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ETF basics for beginners

What we'll cover

  • What ETFs are

  • ETFs vs. mutual funds

  • How to evaluate an ETF

Diving into investing can be intimidating — maybe it's even keeping you from getting started. But rather than trying to absorb the whole stock market, first try learning more about this building block of many portfolios: the exchange-traded fund (ETF).​

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).

ETFs are easily traded on the stock exchange, bought and sold throughout the trading day. This also means the price of an ETF share can fluctuate above or below its net asset value (NAV) based on supply and demand — just like a stock.

An important aspect of 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 vs. 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.

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.

How do you invest in ETFs at Ally?

1. You can purchase ETFs through Ally Invest's Self-Directed Trading account and buy through the brokerage platform after conducting your own research.

2. You can select an Ally Invest Robo Portfolio , which is primarily built on ETFs and is a more hands-off approach to investing.

What kinds of ETFs can you invest in?

Several types of ETFs exist, all with different performances and varying levels of associated risk. That's why it's important to evaluate any ETF you're considering as an investment. Here is a basic breakdown:

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

How to evaluate an ETF

There are numerous ways to evaluate ETFs, including noting the costs, portfolio construction, past performance and more. None of these will guarantee success, but it will help you get a full picture before investing. Here are a few other factors:

  • 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.

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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