Maybe you have heard investors, family, friends, or someone else that you respect say how important it is to have a diversified portfolio. That’s investor lingo for “Don’t put all your eggs in one basket.”
The truth is that a person would need to invest in a lot of companies to achieve diversity on their own. Some investors believe a person would need a minimum of 25 to 30 stocks. Most people do not have the time and money to invest in that many companies?
That’s why investing in exchange-traded funds, or ETFs provide a very attractive instrument achieving one’s financial goals. Purchasing shares in a single ETF allows you to invest your money in hundreds, or thousands of companies. The good news: You can get started even if you don’t have a lot of money, which makes ETFs the option of choice for many beginning investors.
Describing the ETF and How It Works?
An exchange-traded fund (ETF) exist as a bundle of investments packaged together and traded as a single investment.
ETFs are packaged by big investment companies who submit detailed plans to the U.S. Securities and Exchange Commission (SEC) for approval prior to selling shares to investors.
ETFs can be actively managed, in other words humans are choosing the investments. In contrast the majority of these funds are passively managed, defined as these funds attempt to mirror the makeup of a market index.
Example: The most popular ETF is the SPDR S&P 500 Trust (SPY), this ETF tracks the S&P 500. When someone purchase this fund, or any S&P 500 fund, their investment is made to reflect the makeup of the stocks on the overall S&P 500. If the S&P 500 is up, this investor’s overall investment should rise as well. If the S&P 500 has a bad day, so does this investors investment.
The index is always considered a benchmark. Your goal should always be to pick funds that will perform at the benchmark level or higher.
The S&P 500 is known as the most common stock indexes, however, many obscure market indexes exist that you may or may not have ever heard of — and there’s often a corresponding ETF. ETFs exist that focuse on specific industries, regions of the globe or smaller companies, just to share some more few examples, and they normally use a market index as a benchmark.
ETFs first showcased in 1993, but they’ve skyrocketed in popularity in the decade since the Great Recession. CNBC reports that U.S. investors possessed $4 trillion parked in ETFs as of 2019, up from $530 billion in 2008. The attraction is largely attributed to the low fees, simplicity of trading and management style ETFs offer.
How Is an ETF Like a Stock?
When you buy and sell an ETF, it’s a lot like buying and selling stocks.
ETF shares are bought and sold throughout the trading day on stock market exchanges, hence the name “exchange-traded fund.”
One big advantage of ETFs is that they’re less risky than individual stocks. If you own stock in a company that goes under, your shares become worthless. But if you owned an ETF that included that same stock, the overall value of your investment probably won’t drop much because it includes plenty of other investments to mitigate the damage.
But less risk can also mean less reward. Owning an ETF that includes the next Amazon or Apple won’t bring the big payout that owning the individual stock would because within your investment in the ETF you probably own only a few shares or even a fraction of a particular stock.
ETF or Mutual Fund and Similarities?
What is an ETF? Most people know about or at least heard of mutual funds. ETFs are similar to mutual funds because both bundle many assets into a single investment.
One difference being mutual funds aren’t traded on the stock market. You buy mutual funds directly from the investment company, and you are limited to purchasing once a day after the stock market closes.
Another big difference: Most mutual funds are actively managed by humans, which translates to higher overhead costs. For this reason mutual funds usually have higher fees than ETFs.
To compare the costs of ETFs vs. mutual funds, let’s look at the expense ratios for each, which is the percentage of your investment that goes toward fees. Investment research firm Morningstar reported the following in 2018:
The average expense ratio for actively managed funds was 0.67%.
The average expense ratio for passively managed funds was 0.15%.
That translates to if you invested $1,000 in an actively managed fund, like a mutual fund, you would probably pay $52 more in fees in a year than you would for a passively managed fund, like an ETF.
A human managing the fund may not be worth the extra cost. Many studies have found that most investment managers underperform compared with market indexes over the long term.
Another advantage of ETFs is that you can start investing for whatever it costs to buy a single share. Mutual funds may require an upfront investment of anywhere from $1,000 to $2,500. By contrast, the SPDR S&P 500 ETF mentioned earlier was trading at $315.88 per share as of July 10.
Types of ETFs
Let’s discuss all the ETFs that exist out there. As of 2019, there were 2,096 exchange-traded funds — and all those were not limited to stocks. Here are some common types of ETFs:
Broad-Market Stock ETFs
These track the performance either of the overall stock market or a large chunk of it. Those with the broadest exposure are usually called total market funds.
These focus on specific industries within the overall market. For example, you could invest in a health care or energy ETF. Investing in a sector ETF many times makes sense if you believe a certain segment of the economy will be hot, but you don’t want to make bets on individual companies.
Bond ETFs exist that invest in specific types of bonds, for example., corporate bonds, municipal bonds, Treasuries, or bonds that invest across the entire bond market, these are called broad market bond ETFs. Basically, investing in bonds is an excellent strategy for people who need fixed income, like retirees.
These ETFs consist of investments outside the U.S. Investors looking to diversify their portfolios often choose these especially those investors wanting more diversity as well as desiring to invest in growing economies throughout the world.
Commodity ETFs invest in physical assets, like precious metals, including., silver and gold, coal, wheat, oil and natural gas.
The tax on ETF gains applies only when you sell your shares at a profit. When this occurs, you’re taxed the same way the underlying assets are taxed. This means that if you sold stock ETF shares, you’d be taxed the same way you would be if you’d earned a profit on individual stocks, and that is the following:
Long-term capital gains rates, if you held the funds for a year or longer: Your earnings would be taxed in brackets of 0%, 15% and 20%, depending on your overall income.
Short-term capital gains rates, if you held the funds for less than a year: Your earnings would be taxed at the higher ordinary income rates, which consist of seven progressively higher brackets that cap out at 37%.
ETFs are praised as more tax efficient than mutual funds, in other words you often pay less taxes on them. The reason is that mutual fund managers are frequently buying and selling investments, and if there’s a gain, they have to distribute most of it to you, the investor, even if you haven’t sold your shares.
Note that if you earn money from your ETF shares — for example, because you’re paid stock dividends or bond interest — you will owe taxes on these earnings, but not your gains, while you’re still holding the shares.
But if you really want to max out those gains, owning ETFs in a Roth IRA is a great option. You don’t get to deduct your contributions from your taxes up front, but you get that money tax-free when you reach retirement age.
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Are ETFs a Good Investment? Here Are the Pros and Cons
The answer lies in what the ETF is invested in. So, let’s reexamine some advantages and disadvantages of ETFs.
Instant diversification. You can invest in hundreds or even thousands of companies with a single purchase.
Lower risk compared to individual stocks. The diversity that ETFs offer protects you from losing big if one investment performs poorly.
Low up-front cost. You can invest for whatever it costs to buy a single share.
Easy to buy and sell. You can sell them throughout the trading day on stock exchanges.
Tax efficient. ETFs often come with a lower tax bill than mutual funds.
Transparency. You can verify what your money is invested in pretty much in real time using the prospectus on the ETF website or by entering the ticker on a free website, like Yahoo! Finance. Mutual funds, by contrast, are only required to disclose their holdings on a quarterly basis.
Low fees. These are some of the cheapest investments, fee-wise, because they are not actively managed.
Less potential for big rewards. The downside of diversification is that you don’t earn big if one investment skyrockets.
There’s still some risk. ETFs aren’t guaranteed to make money and can also lose money if the stock market drops or the sector you’ve invested in performs poorly.
They have some fees. Still, they’re usually lower than mutual fund fees, and you can avoid commission fees by using a discount online broker.
How To Invest in ETFs?
Many have taken the ETF plunge already as an ETF investor and may not realize it. If you purchased a Roth or traditional IRA that you automatically invest in through a robo-advisor, you may already own some ETFs.
Because you can select your own IRA investments, you may configure your IRA to pick your own ETFs, however many investors suggest sticking to what the robots suggests. The robo-advisor has a better track record as investors than humans, plus they’ll take your age, your goals and how much risk you’re comfortable with taking into account.
Employer-sponsored retirement accounts, like 401(k)s, traditionally don’t adopt ETFs as investment options because they prefer mutual funds instead.
To pick your own ETFs, get started by opening a brokerage account. That way you can start small without placing your retirement account at risk.
What to Look for in an ETF
Picking any investment requires patience and understanding, and ETFs are no different. Below are some things to look at when you make your pick.
Underlying index: Make sure you understand the index that an ETF is tracking because that tells you what you’re investing in. If you’re investing in an ETF that’s based on the Dow Jones Industrial Average, you’re investing only in the 30 stocks that the index represents. But an index that tracks the total stock market will probably have over 3,000 stocks.
Low expense ratio: The lower the expense ratio, the more of your investment will go toward actual investing. Many major brokerages offer ETFs with expense ratios below 0.1%.
No commission fees: Many online brokerages now offer commission-free trading.
Assets under management (AUM): If an ETF has lots of money invested in it, that means there are lots of willing buyers. Many investors recommend buying an ETF with at least $50 million in assets under management.
Past performance: Just because an investment was profitable in the past, that doesn’t mean it will be in the future. Still, past performance is a pretty good way to gauge whether an ETF is a good investment.
Many experts recommend starting with ETFs that track a large segment of the stock market. Historically, the stock market has averaged returns of 10% per year before inflation. By investing in the broader stock market, you can take advantage of this long-term growth.
How to Buy an ETF
First fund your IRA or brokerage account and then select the ETF you want to buy, Next, you are ready to place an order. If you have purchased stock do this exactly the same way you would when you place an order for a stock.
When using an online brokerage, you enter the ETF ticker symbol and choose how many shares you want to buy. When trading through a human broker, simple contact the broker and provide the information.
If you want to place a market order, meaning you’re willing to pay whatever the prevailing price is for the fund.
Another option is toa buy limit order. Justl tell your broker how much you’re willing to pay and they’ll only place the order at a price equal to or less than the amount you choose. For example, if you wanted to buy Fund CIF and it was trading for $100 per share, you could place a buy limit order that tells your broker to only buy it if share prices drop to $90.
If you decide to invest in ETFs, execute for long-term success by practicing dollar-cost averaging. That’s where you decide how much you can afford to invest and invest that amount, without considering what the market is doing. The easiest way to do this is to budget a certain amount to invest each month. That protects you against buying too many assets while prices are high.
Remember: Don’t get excited about day-to-day performance of your ETFs. THe stock market has good days and bad days, and ETFs will have up and down days, too.
The goal with ETFs should be long-term growth, ignor short-term profit. No investment including ETFs is without risk, never invest money that you’ll need in the next few years.