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Diversifying your investments is an important component of having a healthy portfolio. It helps reduce the risk of losing money since it’s not invested in just one stock. When you’re invested broadly in the market, you are less likely to suffer major losses if a sector contracts or a company’s stock plunges.
Historically, investors used mutual funds as a way to buy a large number of stocks at once. Exchange-traded funds (or ETFs as they are more commonly known) are a newer offering. ETFs combine the diversification benefits of a mutual fund with the liquidity and ease of entry offered by stocks.
Here’s what you need to know about this popular investment category, including top recommended ETFs for new investors.
How to Buy an ETF
In order to buy ETF shares, you’ll need to have a brokerage account. These accounts are easy to open and sometimes only take ten minutes online. You’ll need to have a bank account number and Social Security number to do so. We recommend discount brokerages like Vanguard, Fidelity, and Schwab. You can buy ETFs within retirement accounts like 401(k)s and 403(b)s, as well as tax-advantaged brokerage accounts like traditional and Roth IRAs.
Once you’ve selected your account, you’ll transfer cash to fund it. When the cash clears, you can then buy ETFs.
Do ETFs Pay Dividends?
Many ETFs pay dividends,which is a cash payout on a quarterly basis, though they tend to be lower than stock dividends. With dividend-paying ETFs, you’ll have two choices:
- Reinvest the dividends into the fund, so you gain more shares of the ETF
- Receive dividend as cash
Can You Sell an ETF at Any Time?
ETFs are collections of equities, similar to a mutual fund, but they’re traded more like stocks. While a mutual fund is priced once per day, with purchases closed at the end of the day, ETFs buy and sell throughout the day.
Before you buy ETFs, make sure you understand any fees and commissions associated with the trade.
Theoretically, you can sell an ETF at any time because they are traded in real time, just like stocks. Whether you’d want to is a different question. By trading ETFs, you miss out on the long-term appreciation.
Keep in mind, there are caveats about selling ETFs. To sell, you’ll need to find a buyer. Ideally, if you’re selling the ETF at market price, you’ll be matched with a buyer who wants to purchase those shares quickly and everyone gets what they want.
But it doesn’t always work this way. “Wild intraday swings are normaI with ETFs,” says Inna Rosputnia, trader and wealth manager. If the market moves quickly, you may not be able to get in or out at the price you want.
When the market is closed (overnight, on weekends, or on holidays), you can still put in an order to sell your ETF, but this after-hours order is only good until the market opens. After-hours trading tends to be more volatile and potentially riskier. There are fewer participants, so the bid-ask (the price a buyer will pay vs. what a seller wants) tends to become wider. Rosputnia recommends watching the spread (which is the difference between the bid and ask prices) carefully whenever you’re considering buying or selling an ETF.
ETFs to Get Started With
Given the steep learning curve of investing, index ETFs are best for new investors, says Ben Reynolds, CEO and Founder of SureDividend.com, an investing blog. Index ETFs cover U.S. and foreign markets. “Index ETFs can be used for long-term investing, and can help eliminate the research process that comes with vetting actively managed ETFs,” says Reynolds.
Three recommended index ETFs are:
- SPDR S&P 500 ETF (SPY)
- Vanguard S&P 500 ETF (VOO)
- iShares Core S&P 500 (IVV)
Any of these will expose you to every company in the S&P 500 index with relatively low expense ratios. Keep in mind, the SPDR fund does tend to have slightly higher expenses ratios than the others, Reynolds says.
Index ETFs typically give you broad diversification. There are also ETFs that segment the market by size, like small, medium or large cap funds. Other ETFs curate stocks in a particular sector, be it healthcare or green energy, or focus on a geographic region. It’s good to have some exposure to international ETFs.
Frequently Asked Questions
How long should you hold an ETF for?
This depends on your investment goals. “Buy and hold” is the recommended strategy, but there may be times when you want to use ETFs as short-term investments. In the short term, ETFs could help you gain access to an emerging market or industry, be it cannabis stocks or electric vehicles. Keep in mind, there’s risk involved when seeking short-term market gains from any equity, ETFs included.
What are the downside of ETFs?
ETFs can have fees and commissions associated with them. Before you invest in a fund, know what fees (if any) your brokerage charges for ETF trades. Given the rise of no-commission online brokerages, you can move your account to a brokerage that does not charge fees for every trade.
Management fees come into play with ETFs that are actively managed rather than passively managed ETFs, which track indexes. To keep fees low, choose indexed ETFs.
Volatility and liquidity can affect ETFs, just like stocks. Prices may fluctuate wildly. If there is low liquidity, you may not be able to get out at your desired price due to lack of interested buyers.
Why choose an ETF instead of a mutual fund?
Given the similarities between ETFs and mutual funds, why choose one over the other? Both are less risky than individual stocks since they represent a collection of stocks.
Mutual funds often have investment minimums. Since ETFs don’t, they may be more attractive to beginner investors who can’t meet mutual fund minimums. ETFs often, but not always, have lower expense ratios.
If you’re a set-it-and-forget-it type, mutual funds are a better pick. You can set up recurring investments or withdrawals for hands-off portfolio management. Since mutual funds are older investment vehicles, there tend to be more options for exposure to particular asset classes, like fixed income. If you’re not interested in index investments and prefer actively managed funds, mutual funds might be for you.