How to Invest in ETFs: A Beginner’s Guide

Key Takeaways


Many beginning investors are eager to open a brokerage account and purchase their first corporate stocks. But it’s important not to forget about exchange traded funds. ETFs are often more beneficial for a new investor because they generate more reliable returns and can help with diversification.

Here’s a beginner’s guide that’ll teach you how to invest in ETFs, and how to know whether an ETF is the right investment for you.


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how to invest in etfs

What is an ETF?

An exchange traded fund (ETF) is a fund that holds multiple assets rather than just a single stock. The assets may include stocks, bonds, or commodities.

An ETF may contain hundreds or thousands of assets. The assets may represent a variety of different industries or only a single sector. Furthermore, they may contain international assets or only American assets.

Because an ETF contains so many different assets, it can be a great way for an investor to diversify his or her investment portfolio.

How Do ETFs Work?

Let’s explain how an ETF works. First, a fund provider (usually a brokerage firm) purchases all of the underlying assets that are going to be used in the fund. Then, the fund provider designs a fund that will track the performance of all the underlying assets. Lastly, the fund provider sells shares of the fund to investors.

Shareholders own a portion of the ETF, but they don’t own any of the underlying assets—those are still owned by the fund provider. However, all shareholders that have a stake in the ETF will receive dividends from the stocks in the fund.

If you need a refresher, dividends are a portion of a company’s profit that are paid out to shareholders. ETF shareholders are entitled to earned interest and dividends that are generated by the assets in the fund, and they may also get a residual value if the ETF is liquidated.

ETFs are bought and sold on an exchange during the trading day—unlike mutual funds, which are traded once at the end of the trading day (we’ll compare ETFs and mutual funds in the next section). Thus, ETFs may be a suitable investment option for both long-term investors and active traders.

As mentioned earlier, ETFs are an attractive option for investors because they can help you build a diverse investment portfolio. But it’s important to know that not all ETFs are equally diversified. Some ETFs only hold stocks within a single industry, or they hold a relatively small number of stocks. Keep this in mind when you’re shopping around for ETFs.

Pro Tip: What about ETFs that track commodities, like crude oil or gold? Commodity ETFs trade at market-determined prices which are different from the price of the commodity itself.

ETFs vs. Mutual Funds

ETFs are often compared to mutual funds because both types of funds are essentially a basket of securities. However, ETFs are generally more cost-efficient than mutual funds. The average expense ratio for a mutual fund is 1.42%, while it’s only 0.53% for ETFs. Mutual funds employ an investment manager that is constantly choosing which securities are going to be included in the fund, and that’s why mutual fund fees are higher.

ETFs also tend to be more tax-efficient than mutual funds. Any time an investor enters or leaves a mutual fund, additional securities are bought and sold for the fund—if sold for a gain, all investors in the mutual fund will have to pay capital gains tax. So when you’re invested in a mutual fund, you may have to pay capital gains tax even if you haven’t made any transactions.

But the biggest difference between ETFs and mutual funds is in how they’re traded. ETFs are traded during the day on an exchange. The prices fluctuate constantly throughout the day, and it’s relatively easy to buy or sell shares when you spot favorable prices.

Mutual funds, on the other hand, are bought and sold only once per day after the markets have closed. You’re not able to capitalize on price fluctuations as easily. Long-term investors won’t notice these differences so much, but they make a world of difference for those investors who want to do active trading.

Types of ETFs

There are many different types of ETFs. Here are the most common types:

  • Stock ETFs: Hold stocks. These ETFs are designed for long-term growth and carry more risk than other types of ETFs.

  • Bond ETFs: Hold government bonds, corporate bonds, and municipal bonds.

  • Industry ETFs: Hold stocks within a particular industry (like technology or manufacturing).

  • Commodity ETFs: These ETFs invest in commodities, like crude oil or gold.

  • Currency ETFs: These ETFs invest in foreign currencies, like the Euro or the Canadian dollar.

  • Index ETFs: Hold stocks within a particular market index. Popular because they provide the investor with all the diversification, security, and reliability of an index fund.

There are a couple of other ETF types that you should know about.

An inverse ETF is an ETF that attempts to earn gains by shorting stocks. Stock shorting is when you sell a stock, expecting the price to decline in value. Then you repurchase the stock at a lower price. Most inverse ETFs are not real ETFs—they’re exchange traded notes (ETNs). They’re not a priority investment option for beginning investors.

You might also stumble upon actively managed ETFs, which, like mutual funds, employ an investment manager who is constantly overseeing the fund. While these ETFs may see strong gains over a short period, their expense ratios are also more expensive and they might not be worth holding if you’re a long-term investor.

how to invest in etfs

How to Invest in ETFs

How exactly do you invest in ETFs? It’s easy! You can do it in three steps.

1. Open an Account

First, you need to open an account at a brokerage firm. A brokerage firm is a middleman that facilitates the buying and selling of securities. Opening an account at a brokerage firm is not so different than opening a bank account.

There are a lot of different brokerage firms to choose from. Full-service brokerage firms may provide financial advisory services, but they also tend to be more expensive. Online brokers might be your best bet if you want to trade ETFs. Many online brokers offer commission-free trading on stocks and ETFs, so they’re a great value.

2. Find and Compare ETFs

Once you’ve opened your brokerage account, you can start shopping around for a suitable ETF in which to invest. ETF costs may vary widely from fund to fund, so it’s important to do your homework and compare them against each other.

Here are some of the features you can compare:

  • Administrative expenses: Also known as the “expense ratio,” these are fees that go toward the upkeep of the fund.

  • Commissions: This is a transaction fee every time you buy or sell an ETF.

  • Volume: How many investors are involved with a particular ETF? The more investors there are, the easier it may be to buy and sell.

  • Holdings: Which stocks does the fund contain? Do you think they’ll generate strong returns?

  • Performance: How much profit has the fund generated? This is an important consideration for long-term investors—not necessarily for active traders.

  • Trading prices: How much is the price per share?

Before you purchase an ETF, consider your budget and your investment goals.

3. Start Trading

Once you’ve selected a good ETF, you can make an order to buy! Remember that most ETFs are designed to require little to no maintenance. If you’re a long-term investor, don’t make knee-jerk reactions to short-term fluctuations in the price. Many ETFs tend to provide solid returns over a long period.

Pros of ETF Investments

Here are some of the pros of investing in ETFs:

  • Low cost: It would be expensive for an investor to buy all the stocks in an ETF individually—an ETF provides all the underlying assets for a fraction of the cost with only a single transaction. There are fewer trading costs, a low expense ratio, and greater tax efficiency.

  • Diversification: High-volume ETFs contain many different stocks, so it’s a good way to build a diverse investment portfolio. Diversification protects you in the event one of your stocks fails and falls dramatically in price.

  • Variety: You’re able to find ETFs that target several different markets and assets, so it’s easy to find one that suits your investment interest.

  • Transparency: You can find the price activity for an ETF with a quick internet search. Furthermore, an ETF’s holdings are disclosed to the public every day (as opposed to monthly or quarterly disclosures with mutual funds).

  • Liquidity: When you want to buy or sell an ETF, you don’t have to jump through the hoops like you will when trading mutual funds. ETFs trade like stocks, so you can buy or sell at a moment’s notice.

  • Bond Investing: Bonds are not the easiest asset to invest in—bond ETFs are so much simpler.

Cons of ETF Investments

Here are some of the cons of investing in ETFs:

  • Trading costs: Some brokerages may charge commission fees on ETF trading.

  • Liquidity: Not all ETFs have high liquidity. ETFs that aren’t traded frequently may be very difficult to sell. There’s a possibility you could be forced to sell at a loss. Larger ETFs may also be more difficult to buy and sell.

  • Closure: There’s always a risk that an ETF will close—this usually happens because a fund hasn’t brought in enough money to cover administrative costs. Closure forces investors to sell earlier than intended, and it may also force investors to reinvest their money and pay capital gains tax.

  • Profits: An ETF won’t give you as much return potential as individual stocks. You won’t be able to make a fortune by investing in the “Next Google” or “Next Amazon.” However, ETFs do provide more reliable returns for long-term investors, like those investors who are saving for retirement.

  • Diversification: Singe-industry ETFs are not well-diversified.

You should also know that there has been some concern about the effect of ETFs on the stock market. Some financial experts believe that the high demand for ETFs inflates stock prices and creates economic bubbles within specific industries. In fact, ETFs have been linked to several flash-crashes since the 2008 financial crisis.

Does that mean you shouldn’t invest in ETFs? Of course not! Just remember that diversification is the best way to protect yourself in the event of a market crash. Consider investing in other types of assets, like real estate or cryptocurrency.

how to invest in etfs

Are ETFs Good for Beginners?

ETFs are a great investment option for beginning investors. New investors often don’t have enough capital to buy many stocks or to build a diverse portfolio. An ETF solves that problem by providing solid returns and diversification for a low cost.

ETFs trade on a per-share basis, so you only need money to purchase a single share. And some fund providers even offer fractional shares.

The Best ETFs to Invest In

Here are some of the best ETFs to invest in. Let’s start with some of the most well-known index ETFs:

  • SPDR S&P 500 (SPY): Holds stocks in the S&P 500 index. It’s one of the oldest and most popular ETFs.

  • iShares Russell 2000 (IWM): Holds stocks in the Russell 2000 small-cap index.

  • SPDR Dow Jones Industrial Average: Holds the 30 stocks in the Dow Jones Industrial Average Index.

Some other best-value ETFs include:

  • Vanguard Large-Cap (VV)

  • SPDR Portfolio S&P 500 (SPLG)

  • iShares Core S&P 500 (MGC)

Why are index ETFs the best ETFs for beginners? Most market indexes tend to appreciate in value over time, so they’re a safe bet for long-term investors.

Summary

An ETF is a bundle of securities. ETFs may hold dozens or even thousands of different assets. They’re a good investment option because they’re easy to trade, are low-cost, and sometimes help you with diversification. It’s easy to invest in ETFs—you just need to open a brokerage account and find an ETF that suits your budget and investment goals.

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