Diving into the stock market head-first can be intimidating — where do you even begin? If you’re a self-directed investor, the idea of having to pick out all your own investments could be enough to keep you from getting started. But rather than just focusing on individual stocks, getting started with exchange-traded funds (ETFs) might help.
Don’t be turned off by the acronym: This three-letter investment vehicle can be a valuable addition to investors’ portfolios at any level. Interested and want to learn more? Get started with our ETF beginners’ guide.
First, the Basics of ETFs
Let’s begin with a definition: ETFs are funds that pool together the money of many investors to invest in a basket of securities that can include stocks, bonds, commodities, etc. That means when you invest in one ETF, you’re going to be exposed to all the underlying securities held by that fund (which can be hundreds).
One important characteristic of many (but not all) ETFs is that they’re typically passively managed. That means instead of having a portfolio manager who uses their best judgment to select specific securities to buy and sell, they attempt to replicate the performance of a specific index. An ETF might do this by tracking a certain index (like the Dow Jones Industrial Average) and holding a collection of securities from that index. Or it might track an industry (like biotechnology) by investing in stocks from a range of companies within that sector.
Another thing you should know about ETFs is that they’re traded like stocks on the stock exchange (hence, the name exchange-traded fund). This is significant because it means ETFs are bought and sold throughout the trading day, and the price of an ETF share can fluctuate above or below its net asset value (NAV) based on supply and demand.
Though ETFs and mutual funds might look similar from the outside — they are both baskets of securities that, typically, thousands of shareholders invest in — ETFs and mutual funds have a few major differences. For example, mutual funds are typically actively managed. And unlike ETFs that trade throughout the day, mutual funds are bought and sold just once per day. The price of mutual funds is set once every 24 hours based on its NAV at the end of each trading day.
Next, what kinds of ETFs can you invest in?
Several types of ETFs exist. Since they are easily traded on the stock market, ETFs that invest in assets like commodities or currencies can be an available vehicle for beginners looking for exposure to new or more advanced markets.
Stock ETF: Stock ETFs track a particular set of stocks. They can track these equities based on their index or industry. Because stocks are subject to market volatility, these can be a good option for long-term investors, since a longer investment horizon allows securities more time to recover should the market see a periodic downturn.
Bond ETF: Bonds ETFs may be attractive for investors interested in fixed income investments. This is because they pay regular interest dividends from corporate or government bonds. Bonds are typically a less risky investment.
Commodity ETF: These ETFs invest in commodities like precious metals, agricultural goods, or natural resources.
Sector or Industry ETF: These ETFs track particular industries, like biotech, health care, energy, etc.
Currency ETF: Currency ETFs trade foreign currencies and can provide investors exposure to the foreign exchange market.
Leveraged ETF: Leveraged ETFs aim to amplify returns, typically by two or three times more than that of a typical ETF tracking the same index. They’re most often used as a short-term investment strategy. While they can provide significant returns when the underlying index is on the rise, losses are also magnified — generally making them a higher-risk investment.
Inverse ETF: Also known as short ETFs or bear ETFs, inverse ETFs aim to deliver returns on the decline of the indexes they track. Meaning if the underlying index decreases, the inverse ETF increases at a corresponding rate. Like leveraged ETFs, they’re often a short-term investment and can result in significant losses should the market fluctuate.
Note: All ETFs incur varying levels of risk, and some types are inherently riskier than others.
Lastly, ETFs Pros and Cons
Remember how we mentioned ETFs are usually passively managed? This can be beneficial to you, because it means that as an investor, you’ll likely have to pay lower fees than if you were investing in an actively managed fund. We’ll explain: All funds have what is called an expense ratio, which is the cost you pay so a fund manager can, well, manage the fund. Since passively managed funds take less work, they’re often cheaper.
Another perk of investing in ETFs is that, depending on your broker, you may not have to pay a commission, fee, or an added cost, when you buy or sell shares. When you open a Self-Directed Trading account with Ally Invest, you have access to hundreds of commission-free ETFs.
For those newer to the stock market or investing in general, ETFs can be more accessible investments than something like a mutual fund because they do not have investment minimums when investing through a self-directed platform. You can buy just one share of an ETF to begin with if you choose, and you’ll pay the market price of that share. Mutual funds, on the other hand, typically have a flat investment minimum that, depending on the fund, may be a few thousand dollars.
If you prefer to be more hands off with your trading, you can still invest in ETFs with as little as a $100 initial investment. Our Managed Portfolios are professionally designed and include a mix of low-cost, diversified ETFs that align with your time horizon, goals, risk tolerance, and what matters most to you — whether it’s investing for income, tax optimization, or social responsibility.
What’s often said to be one of the biggest benefits of investing in ETFs is diversification. Diversification is a risk management strategy that aims to lessen the effects of market volatility and create balance within your portfolio by spreading out investments across different or unrelated asset classes and industries. ETFs can be a good source of diversification in a portfolio, because they contain stock (or other assets) from several companies — not just one.
Now, it’s important to understand that while the securities within an ETF are diversified, investing only in ETFs doesn’t guarantee a diversified portfolio. Think of it this way: If you invest in three different ETFs that all track indices related to the technology sector, and that industry faces a downturn, all of your investments could be negatively affected. So, don’t fall in the trap of believing that ETFs ensure your portfolio is totally diversified and balanced.
Your ETF Investment Study Guide
Now that you’ve got a grasp on exchange-traded funds themselves, it’s time to start thinking about whether they are a good fit for your portfolio. This is where doing a little bit of homework comes in. We’ve outlined a few fundamentals that are important, plus some helpful resources, so you can feel confident when investing in ETFs for the first time. Here’s what you should know:
- How ETFs can impact your taxes
- Request a prospectus from your broker, either by mail or online, and learn how to understand it
- The meaning of an ETF’s stated average annual returns
- How to obtain and read basic quotes using a ticker symbol (bid, ask, size, last, change, high, low, open, close and volume)
- The concept of dollar cost averaging, its risks and costs, and if it’s right for you
- What unsettled funds are, and how they affect ETF transactions
- Order entry terminology (action of buy or sell, quantity, price, type of order, duration)
- Position terminology (long, short)
- Monitoring the major market indices (S&P 500, DJIA, Nasdaq composite, Nasdaq 100, Russell 2000, etc.)
- The difference between an ETF and an index mutual fund
- How to regard your gains or losses as real, even if they are still unrealized
- What basic SIPC insurance is (and why it matters)
Ready to learn more about trading commission-free ETFs?