How to Invest in Exchange-Traded Funds (ETFs)
Learn to build a perfect investment portfolio using ETFs.
Whether you’re an experienced investor or a total newbie, exchange-traded funds (ETFs) are a great way to build a perfect investment portfolio. I’ll explain what ETFs are, why they’re a smart investment, and the best places to buy them.
What is an Exchange-Traded Fund (ETF)?
Exchange-traded funds are like the electric car of the investing world—they look like a regular car, but have some cutting-edge technology going on under the hood. Let me explain.
On the surface, an ETF looks like an old-fashioned mutual fund. Both pool money to buy a variety of underlying investments, like stocks, bonds, real estate, commodities, currencies, or other assets. But unlike a mutual fund, an ETF trades on an exchange (just like a stock), where you can track its price and buy or sell it at any time the market is open. With a mutual fund, you can only buy or sell shares from a fund family and the price is calculated just once a day, after the markets have closed.
5 Benefits of Owning Exchange-Traded Funds (ETFs)
So how do ETFs benefit investors? Here are 5 reasons you should use ETFs to create a perfect portfolio:
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Low Fees – If you like the idea of paying fewer fees and keeping more of your hard-earned money in your investment portfolio, exchange-traded funds are the way to go. They have low operating expenses when compared to the average mutual fund because the vast majority of ETFs are managed passively. That means their objective is to match a particular index, like the Dow Jones or S&P 500. To get the job done, they don’t need to buy and sell investments frequently, pay transaction costs, or hire a large staff. Those savings get passed along to investors. This is different from actively managed mutual funds that aim to beat the market with various investing strategies and have to pay management for ongoing research and shell out for transaction costs. In addition to saving you money in fees, many investment analysts have found that passive funds beat actively managed ones over time.
If you like the idea of paying fewer fees and keeping more of your hard-earned money in your investment portfolio, exchange-traded funds are the way to go.
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Diversification – Smart investing is all about being diversified, or spreading your money out into a variety of investments, so you reduce risk and increase returns. For instance, having $10,000 invested in 1,000 different stocks is better than having the entire amount in just one stock. But that’s difficult, time-consuming, and cost-prohibitive for the average investor. ETFs come to the rescue because they cover every major index, market sector, industry, and region of the world, allowing you to have affordable and convenient diversification.
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Asset Allocation – Studies show that how you allocate your money among major types of assets—such as stocks, bonds, and cash—is what really matters. Stocks have historically outperformed all other asset classes, even though they’re more volatile. That’s why young investors should allocate a higher percentage of their portfolio to stock funds. There are thousands of ETFs and they cover all the different asset classes and make it easy to create a portfolio that’s suitable for your investment objectives and risk tolerance.
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Tax Efficiency – ETFs can minimize your taxes because, as I mentioned, trading occurs on an exchange. With mutual funds, buying and selling can actually trigger taxable capital gains distributions for all the fund’s shareholders, because the fund family is a middleman. ETFs generally protect you from events that could unnecessarily raise your tax bill. To learn more about how mutual funds tax shareholders read Can You Lose When You Gain?.
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Transparency – With ETFs, you know the exact companies or assets you own because that information is available on a daily basis. With mutual funds, many reveal their portfolio holdings two times a year only. So ETFs never leave you guessing about where your money is exactly.
Where to Buy Exchange-Traded Funds (ETFs)
If you’re ready to start investing in exchange-traded funds, visit a few of the most popular ETF families at sites like ishares.com and powershares.com to learn more. You can also get some direction from personal finance magazines, like Money or Kiplinger’s, which usually include top ETF picks from analysts.
Since you buy ETFs through a brokerage firm, one important thing to keep in mind is that each trade may incur a commission, just like when you buy shares of stock. Though that’s a disadvantage of ETFs, a growing number of brokerages offer low-cost or free ETF trades. Check out some great brokerage options like betterment moneygirl, vanguard.com, and schwab.com.
Benefit administrators in the workplace are starting to see the light when it comes to owning ETFs. If your 401(k) doesn’t offer them, speak up and let the benefits department know that you’d like the option to invest in low-cost ETFs to build your retirement nest egg as quickly as possible.
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More Resources:
State Street Global Advisors at globalspdrs.com
An Inside Look At ETF Construction
Active Vs. Passive Investing in ETFs
How to Get Started Investing: 5 Things You Should Do With Your Money Now! – free webinar
Dollar image courtesy of Shutterstock
About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
