Table of Contents
What is an ETF?
How to choose an ETF
Active vs. passive ETFs
How to buy an ETF
ETF transaction costs
FAQs about ETFs
The bottom line
Jun 21, 2022
7 min read
ETF investing is a relatively simple way to build a diverse portfolio. Investors usually start by understanding the ETF expenses, and figuring out how much to invest.
An exchange-traded fund (ETF) can be an easy way to build a portfolio and manage it for the long term. ETFs generally offer the benefit of built-in diversification, replicating the performance of an index or bundle of assets. Here’s what to know about how to invest in ETFs.
An ETF is a basket of securities that tracks an underlying asset such as an index, sector, commodity, or market. Because an ETF contains many securities, it provides diversification, potentially reduces risk in a portfolio, and allows investors to target the kinds of assets they want.
ETFs trade like stocks, so they can be bought and sold throughout the day on the market. The fund uses the pooled money to invest according to a certain objective. For instance, with an S&P 500 ETF, an investor’s money is used to buy shares in the 500 companies in that index.
As of September 2021, there were nearly 2,700 ETFs in the US with assets of $6.67 trillion. Each fund is different, so investors have to decide how to choose ETFs that achieve specific investment goals.
ETFs have many underlying assets, and investors have the option of looking under the hood to find out what each fund contains and how they’re managed. ETFs generally disclose their holdings on a daily basis, so this information should be relatively up-to-date.
Among the information disclosed: what benchmark the ETF tracks, what’s in the fund, how the assets are weighted, whether the fund reliably tracks its underlying assets, and whether the ETF is actively or passively managed. The ETF issuer’s website may provide a list of the fund’s holdings and associated weights. An ETF’s prospectus also provides the fund’s objectives, investment strategies, performance over the years, risks, management team, fees, and distribution policy.
Some investors select funds with low or no commission fees and a low ETF expense ratio because, all else being equal, these costs cut into profits. But the ETF can also cost investors in other ways. For instance, a fund may have a tracking error, which means its value doesn’t align perfectly with the index the ETF tracks. As a result, an investor may overpay for an ETF in some cases.
Generally, funds that trade at higher volumes and contain more assets under management tend to trade at narrower spreads than funds with less daily trading or lower assets. A tight bid-ask spread can be advantageous for investors who are keeping an eye on costs or have a very short time horizon.
Most ETFs don’t have a set minimum investment, which can be beneficial for investors who want to spend a small amount. Buyers will need enough to purchase at least one share of the fund, plus any associated fees or commissions, unless the ETF issuer offers fractional shares.
ETFs come with built-in diversification, but investors can also buy more than one fund to target different assets, commodities, or industries. For instance, an investor might buy stock ETFs and one that’s focused on real estate or precious metals. With this approach, investors use different methods that work for their timeline and goals.
Over time, investors can set up an automatic investment plan with the help of a brokerage or manually add to their holdings. For instance, an investor might set aside money each week or month and divide it among their ETFs according to the ratio they prefer. Some ETFs pay dividends, which can either be reinvested in the fund or paid out to use it some other way.
ETFs can either be passively or actively managed.
These are designed to match the performance of the index they track. Most ETFs are passively managed and come with lower expense ratios.
By contrast, actively managed ETFs hire fund managers to pick investments and try to outperform the market. These typically have higher expense ratios.
Here’s an overview on how to buy ETFs in just a few steps.
Investors need a brokerage account to buy and sell ETFs and other types of investments. Many online brokers offer commission-free ETF trades, though individual ETFs may come with other costs paid through an expense ratio.
The next step is adding money to the brokerage account that eventually will be used to invest. Brokerages usually allow account holders to link a bank account, such as a checking or savings account, and transfer money into the brokerage account from there. Investors may also be able to deposit a check, wire money, or transfer assets from another broker. Some brokerages set a funding minimum before the account can be activated.
Depending on what the brokerage offers, an investor may be able to choose an ETF based on asset type, geography, industry, trading performance, or fund provider. The process may vary with each brokerage, though there’s usually a “trading” section where an ETF can be found using its ticker symbol, a set of letters that serve as the fund’s unique identifier. The current trading price will be determined by the “bid,” which is the highest price someone is willing to pay for a share, and the “ask,” or the lowest price a seller will accept.
An investor can plug in the number of shares to buy and place an order. A market order is an order to buy the ETF shares as soon as possible at the best market prices available, while a limit order is an order to buy shares only at a specified price or better.
ETFs may charge two types of fees.
ETF trading fees are a flat commission paid each time an investor buys or sells shares in the fund. The average trading fee is about $8, but some may range to $20 or more. These can add up when investors buy and sell frequently—and brokerages might also hike up the fee when trading in person or over the phone. Some ETFs are commission-free, but it depends on the ETF sponsor and the brokerage or platform used to buy and sell the fund.
An ETF expense ratio shows how much of the assets in an ETF will be deducted annually as fees. The fees compensate the fund issuer for expenses related to operating the fund, such as salaries, marketing, and recordkeeping. To calculate the expense ratio, the fund manager divides the fund’s operating expenses by the average assets of the fund. The average ETF expense ratio was 0.54% in 2020, which translates to $5.40 per year in fees for every $1,000 invested. Some funds charge much less, which can help keep costs low.
Investors don’t have to spend a set dollar amount on an ETF. But because ETFs trade on a per-share basis, an investor will need enough money to buy at least one share of the fund, plus any ETF transaction costs. Some ETFs offer fractional shares, allowing the investor to purchase stock based on a specific dollar amount rather than the price of a whole share.
Yes, if the ETF contains underlying stocks that pay dividends. The ETF issuer will collect the dividends and pay them to investors based on the number of shares they own. The issuer either distributes cash to the fund investors or reinvests the money into the fund’s assets. With either method, the investor is responsible for paying capital gains tax on the dividends.
Yes. ETF investors can sell their shares anytime throughout the trading day, which allows them to take advantage of intraday price fluctuations.
ETF investing is a relatively simple way to build a diverse portfolio. Once a brokerage accounthas been opened, an investor can buy (or sell) ETFs within and across several asset classes with little more than the touch of a button. Investors usually start by doing research, understanding the ETF expenses, and figuring out how much to invest
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