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ETF basics for beginners

What we'll cover

  • Differences between ETFs and mutual funds

  • Pros and cons of ETFs

  • How to evaluate an ETF

Diving into the stock market head-first can be intimidating — where do you 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, you may want to get started with exchange-traded funds (ETFs).

Don’t be turned off by the acronym. This three-letter investment vehicle can be a valuable addition to your portfolio, whether you're a beginner or advanced investor. 

Interested and want to learn more? Let’s dive in.

What are exchange-traded funds?

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 and commodities. 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).

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.

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.

ETFs are traded like stocks on the stock exchange. In other words, 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 thousands of shareholders typically invest in) ETFs and mutual funds have a few major differences. For example, mutual funds are typically actively managed. Unlike ETFs that trade throughout the day, mutual funds are bought and sold just once per day. The prices of mutual funds are set once every 24 hours based on their NAV at the end of each trading day.

Differences between ETFs and mutual funds

ETFs and mutual funds are both types of investment vehicles that allow you to invest in a diverse portfolio of stocks, bonds or other securities. 

Mutual funds are investment vehicles that pool money from many investors to purchase stocks, bonds and other types of securities. Professional portfolio managers manage the investment decisions in actively managed mutual funds (which isn't the case for most index-based mutual funds). When you invest in mutual funds, you buy shares of the fund, and the investment value fluctuates based on how well the underlying securities in the fund's portfolio perform.

So, what's the difference between ETFs and mutual funds? You can pinpoint both similarities and key differences between these two types of investment vehicles.

  • Trading differences: ETFs are traded on stock exchanges, like individual stocks, and their prices fluctuate throughout the day based on supply and demand. On the other hand, mutual funds are bought and sold at the end of the trading day at their net asset value (NAV).

  • Management differences: ETFs are typically passive investments because they track the performance of a specific index, like the S&P 500. As mentioned before, portfolio managers choose the securities to buy and sell in mutual funds.

  • Cost differences: ETFs generally have lower expense ratios than mutual funds because of their passive management properties. 

ETFs and mutual funds both offer diversified investment opportunities but have different investment objectives. For example, if you want to trade frequently and incur fewer expenses, an ETF may be more suitable. However, if you prefer a portfolio manager overseeing your investments, mutual funds may be more appropriate.

Who can buy ETFs?

Anyone can purchase ETFs — all you need is a brokerage account with a firm that offers ETF trading. Once you successfully open your brokerage account, you can purchase ETFs by placing a buy order through your brokerage's platform based on what you're investing for, which includes your unique investment objective, time frame and risk tolerance.

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 choice 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 typically pay regular interest dividends from corporate, municipal, high-yield bonds or U.S. Treasuries. Bonds are typically less risky than other investments, although high-yield bonds offer higher interest rates due to increased risk with lower credit ratings.

  • 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 and energy.

  • Currency ETF: Currency ETFs track foreign currencies and can provide investors exposure to the foreign exchange market.

  • Leveraged ETF: Leveraged ETFs aim to amplify returns, more than that of a typical ETF tracking the same index. You may choose to use them as a short-term investment strategy. They can provide significant returns when the underlying index is on the rise, but you may also magnify losses, making them a more high-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. If the underlying index decreases, the inverse ETF increases at a corresponding rate. Like leveraged ETFs, these short-term investments 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.

Image defines seven types of ETFs: Stock ETFs track a particular set of related stocks; currency ETFs track foreign currencies; bond ETFs are made up of fixed income investments or bonds; leveraged ETFs use leverage to amplify returns; commodity ETFs invest in commodities like precious metals, agricultural goods or natural resources; inverse ETFs aim to deliver returns on the decline of the indexes they track; sector or industry ETFs track stocks within particular industries

Lastly, ETFs pros and cons

It's a great idea to look at the pros and cons before you choose to invest in ETFs. 

Advantages of ETFs

Take a peek at the advantages of ETFs:

  • Flexible: Mutual funds are traded only once per day, after the markets close, while ETFs can be bought and sold throughout the day while the markets are open. This gives you greater flexibility as you buy and sell your investments — you can get more out of your investments. 

  • Diversification: You can expose your portfolio to a wide variety of sectors, companies, industries and other "groupings" within ETFs. ETFs offer more diversification than single stocks, which only allow you to invest in a single company. This helps reduce your risk. Diversification is a risk management strategy that aims to lessen the effects of market volatility and create more 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.

  • Lower costs: You may pay less for ETFs compared to other types of investments. ETF costs can be lower because service-related and administrative costs usually cost less. 

  • Tax benefits: Shareholders usually have to pay capital gains taxes when assets in a mutual fund are sold. However, ETF sales within the fund do not generally trigger taxable events for shareholders of ETFs.

Disadvantages of ETFs

Now, the disadvantages of ETFs include the following:

  • Lack of liquidity: Some ETFs may trade infrequently, which can make it difficult for investors to buy or sell shares.

  • Bid-ask spread: The difference between the highest price at which someone is willing to buy an ETF and the lowest price at which someone is willing to sell it can be substantial, which can be costly to investors.

  • Tracking error: ETFs may not perform exactly in line with the index they track, which can mean there are differences between ETFs and the underlying index.

  • Potential for fraud: As with any investment, ETFs may be subject to fraud or mismanagement by the fund's management or other parties.

  • High expense ratios: ETFs may have higher expense ratios than traditional mutual funds, which can reduce returns for investors.

  • Lack of customization: ETFs track a specific index or market sector, so if you're looking for a customized investment strategy, you may not find one in an ETF.

It's important to understand the potential disadvantages before you invest in an ETF.

How to evaluate an ETF

There are numerous ways to evaluate ETFs, including checking into all the factors we've listed above: looking at all the costs involved, evaluating the portfolio construction, past performance of the ETF and more (though note that past performance does not always guarantee future performance!). 

  • Investment objectives: Check on investment objectives, risks, charges and expenses, which are included in the prospectus available from the fund.

  • The index it tracks: Understand what the index consists of and what rules it follows in selecting and weighting the securities in it.

  • Length of time: How long the fund and/or its underlying index have been in existence, and if possible, how both have performed in good times and bad.

  • Expense ratio: The more straightforward its investing strategy and the more widely traded the securities in its index are, the lower expenses are likely to be. For example, an actively managed ETF is likely to have higher expenses than one that simply replicates the S&P 500.

  • Taxes: Depending on what it invests in and how the ETF is structured, returns may be taxed in a variety of ways. For example, an ETF that invests directly in gold bullion will be subject to the 28% maximum tax rate for collectibles. An ETF that uses futures contracts, as many commodity ETFs do, may distribute both long-term and short-term capital gains. A bond ETF pays interest, which is taxable as ordinary income.

Also check into the management team's experience and track record. You may want to consider talking with an investment professional to decide whether an ETF makes sense for your situation. They can help guide you toward what's best for your goals and timeline.

Before you invest, you should carefully review and consider the investment objections, risks, charges and expenses of any ETF you are considering.

ETFs and your portfolio

Now that you’ve got a grasp on exchange-traded funds themselves, you can start evaluating whether or not they’re a good fit for your portfolio. A good starting place is to examine your current portfolio’s diversification. From there, you can research ETFs that fill any gaps in your portfolio’s makeup. With the fundamentals you’ve learned here and an understanding of your own portfolio needs, you can feel confident when investing in ETFs for the first time.

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