Investors hoping to maximize gains and diversify their investments are always on the lookout for low-cost options.
Remember that the fees you pay to invest are nearly as important as your gains.
High ongoing fees will slowly chip away at your returns over time, whereas low-cost options allow your investments to grow unabated for maximum proficiency.
With these details in mind, it’s no wonder many individuals, money managers, and investment professionals build portfolios that are made up partly (or even in their entirety) with ETFs.
ETFs tend to come with low costs and they allow investors to diversify with little effort on their part.
What Is an ETF Exactly?
In short, an index fund is like an index fund or a mutual fund that is traded on the stock markets like a stock.
According to the investing experts at Vanguard, an ETF is defined as a collection or basket of tens, hundreds, and sometimes thousands of stocks or bonds in a single fund.
This means they operate similarly to an index fund. ETFs allow you to diversify across many investment options in a single fund, versus picking stocks and bonds individually.
The big difference is that ETFs are traded like stocks on major stock exchanges like NASDAQ or the New York Stock Exchange.
This makes them easy to access and find, but also safer than many other investment options since stock exchanges are heavily regulated.
The popularity of ETFs over the last decade cannot be overstated. Each year, investors pour billions of dollars into them hoping to diversify, take advantage of their low costs, and maximize returns in one fell swoop.
Exchange traded funds (ETFs) are usually an index-based investment that is designed to mimic the index and yield the same return on investment of that index.
Here we look at the benefits as well as potential drawbacks of this type of investment.
Where Do You Purchase and Trade ETFs?
Buying an ETF is not that difficult, and you may even own this type of investment already if you use a work-sponsored retirement account. Either way, you can buy ETFs from most online discount brokerage firms, many mutual fund firms, and other places. Basically, you can buy ETFs anywhere you can buy regular stocks.
The benefit of using an online brokerage is you can use smaller investments to get started. Some of the larger firms may require an initial investment of several thousand dollars to begin your investment. Here is a list of some top brokerage companies; this might be a good place to start if you aren’t currently using an investment firm.
Top Places to Buy ETFs:
If you’re eager to set up a brokerage account to purchase or trade ETFs, here are a few of our favorite online brokerages and robo-advisors where you can invest:
- Ally Invest: When you invest with Ally, you get access to a robust offering of trading options and an excellent trading platform.
- E*Trade: E*Trade offers affordable trading and tools to help you along the way when you invest with the platform.
- Betterment: Betterment is one of the best robo-advisors on the market, offering automated investing when you sign up.
- M1 Finance: M1 Finance lets you choose where to invest then steps in to balance your funds and keep you on track once you start investing.
How to Buy ETFs
Exchange traded funds offer investors another opportunity to grow their investments. As with any investment, it is important to fully understand what you are working with as well as the pros and cons in order to make an informed decision.
From there, you can set up a market order for the ETF you want to buy — or an order that fulfills your purchase at the next available price.
You can also submit a limit order that holds off on purchasing the ETF until it drops to an agreed-upon price.
Your brokerage account will also let you sell ETFs whenever you’re ready. You can even set up a stop order that automatically tries to sell your ETF once it reaches an agreed-upon price.
Stop orders are intended to protect you from unusually low prices and the potential for them to drop further.
Understanding the fundamentals of buying and selling will help you avoid making costly investing mistakes.
ETFs vs. Mutual Funds
Because ETFs and mutual funds have so many similarities, you may be wondering why you would choose one option over the other.
Both allow you to diversify your investment with a broad range of stocks and bonds in a single fund, and both tend to be low-cost, so what’s the difference?
The big difference to note with ETFs is that, overall, their ongoing management costs are lower. Mutual funds are more likely to be actively managed, so their expense ratios are usually higher. Also, note that ETFs do not charge the same upfront load fees of some mutual funds.
ETFs also come with tax advantages; namely, you do not have to pay taxes on gains from ETFs until they are redeemed.
This is different from mutual funds, which require you to pay taxes on distributions annually whether you cash them out or reinvest them. ETFs also tend to have lower investment minimums to get started when compared to mutual funds.
Finally, don’t forget the golden rule of long-term investing — the rule that says passively managed funds beat actively managed funds over time.
Where mutual funds are often actively managed, ETFs are not.
This means there’s a good chance you will earn more over time with an ETF if your policy is “buy and hold,” which it probably should be.
Advantages of ETFs
ETFs provide a wide range of advantages over other types of investments, which is likely part of the reason they maintain their popularity. But what are the tangible benefits of ETFs? We’ve outlined them below:
- ETFs come with less risk than many other types of investments. Since ETFs are made up of a collection of stocks and bonds that is diversified for you, they are considerably less risky than some other investment options, including choosing individual stocks. When you invest in ETFs, keep in mind that the stocks and bonds included will balance each other out. Some may be performing poorly while others perform well.
- ETFs are easy to research and purchase. Betting on an individual stock can be extremely stressful and time-consuming since you’ll have to conduct quite a bit of research to fully understand what you’re getting into. ETFs, on the other hand, are easy to research and purchase. ETFs include investments that are selected by a professional fund manager, meaning they do the work on your behalf.
- Easy to manage. ETFs do not require the aggressive management that other funds may require. ETFs are designed to follow versus outperform an index, so only minor adjustments are needed.
- Easy to follow. Each day the creator of the ETF will publish a list of assets in the fund. This makes it easy to follow and for the most part easy to understand versus many mutual funds which are not published as frequently or as clearly.
- ETFs have lower costs. Since ETFs are passively managed, they almost always have a lower expense ratio and lower fees. These lower costs work on your behalf by allowing you to keep more of your hard-earned gains in your portfolio.
- ETFs come with tax benefits. As we mentioned already, you only pay capital gains taxes on ETFs when you sell them. This perk can benefit investors in different ways, but it’s still worth noting. Additionally, capital gains are taxed lower for ETFs than capital gains from mutual funds. This is due to the structure of the actual trade. Whereas mutual fund or index trades capital gains are taxed immediately, the individual capital gains from ETFs are not taxed until assets from the entire fund are sold.
Disadvantages of ETFs
It’s easy to love ETFs due to their low ongoing costs and diversification features, but they are not ideal for everyone.
This doesn’t mean they’re not a great option for you, but it always helps to understand all the pros and cons before you invest your hard-earned cash.
Downsides of ETFs include:
- ETFs do come with fees. While ETFs are often less expensive than mutual funds and many other investment options, they can be more expensive than purchasing an individual stock since individual stocks don’t have management fees at all. That doesn’t mean investing in individual stocks is a better strategy; it only means you should be aware of when you’re paying fees and how much they are.
- Trading costs can be high. While this isn’t always the case, trading costs for ETFs can be high in some cases. This is particularly true if you’re buying ETFs yourself through a traditional brokerage account and investing smaller sums of money each month versus a large lump sum upfront. If you are working with a limited amount of money, trading commissions can offset the economic advantages otherwise found with ETFs.
- You may not know what you’re investing in. Where choosing an individual stock requires you to become acquainted with how you’re investing your money, researching every underlying investment in an ETF would be an amazing feat. After all, ETFs can include tens or hundreds of stocks and bonds. Many investors choose ETFs for this reason (to diversify), but also because it saves them from having to do their research.
- Powerful investment tool. Certain ETFs, such as the leveraged or inverse type, can be very powerful tools. Tools that in the wrong hands or managed incorrectly can be very costly for an inexperienced investor. For this reason, anyone who does not have a solid understanding of the market, as well as individual investment tools, should seek the advice of a financial advisor before jumping on board the ETF bandwagon.
Who Should Buy ETFs for Their Investment Portfolio?
At the end of the day, ETFs are like any other investment option — they aren’t perfect, and they have costs.
Still, the diversification aspect of ETFs combined with their low usual costs makes them an attractive proposition for all kinds of investors.
Still, ETFs will work better for some than for others.
We believe ETFs would work best for:
- Investors who plan to buy and hold over a long timeline — Investors who want to diversify and track the markets over time can benefit from the low-costs and diversification aspects of ETFs. You won’t make a fortune overnight, but ETFs have performed well historically with a long enough timeline.
- People who crave less risk. If you’re someone who can’t bear the thought of losing your shirt with an individual stock, ETFs might be for you. The fact that ETFs are made up of dozens or even hundreds (or thousands) of individual stocks and bonds means that one of them performing poorly won’t cause you to lose everything.
- Investors who want low costs. While ETFs can be pricey to invest in certain situations, they are usually one of the lowest cost options available. They tend to have low expense ratios and refrain from charging upfront load fees.
- You don’t want to pay taxes on distributions each year. Remember how ETFs don’t require investors to pay income taxes on capital gains until they are sold? This can be a big perk for investors with specific tax situations.
- You don’t have a ton of money to invest. Where some mutual funds require you to have $2,500 or more to get started, ETFs tend to be more accessible and offer lower minimums overall.
If you’re ready to invest in ETFs, the best step to take now is opening a brokerage account.
Make sure to compare the best online stock trading companies before you take the plunge and conduct due diligence to make sure you fully understand all costs, account minimums, and features.
The best online stock traders let you trade ETFs and other types of investments with low fees and exceptional perks, but you’ll never know how they stack up unless you check.