A popular choice among people making their first investment is an exchange-traded fund (ETF). This option combines the diversification benefits of a mutual fund with the ease of trading associated with stocks. An ETF is a basket of investments that may include stocks or bonds. By investing in the ETF, you gain exposure to all of these securities at once without needing to directly purchase shares yourself. Instead, you purchase a share of the ETF, which gets traded on exchanges like any other stock. Because of that, ETFs are traded quite easily. Also, it is worth mentioning that ETFs often have low management fees, which is another quality that makes them attractive to investors.
The Basics of Investing in An ETF
When you invest in an ETF, you do not have ownership of the underlying assets. Instead, the fund itself owns these investments. Purchasing shares of an ETF gives you ownership of a portion of the fund itself rather than the underlying assets. At the same time, you may receive dividend payments from the underlying assets depending on the particular investments made by the fund. Many ETFs are designed to track the value of a particular index or asset, such as the S&P 500 or gold. However, the price of the ETF will vary from the underlying asset and the returns will also be different given expenses and other operating costs. You can invest in ETFs directly on an exchange through a brokerage or with a robo-advisor. Importantly, many major brokerages do not charge commissions on ETF trades.
The cost of an ETF can vary widely depending on the particular fund. While some ETFs will cost hundreds of dollars per share, others are only a few dollars. In other words, there is an ETF for virtually any budget. As of the end of 2021, the median price of popular ETFs by trade value was $60 per share, so the investment is relatively affordable for most investors. As you look at an ETF, be sure to consider the expense ratio, or the fee that you will need to pay for fund management. Most ETFs are passively managed, which means that this fee is fairly low, but this is not always the case. Be sure to compare the expense ratios between the different ETFs you are considering. The average expense ratio for ETFs is about 0.2 percent.
The Reasons to Invest in An ETF
There are many reasons exist to invest in an ETF. One of the major points that attracts investors is instant diversification. ETFs make it very easy to diversify across horizontals, such as a particular industry. Mimicking the diversification of an ETF would require a lot of time and money that most investors do not have, so this investment is an easy way to achieve this and protect your portfolio from volatility. The vast majority of ETFs are created with a good amount of diversification already. Another point to consider is transparency. A simple Internet search reveals the price activity for a particular ETF since these investments are traded on an exchange. Plus, ETFs disclose their holdings to the public on a daily basis, whereas mutual funds only do this monthly or even quarterly. This transparency helps you keep your finger on the investments you are connected to more closely.
The other benefits of investing in an ETF have to do with taxes. With a mutual fund, you typically have to pay capital gains taxes over the course of the investments. Mutual funds tend to trade assets more frequently than ETFs, which tend to incur such taxes only when you sell your shares. Mutual fund managers actively buy and sell investments and then pass the capital gains taxes along to investors on both a short-term and long-term basis. These taxes can sometimes be a surprise. With an ETF, you have much more control over when you would have to pay the tax.
The Downsides of Investing in An ETF
While there are many benefits to investing in an ETF, there are also some downsides to consider. Be sure to understand these shortcomings to avoid a surprise down the line. One is the cost of trading. Beyond the expense ratio, you may face a commission from brokers. As stated above, many brokers have begun to waive this fee, but not always. Always ask to make sure you know what you will need to pay to invest. Another issue has to do with liquidity. When it comes time to sell, the market may not be very receptive. This is the same liquidity issue you would face with a stock and you may need to take a hit if you are unable to wait to sell. Furthermore, you always face the risk that the ETF will close. This can happen when a fund hasn’t brought in enough assets to cover the administrative costs. When this happens, you are forced to sell and possibly at a loss.