There are a lot of different investment options out there, and the sheer number of choices can be overwhelming, even for seasoned investors. But ETFs are pretty easy to compare and obtain relative to other securities. And the first step toward investing in ETFs is understanding what they fundamentally are and how to differentiate them.
What is an ETF?
ETF stands for exchange-traded fund. An ETF allows you to purchase a large number of securities — stocks, bonds or commodities — all at once.
You can think of an ETF like a grocery basket, but instead of filling your basket with eggs and milk, you fill it with stocks or bonds. And, instead of purchasing each item individually, you purchase the entire basket all in one go!
Like an individual stock, ETFs are traded on an exchange throughout the day and there are tons of ETFs to choose from. Some ETFs are full of stocks, some hold bonds, and others track the performance of a certain market sector (healthcare, pharmaceuticals, communications, etc.) or a certain index (like the S&P 500, Dow Jones, etc.).
ETFs vs. mutual funds
You might think that an ETF sounds a bit like a mutual fund. While ETFs and mutual funds do have a few things in common, they also have their differences.
They both let you buy different securities
ETFs and mutual funds are similar in that they both allow you to purchase a large number of securities all at one time.
Not only is this convenient, but it also helps to add diversification to your portfolio. By purchasing a mutual fund or ETF you are essentially buying a basket of securities that holds an array of stocks and bonds, as opposed to purchasing lots of shares of just one or a few securities.
ETFs trade multiple times per day, mutual funds just once
The main difference between an ETF and a mutual fund is that ETFs trade throughout the day on the market, like a stock. On the other hand, mutual funds only trade once per day, after the market has closed.
ETFs tend to be cheaper
Another difference is that ETFs are generally cheaper than mutual funds, because they tend to have lower management fees. The majority of ETFs are passively managed. This means that people buy and hold an ETF that tracks an entire index, with the goal of mirroring the market. This is a long-term and relatively hands-off strategy, which helps to keep fees low.
Many mutual funds, on the other hand, are actively managed, which means a fund manager is regularly picking investments and trying to outperform the market. More frequent buying and selling means more human management, and therefore higher fees.
ETFs have lower minimum investment requirements
Lastly, ETFs require a lower minimum investment than a mutual fund. If you want to purchase an ETF you just need to cover the cost of the ETF plus any associated fees or commissions.
This means ETFs are accessible to virtually every investor, no matter how deep or shallow their pockets are. On the other hand, most mutual funds have much higher fees that require a minimum investment of hundreds or thousands of dollars.
Pros and cons of ETFs
You might be thinking, “Wow, ETFs sound pretty great!” And you’re right, ETFs are great — but they’re not perfect. Before you decide if an ETF is right for you, consider the pros and cons.
Pros
- Low barrier to entry. There is no minimum amount required to begin investing in ETFs. All you need is enough to cover the price of one share and any associated commissions or fees.
- Diversification. Rather than purchasing tons of securities individually (which would be extremely time consuming), you can quickly and easily purchase one ETF that contains an array of securities.
- Easy to buy and sell. ETFs are traded just like an individual stock. You can buy and sell at any point throughout the day.
- Tax efficient. You don’t pay any taxes until you sell your ETFs at a profit. So you are in control of when you decide to sell and pay the necessary capital gains tax.
Read more: How are capital gains taxed?
Cons
- Trading costs. While one of the benefits of ETFs is that they typically have lower fees than mutual funds, you still might have to pay fees when you make a trade. Although a lot of discount brokerages have instituted zero-fee trading, not all have.
- Volatility. ETFs are not immune to volatility. While purchasing an ETF may be more stable than putting all of your money into an individual stock, there is still potential for swings in the market. You can reduce your risk by purchasing an ETF that tracks the entire market rather than purchasing ETFs in one sector.
How to buy an ETF
Set up an investment account
To purchase an ETF you need to set up an investment account, specifically a brokerage account. If you feel confident doing things yourself and you want to save on fees, you can open an online brokerage account and purchase ETFs independently.
You can also consider a financial advisor if you go with a more full-service brokerage or wealth management option, who will give you advice and buy the ETFs on your behalf.
Now, if you feel a bit intimidated with the idea of opening a brokerage account and buying ETFs all by yourself, but you also don’t want to pay the fees associated with a full-service account, there’s also a third option for investing in ETFs.
Use a robo-advisor
You can also look into investing in ETFs via a robo-advisor.
A robo-advisor is a digital platform that uses algorithms to assist you in choosing and managing your investments. The best robo-advisors provide many of the same services as a full-service account manager but in the place of the human advisor there’s software.
Don’t worry, it’s not all about software and robots, as robo-advisors still staff humans to design the algorithms, answer your questions, and help you out.
» MORE: Robo-advisors vs discount brokers: What you need to know.
Determine what type of ETF you want to buy
If you’ve decided to go the DIY route and purchase ETFs on your own, then your next step is to do some research.
Do you want an ETF that follows an index like the S&P 500? Or perhaps you’re more interested in ETFs that track a certain market sector, like tech or energy? A good online brokerage will provide research and screening tools to help you review and compare different ETFs’ performances and fees.
The research process can be overwhelming, especially for a beginner. If you’re a first-time buyer you might want to consider a low-cost ETF that tracks an index like the S&P 500.
Decide when you want to buy
A lump-sum payment might be the best financial option for long-term returns. However, dollar-cost averaging (DCA) is another investment strategy that you can consider.
DCA involves making regular, scheduled investments (weekly, monthly, quarterly) without interruption. The main benefit of dollar-cost averaging is that you don’t end up making a big investment when the market is high. By splitting up the payments you will make some purchases when the price is high and some when the price is low, so it helps to average things out. Lump-sum vs dollar-cost averaging is a popular debate, so pick what works best for you and keeps you investing.
Fund your account
Before you can purchase an ETF you need to make sure you’ve deposited money into your brokerage or robo-advisor account.
You can fund your account by either transferring money from your chequing or savings, or by writing a check. Be aware that this process can take a few days, but once the money is in the account you’ll be ready to start investing!
Make a purchase
You’ve opened your brokerage account, spent some time researching ETFs, and now it’s time to execute an order.
The first thing you will need to do is enter the ticker symbol for the ETF you would like to purchase. The ticker symbol is a series of letters that represent the security you are trying to buy. For example, if you’re looking for an ETF that tracks the S&P 500 you might be interested in the Vanguard S&P 500 ETF. This ETF has the ticker symbol “VOO.”
Other things you will need to know to buy an ETF include:
- Ask price — This is the lowest price the seller is willing to accept for the ETF.
- Bid price — This is the amount a buyer is willing to pay for the ETF.
- Quantity — How many shares do you want to purchase? Let’s say you want to spend $200. To figure out how many shares you can afford you simply divide $200 by the cost of the ETF. If it costs $40 a share, then $200 / $40 = 5 shares.
- Order type — The “order” is responsible for providing instructions regarding how you want to purchase the ETF. The two most common order types are a market or limit order.
- A market order allows you to buy an ETF immediately at the market price. The good thing about a market order is that your order will be filled quickly. However, it’s difficult to definitively predict what the price will be.
- With a limit order, you specify the price you are willing to pay for the ETF and the order is only fulfilled when that price (or lower) is reached. So, the price is guaranteed. However, if that price isn’t available then your order will not be executed.
- Time in force — This allows you to define how long your order will remain active before it expires.
If any other terms are unfamiliar to you when you go to purchase an ETF you can look them up on the brokerage site, google them, or call the brokerage for clarification. After you’ve filled in your order and carefully reviewed it to ensure everything is correct, you’re ready to hit the buy button!
Give yourself a high five
You did it — congratulations! Buying your first ETF can be intimidating. But as you can see, the actual process is pretty simple. It’s taking that first step and committing to the purchase that can be a challenge.
What is the best way to invest in ETFs?
With a large number of ETFs available it can be difficult to determine which ETFs are best. Honestly, the answer will be different for each investor depending on their risk tolerance, level of expertise, and even value system.
However, there are some characteristics that everyone should keep an eye out for when purchasing ETFs:
Commission-free ETFs
Trading costs — the fees associated with purchasing and selling an ETF — add up over time, particularly if you’re using a technique like dollar-cost averaging. If your goal is to keep fees as low as possible, look for commission-free ETFs offered by the best commission-free brokerages.
Diversification
Don’t put all your eggs in one ETF basket. While an ETF is inherently more diversified than an individual stock, you still want to ensure you are purchasing ETFs from different market sectors; buying into small, mid, and large-cap companies; and possibly looking into ETFs in international or emerging markets.
Learn more about diversification by reading our article on how to diversify your investment portfolio.
Passive investing
If you’re looking to invest for the long term, then low-fee index ETFs might be a good fit. You can purchase an ETF that tracks an entire sector or index.
By taking a long-term, passive approach you can avoid trading fees and also increase the tax efficiency of your ETF portfolio.
Summary
ETFs are a great asset to add to your overall investments. They provide an easy way to build a low-cost, low-effort, and diversified portfolio.
And there are a number of ways to buy ETFs depending on your level of investment experience and financial situation, including using a robo-advisor, opening an account with a self-directed online brokerage, or consulting a financial advisor.
