Let’s face it. In the world of investing, it feels like stocks get all the attention. So, it seems like they would be a natural place to start if you’re a beginner investor. But what if we told you there was a way to invest in numerous — we’re talking hundreds or thousands — of stocks (or bonds or other securities) at once?
With exchange-traded funds (ETFs), you can.
If you’re wondering, “What is an ETF?,” don’t worry. Read on, and you’ll soon enough have a stronger handle on this versatile and diverse investment option.
ETFs are baskets of securities.
An ETF is an investment fund that pools together the money of investors to hold a collection of investments, like stocks, bonds, commodities, or other asset classes.
Several types of ETFs exist on the market, (and we’ll take a closer look at them later). An ETF may be constructed in a variety of ways. One such method is to track an underlying index, like the S&P 500, meaning the holdings within the fund are all found on that particular index, which allows the fund to mimic the behavior of the index.
An ETF may also track an industry/sector. For example, a sector ETF tracking the technology industry may hold stocks from hundreds of tech companies, like Facebook or Google’s parent company, Alphabet.
ETFs are different from mutual funds.
At first glance, ETFs may look quite similar to mutual funds — because in many ways they are. They’re both professionally managed, basket-like funds. But it’s important to know a few key features that set these two types of investments apart and make them more different than you might initially realize.
Mutual funds are only priced once per day at market close based on their net asset value (NAV), or price per share. This means they are also only traded once per day. On the other hand, ETF shares are traded on an exchange throughout the day, much like stocks. The price of an ETF share can fluctuate during the day, based on investors’ buying and selling.
ETFs and mutual funds also differ when it comes to minimum investments, fees, and taxes. ETFs don’t have minimum investments, so you can purchase just one share if you so choose. But mutual funds often have minimum investment requirements that range from a couple hundred dollars to several thousand, which can make them a more costly option for newer investors.
Typically, ETFs also have lower associated fees than mutual funds. Because ETFs are often passively managed (as opposed to actively managed mutual funds), they require less work for the fund manager. That allows them to have lower expense ratios, or costs, to manage the fund.
Keep in mind that while the majority of ETFs are passively managed, there are actively managed ETFs on the market, and those will typically have higher fees.
Some brokers may charge commission fees when buying and selling mutual funds or ETFs. At Ally Invest, we offer commission-free trading for all our stocks and ETFs through our Self-Directed Trading platform.
Mutual funds and ETFs are also taxed differently. ETFs are often more tax efficient because the creation and redemption of ETF shares doesn’t trigger a taxable event, unlike a mutual fund. When selling an ETF, you’ll either be subject to the short-term or long-term capital gains tax, depending on how long the investment was held.
While we’re on the topic of what ETFs aren’t: ETFs are not closed-end funds (CEFs). Closed-end funds are similar to both mutual funds and ETFs, but certain characteristics set them apart from both.
CEFs pool together the money of investors to raise a certain amount of capital (through an initial public offering). Then, like an ETF, those shares are traded between investors on an exchange. Closed-end funds are typically actively managed and trade at more extreme premiums or discounts (meaning prices higher or lower than their net asset value) than ETFs. That’s because the price of CEF shares fluctuates based on supply and demand in the market, as CEFs do not create and redeem shares like ETFs do.
You can invest in many types of different ETFs.
As we mentioned, ETFs can track an index, but you can invest in several other types of ETFs as well. Here are some of the most common:
Stock ETFs: Stock ETFs are made up of a collection of related stocks, typically from the same index.
Bond ETFs: Like the name implies, bond ETFs invest exclusively in bonds — either government or corporate. Because they’re traded on an exchange, bond ETFs can be more liquid and easier to trade than individual bonds. These investments typically pay monthly dividends and can be a great asset in a fixed-income portfolio.
Sector ETFs: The equities within sector ETFs are all related by industry.
Commodity ETFs: This type of ETF invests in commodities like precious metals, oil, or other natural resources. Commodity ETFs can be a more accessible way to invest in these markets.
Currency ETFs: If you want exposure to the forex market, currency ETFs (which trade foreign currencies) can be a smart option.
Inverse ETFs: While inverse ETFs do track indexes, they actually aim to profit on the decline of the underlying index. Also sometimes known as bear ETFs or short ETFs, these funds can help you make money during a market decline. However, they can be quite risky and typically have a higher expense ratio than other ETFs.
Leveraged ETFs: Also a higher risk investment, a leveraged ETF aims to magnify the returns of the index it tracks. They’re a short-term investment and can have high management fees. While leveraged ETFs can provide significant gains, a market decline can result in serious losses.
ETFs promote diversification.
The low expense ratios and liquidity of ETFs add to their appeal. But the main feature of ETFs that makes them an attractive and important portfolio asset is their ability to add diversification. Diversification is a key 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.
Since one ETF can hold hundreds or even thousands of securities, you don’t have to be as reliant on the success of a single stock or bond. Even if one security within the ETF is facing a decline, the ETF as a whole likely won’t be affected.
Like all investments, ETFs have risks.
Exchange-traded funds can be a powerful tool for portfolio diversification, but investing too much in any one investment type is typically not a great idea.
One of the disadvantages of ETFs is that the holdings within ETF shares are related, based on industry or commodity type, etc., which means those individual securities will most often be affected by the same market influences.
For example, an oil commodity ETF that’s invested in stocks of oil companies would likely face an overall downturn if a large oil spill occurs — as the whole industry would face backlash. For that reason, if you choose to invest in multiple ETFs, consider investing in either different types (like a mix of index ETFs and bond ETFs) or across various industries.
ETFs are for all investors.
Young, old, novice, or expert: ETFs can have a place in all investors’ portfolios. With no investment minimums, little or no commission fees, and built-in diversification, an ETF portfolio can be a great place for beginner investors to start. But even if you’re more experienced and looking for exposure to new markets, commission-free ETFs could be a way to dip your toes in.
With an Ally Invest cash-enhanced Managed Portfolio, you can invest in ETFs for as little as $100. Customized with investments based on your goals, you can choose between an income, core, tax-optimized, or socially responsible professionally-managed portfolio. And if market swings make you want to cry, “Sell everything!,” you can reduce your risk even more by adding a 30% cash buffer as well — and you’ll pay $0 in advisory fees.
Stocks can be flashy, and they often seem to steal the investment show. But when you take a look behind the scenes, the real star might just be ETFs. These show-stopping investments can be a great asset to build wealth long-term and add diversification to your portfolio, no matter your investment goals or experience in the market.
Learn more about our Managed Portfolios.