Exchange-traded funds or ETFs are a simple way to get started investing. ETFs are straightforward to understand and can produce significant returns without requiring much money or effort. Here’s what you need to know about ETFs, how they operate, and how to invest in them.
What’s an ETF?
ETFs, let investors buy multiple stocks or bonds at the same time. Moreover, when you purchase shares of an ETF, you use that money to achieve a specific goal. So, for example, if you’re interested in the S&P 500 (^GSPC), you can buy an ETF focused on those 500 companies.
Exchange-traded funds or mutual funds
Another popular question is whether ETFs are comparable to mutual funds, given that the underlying principle is similar.
The distinction between these two investment vehicles lies in how you buy and sell them. Mutual funds are priced once daily, with an agreed-upon sum invested. An investor can purchase mutual funds through a broker or the issuer. The critical thing to remember is that the purchase transaction takes time.
On the other hand, exchange-traded funds trade just like stocks on major exchanges such as the NYSE and Nasdaq. Instead of investing a set amount, you choose how many shares you want to buy. ETF prices constantly change throughout the trading day because they trade like stocks, and you can purchase shares of ETFs at any time during the stock market’s opening hours.
Understanding the basics
Before we go any further, there are a few terms you should be aware of before investing in your first exchange-traded funds.
- Passive vs. active ETFs: There are two primary types of ETFs. Passive ETFs (also called index funds) track a stock index, such as the S&P 500 (^GSPC). Active ETFs hire portfolio managers who attempt to outperform an index. In other words, passive ETFs seek to match an index’s performance, while active ETFs acquire exposure to beat an index’s returns.
- Expense ratios: The fees for ETFs, known as the expense ratio, are listed as an annual percentage. For example, a 1% expense ratio means you would pay $10 in fees for every $1,000 invested. In general, a lower expense ratio will save you money.
- Dividends and DRIPs: Many ETFs produce dividends. You can have your ETF dividends paid to you as cash or automatically reinvested through a dividend reinvestment plan, also known as a DRIP.
Understanding the taxes
If you purchase exchange-traded funds in a standard brokerage account (not an IRA), you should know that it might result in taxable income. This is because the IRS will tax any profits from selling an ETF according to capital gains tax rules, and any dividends received are also likely to be taxed.
Of course, if you invest in ETFs through an IRA, taxes won’t even enter your mind. In a traditional IRA, money saved is only considered taxable income once withdrawn, while Roth IRA investments aren’t taxable under most circumstances.
How much money do you need to start investing in ETFs?
Unlike mutual funds, exchange-traded funds don’t have minimum investment requirements. Nevertheless, ETFs trade per share, so unless your broker allows you to buy fractional shares of stock, you’ll need at least the cost of one share to begin.
Pros and Cons of Exchange-traded funds
Pros of ETFs:
- ETFs allow you to invest in many different stocks, bonds, and other assets at a low price.
- ETFs are a fantastic way to invest in stocks without all the guesswork. They let you see and follow how well the market is doing over time.
- ETFs are more liquid (more accessible to purchase and sell) than mutual funds. ETFs may be bought or sold through an online broker with a simple click.
- Individual bonds might be challenging to invest in, but a bond ETF may help you manage your fixed-income assets.
Cons of ETFs:
- ETFs don’t have as much return potential as buying individual stocks because they own a wide range of equities.
- ETFs are often low-cost, but they aren’t always free. You won’t have to pay management fees if you invest in a portfolio of individual equities on your own.