Read This Before You Invest in an ETF
Dear Rich Lifer,
Exchange-traded funds (ETFs) are attracting a lot of attention these days because of their low fees and tax efficiency.
But, as investments go they’re still fairly new, and potential investors are likely to have lots of questions.
And whether you’ve already started taking advantage of ETFs or new to it, there are a few things you need to know.
Today we’ll go over the basics of ETF trading, what are some of the benefits, the risks, and show you how to get started investing in them.
Read on for the top four reasons to invest in these profit opportunities… and the top four downsides to watch out for.
How Do ETFs Differ From Other Funds?
An ETF is simply a basket of securities you buy or sell on an exchange like a stock. ETFs are similar to mutual funds in that they are a combination of various investment assets chosen and maintained by a particular management strategy.
However, ETFs differ from mutual funds in that they are bought and sold on the open market while mutual funds are bought and sold based on their price at day’s end.
ETFs will typically track an index, sector, commodity or other asset. So, a fund provider will buy the underlying assets that make up the fund, establish details like fees and the number of shares to be created, then the Securities and Exchange Commission will review and either approve or deny the plan.
If approved, investors can start to buy shares in the ETF. One example of a popular ETF is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.
What Are the Benefits?
There are several advantages to ETFs, especially when compared to mutual funds. A few advantages to note are:
- Diversification – Like we said, most ETFs track a broad range of assets, including commodities, indexes, even the returns of a specific country. For this reason, ETFs can give you exposure to a variety of market segments with the convenience of not having to buy up individual stocks.
- Easy-to-Trade – Another bonus to investing in ETFs is they trade like a stock. For instance:
ETFs can be purchased on margin and sold short
ETFs trade on the open market and prices are updated throughout the day
ETFs allow you to manage risk by trading futures and options like a stock
Since ETFs trade like a stock, it’s easy to look up daily price changes using their ticker symbols. This makes comparing them to indexes or commodities the fund is tracking, no hassle.
- Lower Fees – If you’re buying passively managed ETFs, you’ll be paying a lot less compared to actively managed mutual funds. The reason being mutual funds charge not only a management fee, but there’s shareholder accounting expenses, marketing service fees, fees for sale and distribution, etc. All these drive up the expense ratio. Because most ETFs are passively managed, they usually have lower fees.
- Tax benefits – ETFs are generally more tax-efficient than mutual funds because the buying and selling happens on an exchange. Therefore the ETF sponsor does not need to redeem shares every time an investor wishes to sell, or issue new shares when someone wants to buy.
Redeeming shares can trigger taxes so listing shares on an exchange keeps tax costs low. Everytime an investor sells their shares of a mutual fund, they sell it back to the fund and are hit with a tax liability that must be paid by the shareholders of the fund.
The Disadvantages of ETFs
While ETFs have a lot going for them, they also have some downsides you should be aware of before diving in. Here are few drawbacks:
- Can Be Limited to Large-Cap Stocks – While it’s true ETFs are great for diversifying, depending on the sector however, you might be limited to only large-cap stocks because of a narrow group of equities in a market index.
This lack of exposure to small- and mid-cap stocks could leave a lot to be desired depending on the sector and growth potential.
- Intraday Pricing – We said one of the advantages to ETFs is their easy to trade, well this is a double-edge sword. For some investors, intraday pricing is overkill. If your time horizon is 10-15 years, intraday pricing is irrelevant.
For others, simply having the freedom to trade more often as opposed to waiting until the day’s end could lead to some emotional trading, which is not ideal.
- Costs Can be Misleading – When you compare ETFs with other funds, the costs are typically lower. But if you compare the costs of investing in individual stocks compared to ETFs, the costs are actually higher. Depending on your brokerage, you may or may not pay a commission fee, but ETFs require management fees, whereas individual stocks do not.
- Lower Dividend Yields – If you’re looking for dividend-paying ETFs, there are some. However, don’t expect the same kind of returns as individual high-yielding stock or groups of stock. Since ETFs usually track a broad market, the overall dividend yield will average out to be lower. The benefit though is dividend-paying ETFs are typically less risky.
How to Invest in ETFs
To get started, we recommend opening an account with a discount brokerage online. If you’re more hands-on, you can begin researching and buying up different ETFs to build your portfolio. If you want a more hands-off approach, there are several robo-advisors that will build a portfolio for you.
The last thing to note is what type of investments are most common since these are what you’ll research to build your portfolio from the ground up. There are really five types of ETFs to keep track of: Commodity ETFs, Bond ETFs, International ETFs, Stock ETFs, and Sector ETFs. Keep these five in mind as you build a balanced portfolio of ETFs.
To a Richer Life,
The Rich Life Roadmap Team