Stock picking not your thing? Don’t know the difference between a municipal bond and a junk bond? But you’re still looking for an easy way to invest and grow your hard-earned money?
Well, investing in an exchange traded fund, a popular investment better known as an ETF, could help resolve your dilemma.
Investing doesn’t have to be complicated or require you to be watching the market closely. That’s why learning the ABCs of ETFs should be on every investor’s to-do list.
Here’s what you need to know about ETFs.
What’s an ETF?
As the acronym suggests, an ETF is a type of investment fund that trades like a stock on an exchange.
“An ETF is similar to a mutual fund: It’s made up of many investments wrapped in a single package,” says Arielle O’Shea, investing and retirement specialist at NerdWallet.
ETFs provide broad diversification by owning a basket of securities, such as all the stocks in the Standard & Poor’s 500 stock index, or equities in popular parts of the market, like technology and health care.
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“If you buy an ETF, you won’t be buying one stock, you’ll be buying shares of many stocks – dozens, perhaps hundreds in one fell swoop,” says Russell Wild, author of “Investing in ETFs for Dummies.”
What kinds of ETFs are there?
ETFs come in all flavors.
They can track major stock indexes like the Dow or Nasdaq. Or they can focus on more niche equity investments, like small-company stocks, biotech stocks, financial equities and foreign stock markets in Japan or Brazil. But ETFs aren’t just for stock investors. There are ETFs that invest in commodities like oil and natural gas, as well as all types of bonds, including corporate bonds, municipal bonds and junk bonds.
“ETFs allow for ‘slicing and dicing’ a portfolio as much as an investor likes,” Wild says.
Most ETFs are passively managed, which means the ETF is designed to track a benchmark index, such as the S&P 500, O’Shea notes. But some ETFs can be actively managed by a professional money manager who picks and chooses the investments.
At the end of 2019, there were 2,096 ETFs with net assets totaling $4.4 trillion, according to the Investment Company Institute.
How do ETFs differ from mutual funds?
While ETFs are similar to mutual funds in that they provide broad diversification by investing in a broad basket of securities, they do have one major difference: ETFs can trade like a stock during the trading day.
“It is very easy to buy or sell ETF shares,” Wild says. “You can do it at any brokerage house.”
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And just like a share of Apple or Amazon stock, the price of an ETF can fluctuate during the day. Mutual funds, in contrast, are traded and priced just once a day at the end of the trading session, when a net asset value is calculated.
Benefits of investing in ETFs
Since ETFs invest in a basket of securities, it reduces the risk associated with investors having all their eggs in one basket. Instead of betting it all on, say, a hot stock like Amazon, the ETF spreads its bets around.
“An ETF typically holds many different investments instead of just an investment in one company,” says Kevin Grogan, managing director of investment strategy at Buckingham Wealth Partners. “As an example, the Vanguard Total Stock Market Index Fund ETF (ticker: VTI) owns over 3,500 different individual stocks.”
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Broad diversification, O’Shea adds, has another benefit: “This takes a lot of the guesswork out of investing, and it allows you to easily diversify with just a few funds.”
► Low fees
Since most ETFs simply track broad indexes, which doesn’t require expensive portfolio managers to analyze and trade stocks on a regular basis, the cost of owning an ETF is much lower than owning a so-called actively managed fund. Many ETFs now come with zero expense ratios, which means every investment dollar is put to work in the fund.
Another plus is that one of the major cons of ETFs, namely trading commissions costing $5 or $10 a trade, has been largely eliminated as the shift to commission-free trading intensifies.
“Now, commissions are largely a thing of the past,” O’Shea says.
Since the bulk of ETFs are passively managed and mimic so-called index mutual funds, they trade less frequently and generate less taxable transactions, which saves the investor money at tax time.
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“ETFs have lower turnover,” says O’Shea, referring to the term used to describe trading activity. “They typically track an index, so the investment mix doesn’t shift the way it would in an actively managed fund. ETFs also don’t have to sell holdings if an investor wants to redeem their shares – the investor can simply sell the ETF shares to another investor like they would a stock.”
Cons of investing in ETFs
Having the ability to trade an ETF during the day can result in investors trading too frequently, which could hurt returns, Wild warns.
Sure, ETFs that trade like a stock can be a benefit, but it can also be a liability.
“Trading like a stock means that you can day trade ETFs, if you wish,” Wild says. “But is this a good thing? Many studies show that investors who trade the least tend to make the most. ETFs, like candy bars at the supermarket cashier, are readily available for impulse purchasing, and perhaps selling the next day. This is generally not a winning strategy.”
ETFs are best used as a buy-and-hold investment, as opposed to buying and selling throughout the day, Grogan adds.
Another con of ETF trading is that, like some stocks, they can trade with a wide bid-ask spread, or the difference between what price a buyer is willing to pay and what price a seller is willing to sell at. The wider the spread, the higher the cost investors pay.
“The bid-ask spread can vary widely from one ETF to another, so investors should keep the spread in mind when considering which ETF to buy,” Grogran says.
How do ETFs fit into an investor’s portfolio?
“There is no reason that an entire portfolio can’t be built using ETFs,” Wild says.
But it’s important, he says, to make sure that the ETFs you choose complement the rest of the ETFs in your portfolio. You want to avoid having many ETFs that own too many of the same securities.
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“I hate when people ask me, ‘Is XYZ a good ETF?’” Wild says. “It depends. An ETF that invests in small-company stocks could be perfect for someone who is currently holding just Microsoft and Amazon. It may be an awful choice for someone who already owns shares in many small companies.”
However, despite the fact that ETFs are growing in popularity in 401(k) plans, they are still less common than index funds or mutual funds in company-sponsored retirement plans, adds O’Shea.
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