple as “ETFs or no ETFs.” There are many different kinds of ETFs, and some will fit into an investor’s portfolio better than others.

Index ETFs

By and large, the most popular type of ETF is the passive index ETF. These ETFs essentially give investors exposure to an entire stock index, such as the S&P 500 or Nasdaq, with a single trade. You can think of owning a single share of an S&P 500 ETF as owning a proportionally fractional share of each company that’s included in the S&P.

There’s a bit more going on behind the scenes, and you actually own the ETF product rather than the underlying shares, but the function is largely the same. When shares on the S&P rise, so does the value of an S&P ETF. That also means an S&P ETF loses value when the S&P index does.

Sector ETFs

These function similarly to a stock index ETF, but they’re specific to an industry, region, strategy, or some other characteristic. Instead of tracking the S&P 500 or another major index, sector ETF managers will decide on a sector-specific index to replicate.

For example, a financial industry ETF might track the MSCI US IMI Financials 25/50 benchmark index, which includes stocks like JP Morgan Chase and Berkshire Hathaway.

Socially Responsible ETFs

One of the most recent trends in ETF investing is the rise of socially responsible ETFs. These products vary widely, but generally speaking, they combine the approach of sector ETFs with the goals of activist investing. Investors choose an impact they’d like to have, and the corresponding ETF aims to provide solid returns while achieving that impact.

One of the most common of these investments is the environmental, social, and corporate governance (ESG) ETF. Companies in these ETFs are weighted by how they score on a broad measure of “ESG” values. For example, more financial transparency will help a company score higher on the ESG scale, as will minimizing its carbon footprint and increasing its ratio of women executives.

Leveraged ETF

Leveraged ETFs are an example of how ETF products can be complicated, risky, and potentially lucrative. Instead of holding underlying stocks from an index like the S&P 500, leveraged ETFs seek multiples on the performance of the underlying index through the trading of complicated assets like futures and options.

The result can help investors beat the overall market, but they can also suffer serious losses, if they don’t correctly time their trading.

Inverse ETF

Inverse ETFs are another product for advanced traders who want to use ETFs to achieve their trading goals. You can think of these as the opposite of index ETFs. In other words, they’re the ETF equivalent to shorting the market. If a trader thinks the S&P 500 is going to tank over the next few weeks, they could buy an inverse ETF that tracks the S&P.

Advantages of ETFs

ETFs have become incredibly popular in recent years, and for good reason. Many investors will find that ETFs come with benefits that are tough to match, especially compared to mutual funds.

Simple Method of Diversification

Traders love ETFs because they’re very liquid. Any time stocks are being traded, ETFs can be traded just as easily. Placing an order for an ETF is the same as placing an order for a single stock, but the ETF investor will enjoy greater asset diversity (and the relatively lower risk that comes with diversifying).

Tax Benefits Over Mutual Funds

ETFs are similar to mutual funds, but ETFs enjoy a better tax structure. That’s because every time you sell an asset for profit, the government will tax that income. ETF managers usually trade the ETF’s underlying assets less frequently (once per quarter is common) than mutual fund managers, so there are fewer opportunities to pay taxes. 

Relatively Cheap Investment Vehicle

ETFs give your portfolio an injection of diversification at a low cost. Replicating the holdings through individual stocks would be expensive, and even mutual funds can have minimum investment levels of $1,000 or more. A single share of an ETF, on the other hand, can trade for under $20. 

Disadvantages of ETFs

No product is perfect, and ETFs are no exception. While ETFs come with lots of advantages, there are also some downsides that investors should be aware of — most of which have to do with ETFs compared to single stocks.

Higher Costs Than Individual Stock Investing

While ETFs are relatively cheap products, you can avoid fees altogether by picking and buying stocks yourself. The trade-off with individual stock buying is that it would take significantly more money to achieve the same diversification as a single ETF. If you have the means to buy up every stock on the Nasdaq, though, then there might not be a good reason to buy a Nasdaq ETF. 

Fewer Dividends With ETFs

Dividend investors may be disappointed by the yield with ETFs. Dividend ETFs do exist, but the expense fees will eat into the yields. Some dividend ETFs may offer relative price stability, compared to owning individual stocks, but those looking purely for yield may want to look elsewhere for opportunity. 

Some ETFs Contain Complicated (and Risky) Products

If you aren’t careful about which ETFs you buy, you can end up making a costly mistake. Instead of holding simple stocks, leveraged and inverse ETFs contain futures, options, and similarly complex products. These ETFs aren’t designed to be held over long periods of time, and failing to time your trades can result in serious losses. 

How To Buy ETFs

Now that you know what an ETF is, you might be wondering how to add them to your portfolio. Follow these simple steps to buy your first ETF.

Choose a Broker

Before you can trade, you’ve got to access the market. Ideally, you’ll find a broker that offers superior research tools with low costs and fees. Look for a broker that offers commission-free trades for common investment products like ETFs, as well as stocks and options.

Open an Account (and Fund It)

Before you start trading, make sure you’re buying ETFs for the correct type of account. Most brokerages offer individual brokerage accounts, both cash and margin, as well as individual retirement accounts (IRAs). Open the account that corresponds to your goals, then fund it by transferring cash into the account.

Choose an ETF Strategy

At this point, you’re ready to buy an ETF, but you still need to decide which ETF to buy. For beginners investing on a timeline of five or 10 years, the best option may be to add an index fund, such as the SPDR S&P 500 ETF Trust (ticker: SPY).

This is just an example strategy, and you should consider your existing holdings, your financial situation, and your risk tolerance before deciding on an ETF to buy. If you have any questions, consult a financial adviser.

Place an Order

The process of placing an order for an ETF is the same as placing an order for a single stock. Find the ETF you identified as an opportunity during your research, then select “trade.” This is where you’ll enter details like the number of shares you want to buy, and whether you want to place a limit or a market order.

Market orders will execute the quickest, but you aren’t guaranteed a price. During volatile trading sessions, this means you could end up paying more than you anticipated for the ETF. Limit orders are the opposite. You set a price, and your order will only trigger if it can secure that price (or better). Depending on the price you set, the trade could take minutes or hours to execute. If you set your price too ambitiously, it might not execute at all.

Determine an Exit Strategy

Now that you own an ETF, you’ve got to decide when you’ll sell the ETF. This step will be less important for buy-and-hold index ETF investors operating on a decades-long timeline.

However, for advanced traders buying risky products like inverse ETFs, timing is very important and you’ll need to have a specific profit goal in mind. Once you hit that profit mark, sell the ETF. In the meantime, set up a stop-loss so that you can automatically cut your losses if your trade turns against you.

Have Fun Experimenting with These Versatile Products

That covers the basics of what ETFs are and how to add them to your portfolio. You’re now ready to go out and explore the wide world of ETFs. ETFs truly come in all shapes and sizes, and a curious investor should feel free to try them all out. Just remember to explore while keeping your overall investment goals in mind.

One method that allows for experimentation is known as the “core-satellite” method. A core-satellite investor maintains a “core” investment — such as a large-cap index mutual fund or ETF — that makes up the bulk of the portfolio. Then, smaller investments are built around that core investment, and these smaller investments allow room for trial and error.

For example, one satellite could be a bond ETF that helps reduce the risk of your overall portfolio. Another satellite could be a global stock ETF that adds international exposure. The smallest satellites could be risky investments, such as some sector ETFs or leveraged ETFs.

As long as you manage your risk and invest within your means, you can have fun and learn about the markets through the use of ETFs.