Exchange-traded funds, or ETFs, are low-cost hybrid investment vehicles. They share some features with mutual funds and others with stocks. Around since the 1990s, ETFs are so popular that many brokerage accounts often offer free trading to customers.
Today more than 2,000 ETFs trade in the U.S., with a total net assets valued at over $5 trillion.
These funds can be inexpensive and easy options for diverse investing. But you should ever invest in something you don’t understand. Before diving into ETFs, it’s important to learn the ropes.
What Is an ETF?
An ETF is a fund that offers investors a way to pool money in order to invest in stocks, bonds or other assets. In return, you receive a piece of every asset in that fund.
Essentially, you can buy one ETF share, then have a stake in the entire basket of investments owned by the ETF.
Different types of ETFs have different objectives. Your objectives as an investor determine the ETF shares you buy.
How ETFs Work
ETFs are great in the sense that you can balance your risk if you invest in a wide range of assets. An ETF owns many other assets, so it’s an easy way to spread out your investment and diversify your portfolio.
You buy ETF shares through a broker, not directly. Shares can be purchased throughout the trading day. NextAdvisor recommends discount brokerages like Vanguard, Fidelity, Schwab, and others.
ETF share prices fluctuate throughout the day. The price ETFs trade at during the day is the market price. This price can be higher or lower than the value of the ETF’s underlying assets.
At the end of the day, the ETF’s Net Asset Value, or NAV, is posted. The NAV represents the true value of the ETF’s underlying assets. It’s important to keep in mind that an ETF’s market value and NAV are not always the same.
ETFs vs. Mutual Funds
ETFs and mutual funds both allow investors to pool their money in a fund that invests in underlying assets. Both options can help you diversify your investment portfolio.
“ETFs are easier to trade than mutual funds, have lower minimum investments, are more tax-efficient, and generally have lower expense ratios,” says Lana Khabarova, founder of SustainFi, a personal finance website.
You can buy and sell ETF shares at market value throughout the trading day. The ETF’s market value can be higher or lower than it’s NAV. With mutual funds, you can submit an order to buy or sell anytime during the day, but you won’t know the share price until the end of trading when the mutual fund’s NAV price is posted.
ETFs vs. Stocks
“ETFs share many common characteristics with stocks by how they can be traded, but one way they differ is the diversification that ETFs provide in comparison with individual stocks,” says Chance Burroughs, a financial advisor at Manske Wealth Management.
ETFs and stocks are both traded on exchanges. You can buy and sell shares of stocks and shares of ETFs throughout the trading day.
If you’re trying to diversify your investments, ETF is probably the more cost-effective path. You can buy a single share of an ETF, which spreads your risk between many different assets. With stock, you’ll need to buy shares at different companies to balance your risk.
ETF Pros and Cons
ETFs have traits also found in stocks and mutual funds. While ETFs have become popular due to their unique nature, they’re not always the best choice for investors. It’s important to weigh the good with the bad when researching potential investments.
Diversification – Rather than investing in a single asset, ETFs spread your investment out. Investing is risky, and as the saying goes: it’s smart not to keep all your eggs in one basket.
Tax benefits – Some ETFs can be more tax-efficient when compared to mutual funds, because you have the option to choose when to sell your shares. It enables you to have a better grasp on capital gains taxes.
Some ETFs restrict diversification – ETFs come in many different kinds, and some restrict the underlying assets of the ETF, such as an ETF that targets a specific sector or market-cap. If an ETF’s underlying assets are all associated with a specific sector, and that sector experiences a downturn, the ETF could also be hit hard.
How to find the right ETFs for your portfolio
The right ETF for you largely depends on your existing knowledge and your investing style. ETFs can target specific kinds of assets, industries, market-caps, and more. You’ll probably get better results if you invest in areas of business that you understand.
You should also decide if you want your investments to be passively or actively managed. Active ETFs are run by human financial managers, and these active funds have higher fees and try to outperform the market.
Passive ETFs have lower fees, but these funds are not managed by a human. Usually these funds are more automated and hands-off. Passive funds generally try to keep pace with the market, not outperform it.
How to invest in ETFs
You can also invest in ETFs using a robo-investor service, such as Wealthfront or Vanguard. These automated investing services provide an easy and cost-efficient way to invest in ETFs. But you won’t have a human watching over your investment day-to-day.
Types of ETFs
ETFs come in all shapes and sizes. Here are a few examples of the kinds you might find at major brokerage firms.
- Sector ETFs – focuses on companies in a specific sector, such as healthcare or agriculture.
- Market-cap ETFs – focuses on specific market capitalizations when selecting company stock.
- Dividend ETFs – focuses on companies that have historically paid dividends.
- International ETFs – focuses on companies outside of the U.S.
- Bond ETFs – Focuses on bonds from public and private organizations, such as government treasuries and private companies.
- Commodity ETFs – Focuses on commodities using futures contracts or precious metals held in vaults.
- Currency ETFs – Focuses on tracking the index of a single currency or multiple currencies.
Invest in ETFs that are focused in industries or areas of business you already understand.
No one starts out as an expert investor, and ETFs provide a comparatively simple way to achieve a diversified portfolio.
“Stock-picking is too time-consuming for individual investors,” says Khabarova. “Most individual investors are better off investing in broad market ETFs.”
Keep in mind that investments should make sense to the investor. If you can’t easily explain exactly what you’re investing in, it’s smart to research a bit more before making a commitment.