What Is an ETF? Here’s How They Work (and Why Smart Investors Love Them)

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You’ve probably heard just how important it is to have a diversified portfolio. That’s stock market speak for “Don’t put all your eggs in one basket.”

But you’d need to invest in a lot of companies to achieve diversity on your own. Many investors say you’d need a minimum of 25 to 30 stocks. Where are you supposed to find the time and money to invest in that many companies?

That’s why we love exchange-traded funds, or ETFs. Buying shares in a single ETF allows you to invest your money in hundreds, even thousands of companies. The best part: You can get started even if you don’t have much money, making them a great option beginning investors.

What Is an ETF and How Does It Work?

An exchange-traded fund (ETF) is a bundle of investments that are packaged and traded as a single investment.

ETFs are created by major investment companies that have to submit detailed plans to the U.S. Securities and Exchange Commission (SEC) for approval before they can start selling shares to investors.

Some ETFs are actively managed, which means that humans are choosing the investments. But the vast majority of these funds are passively managed, which means they attempt to mirror the makeup of a market index.

Example: The most popular ETF is the SPDR S&P 500 Trust (SPY), which tracks the S&P 500. When you buy this fund, or any S&P 500 fund, your investment more or less reflects the makeup of the stocks on the overall S&P 500. If the S&P 500 is up, you’d expect your overall investment to rise as well. If the S&P 500 has a bad day, so does your investment.

The index is a benchmark. You want a fund that will perform at the benchmark level or higher.

While the S&P 500 is one of the most common stock indexes, there are plenty of obscure market indexes you’ve never heard of — and there’s often a corresponding ETF. There are ETFs focused on specific industries, regions of the globe or smaller companies, just to name a few examples, and they usually use a market index as a benchmark. We’ll discuss all that in greater detail when we get to “Types of ETFs.”

ETFs were first introduced in 1993, but they’ve exploded in popularity in the decade since the Great Recession. CNBC reports that U.S. investors had $4 trillion sitting in ETFs as of 2019, up from $530 billion in 2008. The appeal has been attributed to the low fees, ease of trading and management style ETFs offer, all of which we’ll get into shortly.

How Is an ETF Like a Stock?

When you buy and sell an ETF, it’s a lot like buying and selling stocks.

ETF shares are bought and sold throughout the trading day on stock market exchanges, hence the name “exchange-traded fund.”

One big advantage of ETFs is that they’re less risky than individual stocks. If you own stock in a company that goes under, your shares become worthless. But if you owned an ETF that included that same stock, the overall value of your investment probably won’t drop much because it includes plenty of other investments to mitigate the damage.

But less risk can also mean less reward. Owning an ETF that includes the next Amazon or Apple won’t bring the big payout that owning the individual stock would because within your investment in the ETF you probably own only a few shares or even a fraction of a particular stock.

How Is an ETF Like a Mutual Fund?

Still wondering what is an ETF, really? You’ve heard of mutual funds, right? Well, ETFs are similar to mutual funds in that both bundle lots of assets into a single investment.

However, mutual funds aren’t traded on the stock market. You buy mutual funds directly from the investment company, and you can only do so once a day after the stock market closes.

Another big difference: Most mutual funds are actively managed by humans, which means the overhead costs are higher. That’s why mutual funds usually have higher fees than ETFs.

To compare the costs of ETFs vs. mutual funds, let’s look at the expense ratios for each, which is the percentage of your investment that goes toward fees. Investment research firm Morningstar reported that in 2018:

  • The average expense ratio for actively managed funds was 0.67%.
  • The average expense ratio for passively managed funds was 0.15%.

That means that if you invested $1,000 in an actively managed fund, like a mutual fund, you could expect to pay $52 more in fees in a year than you would for a passively managed fund, like an ETF.

Think the human oversight is worth the extra cost? Think again. Countless studies have found that most investment managers underperform compared with market indexes over the long haul.

Another advantage of ETFs is that you can start investing for whatever it costs to buy a single share. Mutual funds often require an upfront investment of anywhere from $1,000 to $2,500. By contrast, the SPDR S&P 500 ETF we mentioned earlier was trading at $315.88 per share as of July 10.

Types of ETFs

Let’s delve a little more into all the ETFs there are out there. As of 2019, there were 2,096 exchange-traded funds — and they aren’t just limited to stocks. Here are some common types of ETFs:

Broad-Market Stock ETFs

These track the performance either of the overall stock market or a large chunk of it. Those with the broadest exposure are usually called total market funds.

Sector ETFs

These focus on specific industries within the overall market. For example, you could invest in a health care or energy ETF. Investing in a sector ETF often makes sense if you think a certain segment of the economy will be hot, but you don’t want to make bets on individual companies.

Bond ETFs

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You can find bond ETFs that invest in specific types of bonds, e.g., corporate bonds, municipal bonds, Treasuries, or those that invest across the entire bond market, which are known as broad market bond ETFs. In general, investing in bonds is a good strategy for people who need fixed income, like retirees.

International ETFs

These are made up of investments outside the U.S. Investors often seek them out to diversify their portfolios even more and to invest in growing economies throughout the world.

Commodity ETFs

Commodity ETFs invest in physical assets, like precious metals, e.g., silver and gold, coal, wheat, oil and natural gas.

How Are ETFs Taxed?

You’re taxed on ETF gains only when you sell your shares at a profit. At that point, you’re taxed the same way the underlying assets are taxed. So if you sold stock ETF shares, you’d be taxed the same way you would be if you’d earned a profit on individual stocks, which is:

  • Long-term capital gains rates, if you held the funds for a year or longer: Your earnings would be taxed in brackets of 0%, 15% and 20%, depending on your overall income.
  • Short-term capital gains rates, if you held the funds for less than a year: Your earnings would be taxed at the higher ordinary income rates, which consist of seven progressively higher brackets that cap out at 37%.

ETFs are considered more tax efficient than mutual funds, which is a fancy way of saying you often pay less taxes on them. The reason is that mutual fund managers are frequently buying and selling investments, and if there’s a gain, they have to distribute most of it to you, the investor, even if you haven’t sold your shares.

Note that if you earn money from your ETF shares — for example, because you’re paid stock dividends or bond interest — you will owe taxes on these earnings, but not your gains, while you’re still holding the shares.

But if you really want to max out those gains, owning ETFs in a Roth IRA is a great option. You don’t get to deduct your contributions from your taxes up front, but you get that money tax-free when you’re retirement age.

FROM THE INVESTMENT FORUM

Are ETFs a Good Investment? Here Are the Pros and Cons

So are exchanged-traded funds a good investment? The answer boils down to what the ETF is invested in. But generally speaking, let’s recap some advantages and disadvantages of ETFs.

ETF Pros

  • Instant diversification. You can invest in hundreds or even thousands of companies with a single purchase.
  • Lower risk compared to individual stocks. The diversity that ETFs offer protects you from losing big if one investment performs poorly.
  • Low upfront cost. You can invest for whatever it costs to buy a single share.
  • Easy to buy and sell. You can sell them throughout the trading day on stock exchanges.
  • Tax efficient. ETFs often come with a lower tax bill than mutual funds.
  • Transparency. You can verify what your money is invested in pretty much in real time using the prospectus on the ETF website or by entering the ticker on a free website, like Yahoo! Finance. Mutual funds, by contrast, are only required to disclose their holdings on a quarterly basis.
  • Low fees. These are some of the cheapest investments, fee-wise, because they are not actively managed.

ETF Cons

  • Less potential for big rewards. The downside of diversification is that you don’t earn big if one investment skyrockets.
  • There’s still some risk. ETFs aren’t guaranteed to make money and can also lose money if the stock market drops or the sector you’ve invested in performs poorly.
  • They have some fees. Still, they’re usually lower than mutual fund fees, and you can avoid commission fees by using a discount online broker.

How Do I Start Investing in ETFs?

Ready to start investing in ETFs?

Well, you may already be an ETF investor and not even know it. If you have a Roth or traditional IRA that you automatically invest in using a robo-advisor, there’s a good chance you already own some ETFs.

Since you can select your own IRA investments, you could use your IRA to pick your own ETFs, though we suggest sticking to what the robots recommend. They’re usually better investors than humans, plus they’ll take your age, your goals and how much risk you’re comfortable with taking into account.

Employer-sponsored retirement accounts, like 401(k)s, have been slower to adopt ETFs as investment options and often favor mutual funds instead.

If you want to pick your own ETFs, the best way to start is by opening a brokerage account. That way you can start small without putting something as important as your retirement account at risk.

What to Look for in an ETF

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Picking any investment can be overwhelming, and ETFs are no different. Here are a few things to look at when you make your pick.

  • Underlying index: Make sure you understand the index that an ETF is tracking because that tells you what you’re investing in. If you’re investing in an ETF that’s based on the Dow Jones Industrial Average, you’re investing only in the 30 stocks that the index represents. But an index that tracks the total stock market will probably have over 3,000 stocks.
  • Low expense ratio: The lower the expense ratio, the more of your investment will go toward actual investing. Many major brokerages offer ETFs with expense ratios below 0.1%.
  • No commission fees: Many online brokerages now offer commission-free trading.
  • Assets under management (AUM): If an ETF has lots of money invested in it, that means there are lots of willing buyers. Many investors recommend buying an ETF with at least $50 million in assets under management.
  • Past performance: Just because an investment was profitable in the past, that doesn’t mean it will be in the future. Still, past performance is a pretty good way to gauge whether an ETF is a good investment.

Unless you have expertise in a certain industry, we’d recommend starting with ETFs that track a large segment of the stock market. Historically, the stock market has averaged returns of 10% per year before inflation. By investing in the broader stock market, you can take advantage of this long-term growth.

How to Buy an ETF

Once you’ve funded your IRA or brokerage account and you’ve selected the ETF you want to buy, it’s time to place an order. You’ll do so in exactly the same way you would when you place an order for a stock.

If you’re using an online brokerage, you’ll simply enter the ETF ticker symbol and specify how many shares you want to buy. If you trade through a human broker, you’ll notify them and provide the information.

You can choose to place a market order, which means you’re willing to pay whatever the prevailing price is for the fund.

Or you can use a buy limit order. You’ll tell your broker how much you’re willing to pay and they’ll only execute the order at a price equal to or less than the amount you specified. So if you wanted to buy Fund ABC and it was trading for $50 per share, you could place a buy limit order that tells your broker to only buy it if share prices drop to $45.

Once you’ve decided to invest in ETFs, set yourself up for long-term success by practicing dollar-cost averaging. That’s where you decide how much you can afford to invest and invest that amount, regardless of what the market is doing. The easiest way to do this is to budget a certain amount to invest each month. That protects you against buying too many assets while prices are high.

A final tip: Ignore the day-to-day performance of your ETFs. Just as the stock market has good days and bad days, your ETFs will have up days and down days, too.

Your goal is long-term growth, not a short-term profit. ETFs aren’t risk-free, so don’t invest money in them that you’ll need in the next few years.

Robin Hartill is a certified financial planner and a senior editor at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected]