In the past decade, Exchange-Traded Funds (ETFs) have gained popularity among investors. The amount of money invested in ETFs has grown five times since 2008, and this growth continues. For most investors, ETFs present a low-cost, convenient, and diversified investing opportunity. Because investing in ETFs is so easy, they are great for investors with busy schedules. If you are interested in getting into the ETF market, this article will teach you how to invest in ETFs.
What are ETFs?
Exchange-Traded Funds (ETFs) are funds that pool investor money to make investments. You can think of ETFs as companies that invest your money for you. When you purchase a share of an ETF, you will gain proportional ownership to its portfolio’s incomes and gains. For example, an equity ETF owns stocks from 200 different companies. When you own 1% of the ETF, you essentially indirectly own 1% of all the stocks in its portfolio and receive 1% of all the investment income from the ETF.
As the name suggests, ETFs are traded on exchanges. This makes buying and selling shares of ETFs extremely simple and convenient. You can buy shares of ETFs from your broker or through your online account anytime during the trading hours.
Passive ETFs V.S. Active ETFs
Based on its management style, an ETF can be classified as either passive or active. The intuition is simple. Passive ETFs duplicate the return of an index, without active management. By holding the same underlying investments, passive ETFs can track the returns of stock and bond indices. They are the most common type of ETFs with cheap management costs.
Active ETFs, on the other hand, are managed by professionals striving to exceed the market return. These managers create their own portfolios instead of mimicking an index. They make investment strategies and adjust their investments constantly. Active ETFs could generate great returns. However, they are not guaranteed to beat the market. Due to its active management style and frequent trading, these ETFs also have high management costs.
Benefits of ETFs
Diversification
There is an old saying “don’t put all your eggs in one basket”. Diversification reduces the volatility and risks of your investment. However, building a diversified portfolio takes time and a large amount of capital.
One of the most important advantages of investing in ETFs is automatic diversification.
When you invest in an ETF, you immediately own a portion of a large portfolio, even if you only buy one share. For example, when you buy a share of an ETF that tracks the S&P 500, your investment will have the same rate of return as a diversified index with 500 different stocks. Investing in ETFs is a great alternative to building your own portfolio and picking your own stocks.
Diverse investing strategies
ETFs have a wide range of different investing strategies. Some ETFs replicate returns of stock and bond indices and others invest in particular countries and sectors. For example, many ETFs focus on investing in a specific sector such as technology, healthcare, or consumer staples. With a wide range of ETFs, investors are able to find one that aligns perfectly with their strategies and goals.
Low-cost
Compared to mutual funds, ETFs tend to have lower expense ratios. Many ETFs are passively managed and this allows them to reduce the management cost and leave more money in your pocket.
Convenience
Trading ETFs is straightforward. Buying shares of an ETF is as easy as buying a stock. With a regular brokerage account, you can look up the prices of ETFs and put in orders anytime during trading hours.
How do I make money from ETFs?
Portfolio income
ETF investors are entitled to their portion of the dividends and interests the portfolio generates. If you own 10% of an ETF, you are entitled to 10% of its portfolio income. This includes capital gains the fund captures when it sells securities. It also includes all interests and dividends the fund receives.
Capital gain income
Because ETFs are traded on an exchange, you can also make a profit by trading shares of ETFs. When an ETF’s portfolio appreciates, its share price also goes up. This gives investors the opportunity to sell their shares with a capital gain. Additionally, the price of ETF shares is also driven by supply and demand. When the demand is high, ETF shares tend to trade at a higher price than the actual value of its portfolio. This creates a premium that investors can capture when selling the shares.
Costs of investing in ETFs
Investing in ETFs comes with two costs. First, when you buy or sell an ETF, your broker might charge you a commission for the transaction. Fortunately, many ETFs do not charge commissions anymore. Most likely, the ETF you want to invest in has a commission-free alternative. You can find these commission-free ETFs with just a little research.
The second cost of investing in ETFs is the expense ratio. Like mutual funds, ETFs also pass along its operating costs to the investors. The expense ratio tells you how much the fund charges to manage your money. For example, an ETF with a 0.4% expense ratio will charge you 0.4% of your total investment each year. Because this ratio can vary greatly from one fund to another, it’s a good idea to shop around to find an ETF with a low expense ratio.
What kind of ETFs are there?
Today, there is a whole universe of different ETFs in the market available to you. No matter what your investment strategy is, you will find one that fits your goals.
ETFs of everything
In the market, you can find ETFs for almost any financial product you are interested in. As shown in the table below, you can use ETFs to invest in stocks, bonds, and even cryptocurrencies.
| Types of ETF by Product | Investments |
| Index ETF | Portfolios replicating index compositions |
| Equity ETF | Domestic and international stocks |
| Bond ETF | Treasury, agency, municipal, and corporate bonds |
| Cryptocurrency ETF | Bitcoins, etc |
| Commodity ETF | Precious metal, oil, and gas |
| Foreign Exchange ETF | Foreign currencies |
| REITs ETF | Equity and mortgage REITs |
Targeting sector and country
Within each financial product, each ETF has a specific investment strategy and target. For example, some ETFs invest in only certain sectors such as healthcare or technology. Others focus on investments in particular countries such as China or G10. This helps investors access markets and sectors they want to invest in with ease.
Before you invest – Research
While ETFs are great investment options, careful research is still needed before putting your hard-earned money into an ETF. Every ETF must issue a prospectus that contains important information on the fund, including its investment objective, expense ratio, and even past performance. You can find the prospectus for any ETF through the SEC or your broker. The prospectus is your best friend in selecting a good ETF investment.
Picking a winner
First, you need to decide if you want to invest in an active or passive ETF. Passive ETFs track the market return and active ETFs aim to beat the market. If your goal is to just duplicate the performance of the market or a sector, you should choose a passive ETF. They also have lower expense ratios, leaving more money in your pocket.
If your goal is to beat the market, you can look into active ETFs. Active ETFs rely heavily on the managers to make good investment decisions. A good manager can help you make money but the performance is not guaranteed. To select a good active ETF, you should research the experience and background of the fund managers and their strategies in detail. You can also look at the ETF’s performance in the past. While it doesn’t guarantee future profits, past performance can help you understand the effectiveness of their strategies.
The second step is to find an ETF that matches your investment objective as closely as possible. With the wide varieties of ETFs in the market today, it is very likely that you can find one that aligns with your investment goals. For example, if you want to invest in tech companies in China, you can find an ETF that has a portfolio of Chinese tech stocks.
Checking the expense ratio
In general, ETFs have low expense ratios. However, the expense ratio can be quite high for actively managed ETFs. Thus, during your research, compare the expense ratios for similar ETFs. Often, you will be able to find a cheaper ETF with the same investment objective.
Every bit of saving could help you in the long run.
Commission-free ETFs
Similarly to the expense ratio, you can also shop around for ETFs with zero commission. There are many commission-free ETFs that can meet your investment goal, especially if you want to invest in passive ETFs. Major brokers such as Fidelity all offer commission-free ETFs on their platforms.
Less common ETFs generally charge a commission and are harder to find alternatives for. For example, cryptocurrency ETFs are rare and it will be hard to find a commission-free substitute.
ETF – the answer to investment procrastination
ETFs are easy, hassle-free, and effective investment tools. They make investing simple and can save you precious time. The convenience is especially useful to investors who are putting off their investments because of their busy schedules. With some research, we are sure that this article will help you find the right ETFs to maximize your investment and make your money work for you in 2020!
