What Are ETFs?
ETFs enable you to diversify your portfolio with many different securities. Find out more about how they work in this article.
Whether you’re new to investing or have been around the block a few times, a common term you’ll hear is diversification. Often, this involves spreading around your wealth by investing in various asset classes. By doing so, you avoid focusing on any one investment, which can be a good method of minimizing risk.
Investing in exchange-traded funds (ETFs) is both an advantageous and straightforward way to diversify. This article will tell you how they work, as well as a breakdown of the different types, their pros and cons, and how to go about choosing them. We’ll also highlight the difference between ETFs and mutual funds.
How They Work
They’re generally available through both brokerage and retirement accounts, making them very easy for most regular people to add to their portfolios. Differing from index and mutual funds, you can buy and sell them during the day as you would for individual stock trades.
Buying shares in an ETF provides you with an indirect fraction of each security within it. This means, for instance, if you purchase shares of a real estate ETF, you’ll own a portion of each property according to how much you’ve invested.
ETFs may be either managed passively or by professional fund managers, often registered with the U.S. Securities and Exchange Commission (SEC). Passive funds generally follow a specific broad market index, such as the S&P 500 or Dow Jones Industrial Average. Under active management, however, managers will consistently trade and select stocks to beat the market.
ETFs vs. Mutual Funds
On the surface, it may seem like ETFs and mutual funds have many similarities. For example, they both allow you to diversify your stock portfolio, are often overseen by professionals, and can produce dividends. Despite this, the two have some stark differences.
As mentioned, the most glaring contrast lies in how you can trade them. Mutual funds are only available for trading at the end of the day at their net asset value (NAV), which is a company’s assets minus its liabilities. Conversely, you can trade ETFs at any time of the day on stock exchanges like the Nasdaq or the New York Stock Exchanges (NYSE).
Another important distinction between the two is that ETFs cost less. According to Fidelity, mutual funds tend to have higher expense ratios (the fee you pay each year for a fund’s management) than ETFs. This is likely in large part because many mutual funds have active managers. These are often highly credentialed professionals who put in significant effort deciding which stocks to buy and, therefore, command high salaries.
ETFs also have unique tax efficiency advantages as opposed to mutual funds. That is, if someone who’s invested in a mutual fund sells shares that have grown in value, shareholders must pay capital gains tax. On the other hand, ETF shareholders only must pay taxes upon selling their own shares that have appreciated.
Types of ETFs
There are a wide range of ETFs in which you can invest. All of them have varying goals and potential benefits and drawbacks. The following is a list of some of the most common:
- Index. These follow market indexes such as the S&P 500, Russell 3000, or the MSCI EAFE. Since they’re passive, these tend to have lower expense ratios.
- Actively managed. These employ finance professionals who take an active role in buying and selling securities in the fund to beat the market. Since they require full-time employees with expertise, active funds often have higher fees for investors.
- Sector. These zero in on specific industries, like tech, energy, or health care.
- Commodity. These track specific commodities, such as silver and gold, oil, or agriculture.
- Bond. These funds track and provide exposure exclusively with bonds. According to Vanguard, investing in these allows you to earn interest.
- International. These typically invest in securities around the globe, except for the U.S.
- Inverse. These go against the grain by generating the opposite performance of the underlying index they track. Their primary purpose is to profit while a specific market index goes down.
- Leveraged. These aim to increase the returns, sometimes multiples of double or triple, on certain broad market indexes, using types of leverage, including derivatives.
Pros and Cons
It’s not uncommon to see ETFs garner praise for traits such as how easy they are to trade and their ability to provide solid diversification. However, they can be prone to the overall risks of the market and have annual fees. Below is a snapshot of the advantages and disadvantages of investing in exchange-traded funds:
- Diversification. They often spread out investments within a sector, industry, or type of commodity. Thus, they can be strong vehicles to add diversity to your portfolio.
- Liquidity. Since they trade on stock exchanges, you’re generally able to enter or exit at any time.
- Lower Fees. Contrary to mutual funds, ETFs (especially when managed passively) enjoy lower expense ratio fees.
- Transparency. They disclose which securities they hold each day, leaving no questions on what your money is invested in.
- Flexibility. There are so many of them that it’s easy for investors to increase the diversification of their portfolio rather than concentrate assets in a particular investment sector.
- Prone to market risks. They track stock market securities that can increase or decrease in value. This means that their value fluctuates when the specific assets within it experience volatility or price instability.
- Tracking errors. Sometimes, due to a variety of factors, an ETF might underperform compared to the index it’s trying to replicate.
- Limited control. Unlike picking individual stocks or bonds, you have no say in the securities in the fund beyond, of course, the overall type of ETF.
- Fees. While ETFs often have lower fees and a better expense ratio than actively managed mutual funds, they have transaction and management fees. Therefore, costs can pile up if you make frequent trades.
- Overlapping holdings. Investing in more than one introduces the possibility that some securities may be in several. This results in a less diversified portfolio exposed to unintended risk.
Many well-known companies allow you to add ETFs to your portfolio. As mentioned, you can easily buy them through online brokerage platforms and various types of retirement investment accounts, such as 401(k)s, IRAs, and Roth IRAs. Here are some of the most recognized providers, in no order:
- Vanguard offers several ETF options, including its 500 Index Fund ETF (VOO).
- BlackRock provides ETFs through its iShares product, such as the S&P Total U.S. Stock Market (ITOT), the MSCI Emerging Markets (IEMG), and more.
- Charles Schwab brings a variety of options to the table, including the Schwab 1000 Index ETF and Schwab Emerging Markets Equity ETF.
- Fidelity has a range of offerings, such as its Blue Chip Growth and Disruptive Technology funds.
- Invesco offers plenty of products you can use to diversify. Examples include its Nasdaq 100 and S&P 500 Equal Weight ETFs.
Frequently Asked Questions
Are ETFs a good investment?
ETFs can be good investments if you want to easily diversify your portfolio. They allow you to add exposure to specific industries or types of securities without individually picking them. They also tend to be on the low end for fees, as compared to funds ran by full-time management teams.
However, it’s often prudent to talk with a financial advisor before adding a new investment to your portfolio. If you don’t have one yet and aren’t sure where to look, matching tools, such as this one, can help you find up to three in your area.
What is the minimum investment in an ETF?
If you’d like to invest in an ETF, you only need to pay the price of one share. After this, you’ll successfully be a shareholder. However, you’ll likely need to buy more than this, depending on your situation, if you want to see higher gains or have more exposure to the securities in the fund.
Do I need to pay taxes on ETFs?
Yes, you’ll have to pay capital gains taxes on these types of funds when you sell shares that have appreciated. You’ll likely also face taxes on dividends you receive in one of two ways, qualified or non-qualified. The former normally are taxed at lower long-term capital gains rates, while the latter are taxed your normal income tax bracket.
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