How to Invest in ETFs

Exchange-traded funds, or ETFs, are an easy way to begin investing. ETFs can generate impressive returns without much expense or effort.

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What is an ETF?

An exchange-traded fund (ETF), allows investors to buy many stocks or bonds at once.

Investors buy shares of ETFs, and the money is invested according to a certain objective.

For instance, if you buy an S&P 500 ETF, your money will be invested in the 500 companies in that index.

ETFs:

  • ETFs vs mutual funds:

  • ETFs allow investors to buy many stocks or bonds

  • ETFs are traded on an exchange

  • ETFs are traded whenever the stocks market is open.

Mutual Funds:

  • Mutual funds allow investors to pool money together

  • Mutual funds are bought directly from the issuing company

  • Mutual funds are priced daily.

ETFs vs. Mutual funds

The key difference between these two types of investment vehicles is how you buy and sell them.

Mutual funds are priced once per day, and you usually invest a set amount.

Mutual funds can be bought through a brokerage or directly from the issuer, but the transaction is not instantaneous.

On the other hand, ETFs trade just like stocks on major exchanges such as the NYSE and Nasdaq.

Instead of investing a set amount of money, you choose how many shares you want to purchase.

Because they trade like stocks, ETF prices continuously fluctuate throughout the trading day.

You can buy shares of ETFs whenever the stock market is open.

Understanding ETF basics

Passive vs. active ETFs: There are two basic types of ETFs. Passive ETFs (also known as index funds) track a stock index, such as the S&P 500.

Active ETFs hire portfolio managers to invest their money. Passive ETFs want to match an index’s performance. Active ETFs want to beat an index’s performance.

Expense ratios: ETFs charge fees, known as the expense ratio. The expense ratio is often listed as an annual percentage.

For example, a 1% expense ratio means that you will pay $10 in fees for every $1,000 invested. A lower expense ratio will save you money.

Dividends and DRIPs: Most ETFs pay dividends. You can choose to have your ETF dividends paid to you as cash, or automatically reinvested through a dividend reinvestment plan, or DRIP.

Understanding ETF taxes

If you buy ETFs in a standard brokerage account (not an IRA), they could result in taxable income.

Any gains you make from selling an ETF will be taxed according to capital gains tax rules. Any dividends you receive will likely be taxable as well.

If you invest in ETFs through an IRA, you will not have to worry about capital gains or dividend taxes.

In a traditional IRA, money in the account is only considered taxable income after it is withdrawn. Roth IRA investments are not taxable at all in most cases.

How much money do you need to be able to invest in ETFs?

ETFs don’t have minimum investment requirements like mutual funds.

However, ETFs trade on a per-share basis. Unless your broker offers the ability to buy fractional shares of stock, you will need at least the current price of one share to get started.

Advantages to investing in ETFs:

  • ETFs provide exposure to a variety of stocks, bonds, and other assets, at a minimal expense.

  • ETFs take the guesswork out of stock investing. They allow investors to match the market’s performance over time.

  • ETFs are more liquid (easy to buy and sell) than mutual funds.

  • It can be extremely complicated to invest in individual bonds, but a bond ETF can make the fixed-income portion of your portfolio very easy.

Disadvantages of ETFs:

Since ETFs own a diverse assortment of stocks, they don’t have much return potential as buying individual stocks.

ETFs are often low-cost, but they are not free. If you buy a portfolio of individual stocks on your own, you will not have to pay any management fees.

Other Investment Options

Stocks

Stocks are investments in the future success of a company. When you invest in a company's stock, you profit when they do.

Bonds

Most companies and municipalities also borrow money by using bonds.

Mutual Funds

A low-cost, passive mutual fund can provide broad market exposure to diversify your investments and portfolio.

Index Funds

These are often a good fit for investors who prefer caution when investing.

How to start investing in ETFs

Open a brokerage account.

You need a brokerage account before you can buy or sell ETFs. The best course of action is to compare each broker’s features and platform.

If you’re a new investor, choose a broker that offers an extensive range of educational features, such as TD Ameritrade (NASDAQ:AMTD), E*Trade (NASDAQ:ETFC), or Schwab (NYSE:SCHW).

There are several other excellent brokers to choose from.

Choose your first ETFs.

For beginners, passive index funds are usually the best way to go. Index funds are much cheaper than their actively managed counterparts. Most actively managed funds don’t beat their benchmark index over time.

Here’s a list of ETFs for beginners who are just starting to build their investment portfolios:

Vanguard S&P 500 ETF (NYSEMKT:VOO) - Large U.S. companies

Schwab U.S. Mid-Cap ETF (NYSEMKT:SCHM) - Midsize U.S. companies

Vanguard Russell 2000 ETF (NYSEMKT:VTWO) - Smaller U.S. companies

Schwab International Equity ETF (NYSEMKT:SCHF) - Larger non-U.S. companies

Schwab Emerging Markets Equity ETF (NYSEMKT:SCHE) - Companies from countries with developing economies

Vanguard High-Dividend ETF (NYSEMKT:VYM) - Stocks that pay above-average dividends

Schwab U.S. REIT ETF (NYSEMKT:SCHH) - Real estate investment trusts

Schwab U.S. Aggregate Bond ETF (NYSEMKT:SCHZ) - Bonds of all different varieties and maturity lengths

Vanguard Total World Bond Fund (NASDAQ:BNDW) - Includes international bonds as well as U.S. bonds of various lengths and maturities.

Invesco QQQ Trust (NASDAQ:QQQ) - Tracks the Nasdaq-100 Index, which is heavy on tech and other growth stocks.

Let your ETFs do the hard work for you.

ETFs are often designed to be maintenance-free investments. So, once you buy shares of some great ETFs, the best advice is to leave them alone and let them do what they are intended to do which is to produce excellent investment growth over long periods of time.