Exchange-traded funds (ETFs) have become increasingly popular investment vehicles over the past few decades. An ETF is a collection of securities such as stocks that tracks an underlying index. ETFs offer investors a simple way to gain broad exposure to market sectors or indices. This beginner’s guide will provide an overview of ETFs and tips for investing in them.
What is an ETF?
An exchange-traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset. Unlike mutual funds, ETFs trade like regular stocks on exchanges throughout the trading day. ETFs experience price changes throughout the day as they are bought and sold.
ETFs typically have lower expense ratios than actively managed mutual funds. The passive nature of tracking an index also leads to lower turnover rates and fees. ETFs offer immediate diversification, allowing investors to gain exposure to a wide variety of assets.
How ETFs Work
ETFs operate similarly to index mutual funds. An ETF will track a benchmark index like the S&P 500. The ETF contains a basket of assets that mirrors the performance of the underlying index. The ETF portfolio is managed to match the returns of the index before fees and expenses.
ETFs do not trade at their net asset value (NAV) like mutual funds. Instead, ETFs are bought and sold based on their market prices on exchanges. The market price fluctuates during the trading day as the ETF is bought and sold.
Large institutional investors called authorized participants help keep an ETF’s market price in line with its NAV through a creation/redemption mechanism. If the market price drifts too high compared to the NAV, the authorized participant will exchange underlying basket assets to create new ETF shares. The new shares increase supply, bringing down the ETF’s market price.
Benefits of ETF Investing
There are several advantages to investing in ETFs:
- Diversification – ETFs provide instant diversification. An S&P 500 ETF, for example, offers exposure to 500 large U.S. companies across industries.
- Low Cost – ETFs have lower expense ratios than actively managed mutual funds since they simply track an index. Lower costs increase returns over time.
- Tax Efficiency – ETFs typically generate lower capital gains distributions than mutual funds. This increases after-tax returns for investors.
- Intraday Liquidity – ETFs can be bought and sold at any time during market hours. Mutual funds only trade once per day after the markets close.
- Transparency – ETFs disclose their full holdings daily. Actively managed mutual funds report on a quarterly basis.
- Flexibility – ETFs can track broad markets or specific sectors, countries, or commodities. Investors have thousands of ETFs to choose from.
Types of ETFs
There are several categories of ETFs:
- Market ETFs – Track broad stock indexes like the S&P 500 or Russell 2000. Offer a simple way to gain exposure to the overall stock market.
- Sector ETFs – Track specific sectors like technology, healthcare, or financials. Allow investors to make tactical bets on certain sectors.
- Industry ETFs – Track narrow industry sub-sectors like cybersecurity companies or home construction firms. Provide targeted industry exposure.
- Factor ETFs – Track stocks exhibiting specific factors like value, growth, dividends, or low volatility. Allow factor-based investing.
- Bond ETFs – Track government, corporate, or municipal bond indexes. Offer diversified fixed income exposure.
- Commodity ETFs – Track commodities like gold, oil, or agricultural goods. Provide exposure to physical commodities.
- International ETFs – Track foreign stock indexes or countries. Provide geographic diversification.
- Inverse ETFs – Aim to deliver the opposite of index returns on a daily basis. Allow short-term bearish bets.
- Leveraged ETFs – Use derivatives to amplify index returns by 2X or 3X on a daily basis. Magnify exposure for short holding periods.
How to Trade ETFs
Trading ETFs is very similar to trading individual stocks:
- Open a brokerage account with a firm like Fidelity, Charles Schwab, or Vanguard. Look for no or low trading commissions and no account minimums.
- Place ETF buy and sell orders just like stock trades. You can trade throughout the day during exchange hours. Use limit orders to control the share price.
- Monitor your portfolio and rebalance periodically. Rebalancing involves trimming ETFs that have outperformed and adding to lagging ETFs to maintain target allocations.
Many brokerages allow investors to trade ETFs commission-free to encourage trading activity. This makes ETFs very affordable investment vehicles. However, it’s still wise to use limit orders whenever possible versus market orders. The spreads between the bid and ask prices on ETFs can be wide for less liquid ETFs. Limit orders will prevent overpaying.
ETF Investment Strategies
Here are some proven investing strategies using ETFs:
- Core and Satellite – Use a few ETFs like a total stock or bond market ETF as your portfolio core. Surround the core with satellite ETFs focusing on specific sectors or countries. Rebalance periodically.
- Passive Indexing – Construct a passive portfolio tracking major indexes like the S&P 500, Russell 2000, and MSCI EAFE using ETFs. Rebalance annually and keep costs minimized.
- Factor Tilting – Lean on ETFs tilted towards factors with long-term outperformance like value and momentum. This provides a systematic approach with diversification.
- Tactical Asset Allocation – Make short-term ETF allocation shifts trying to overweight asset classes poised to outperform. Requires active management and diligent risk controls.
- Risk Management – Use ETFs for hedging and managing risks like inflation or stock market declines. Examples include gold ETFs or inverse S&P 500 ETFs.
ETFs can be used to build simple passive portfolios or more active portfolios. The key is controlling costs and diversifying across multiple ETFs. Avoid over-trading and market timing ETFs which often underperforms buy-and-hold approaches.
ETF Investment Risks
While ETFs have advantages, there are some risks to consider:
- Tracking Error – ETF returns may slightly deviate from the underlying index due to fees, expenses, and index replication challenges.
- Liquidity – Trading volume and spreads vary hugely for ETFs. Less liquid ETFs have wider bid-ask spreads and large price jumps.
- Premiums/Discounts – ETF share prices can decouple from NAVs, although arbitrage typically eliminates this. Still, buying at premiums or selling at discounts hurts returns.
- Complexity – Leveraged, inverse, and exotic ETFs contain complex derivatives. Their returns over longer holding periods may significantly deviate from expectations.
- Counterparty – ETFs utilizing swaps or other over-the-counter derivatives carry counterparty default risks.
ETF investors should focus on larger, liquid ETFs and avoid exotic leveraged or inverse ETFs without fully understanding how they operate. Periodically check for any significant premiums or discounts in ETF pricing.
Getting Started with ETFs
Here are some tips for getting started investing in ETFs:
- Open a brokerage account with a low or no commission ETF provider like Fidelity, Charles Schwab, or Vanguard.
- Start small with a core portfolio of 1-4 diversified stock and bond ETFs matching your risk tolerance.
- Consider starting with a target date ETF or balanced ETF to simplify initially.
- Focus on large, liquid ETFs with lower expense ratios and tight bid-ask spreads.
- Use limit orders when trading ETFs to protect against poor liquidity.
- Reinvest dividends to compound gains over time.
- Hold a core portfolio long-term while making occasional tactical shifts with satellite ETFs.
- Rebalance once or twice per year to maintain target allocations.
- Read ETF educational resources available from issuers to become more knowledgeable.
With low costs, diversification, and flexibility, ETFs offer an excellent investment vehicle for beginners and experienced investors alike. Follow core investing principles, control emotions, and ETFs can play a valuable role in achieving long-term investment success.
- ETFs offer a low-cost, diversified way to invest in broad market indexes, sectors, factors, and asset classes.
- Benefits include intraday liquidity, transparency, tax efficiency, flexibility, and low costs.
- Types range from broad market ETFs to sector, industry, factor, bond, commodity, and leveraged ETFs.
- Start with core holdings of 1-4 diversified, liquid ETFs. Reinvest dividends and rebalance occasionally.
- Focus on long-term strategic allocations over tactical market timing when investing in ETFs.
- Kochard, Levi, and Stew Friedman. ETF Investing Strategies: How to Optimize Your ETF Portfolio. Kiplinger’s Personal Finance, 2021.
- Swedroe, Larry E., and Ali Masri. Your Complete Guide to ETF Investing: How to Earn High Rates of Returns Safely. Dover Publications, 2021.
- Rawson, Samuel. “ETFs: How They Work, Benefits, Risks.” Investopedia, 20 Nov. 2022, www.investopedia.com/terms/e/etf.asp.
- “A Guide to Exchange Traded Funds (ETFs).” SEC.gov, www.investor.gov/introduction-investing/investing-basics/investment-products/exchange-traded-funds-etfs.
- “ETFs: What You Need to Know.” Fidelity, www.fidelity.com/learning-center/investment-products/etf/etfs-what-you-need-to-know.