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ETFs, or exchange-traded funds, have become some of the most popular investment options among both veteran and novice investors. Even Rich Powers, Head of Private Equity at Vanguard, has noticed the meteoric rise of the market. He termed the growth of ETFs ‘explosive’, citing their growth against traditional mutual funds as 3 times faster.
These exchange-traded funds have also become some of the biggest markets, with the market average daily transactions reaching as high as $250 billion, according to data insights from NYSE.
Although the market certainly holds a lot of potential for investors to make a major profit, the truth is that most beginners think that market is simple to work around and jump into the deep end. However, while it may be simpler, there is still a lot of nuisance worth considering.
So, to help you on your journey across the ETF market as a beginner, here is a guide on everything that you need to know. Not only will you learn about the ETF market and what it is, but you will also find out about the different types of ETFs in the market and how you can start trading.
- 1 What is an ETF?
- 2 ETFs vs. Mutual funds
- 3 Understanding ETF basics
- 4 Types of ETFs
- 5 Understanding ETF taxes
- 6 Pros and Cons of ETFs
- 7 Special Considerations
- 8 How to start investing in ETFs
- 9 How to Evaluate the Right ETFs
- 10 ETF FAQs
What is an ETF?
ETFs are pooled investment securities that, at least in principle, are very similar to mutual funds. An exchange-traded fund will often track a specific asset, commodity, sector, or index, which is where the similarities to a mutual fund come in.
But where it tends to differ from a mutual fund is that investors can purchase or sell an ETF on the stock market, similarly to most types of stocks in the market.
Another major factor that differentiates ETFs from most other assets on the stock market is that they can possibly track anything. It can track the price of an individual commodity, or it could even track a specific trading strategy.
The first ETF to come around in the market was called the SPDR S&P 500, which tracks the S&P 500 index. Despite being one of the oldest ETFs in the market right now, it is still one of the most actively traded ETFs today.
ETFs vs. Mutual funds
One of the first things that investors will usually struggle with when they start trading is differentiating between mutual funds and ETFs. While they may have the same basic principle, that is the only similarity that they share.
In fact, most of the differences between these two types of investors come down to how you can purchase and sell them.
Mutual Funds receive a single price every day, where investors will then invest a specific amount. To complete the purchase, investors will need to make their investments through the issuer or a brokerage. But regardless of who you buy or sell your mutual funds through, they are not instantaneous transactions.
In comparison, ETFs are very similar to the stocks that you can find on a major exchange. Therefore, instead of investing a specific amount, you can choose the shares that you would like to purchase.
Similarly to stocks, prices for these ETFs can fluctuate throughout the day, and you can easily purchase the shares you want as long as the stock market is open.
Understanding ETF basics
Now that you understand the major differences between ETFs and mutual funds, it is worth looking into some basic concepts of trading in these assets. As a new investor, it is essential for you to understand these concepts before you can start making your investments.
Dividends and DRIPs
ETFs share a lot of similarities with stocks, especially in how it pays out their investors in dividends. You can choose whether to automatically reinvest the money or withdraw the cash. You can automatically reinvest through a DRIP or dividend reinvestment plan.
The expense ratios refer to the fees that you, as an investor, will have to pay, which will always be in the form of an annual percentage. So if you have an expense ratio of 1%, for every $1000 dollars worth of investment you make, you will be paying $10. So if you have a lower expense ratio, you can save even more money.
Passive and Active ETFs
ETFs can fall into two major categories: passive and active ETFs. Active ETFs will often hire portfolio managers to help individuals make smarter investments. A passive ETF is simply tracking a specific asset or strategy.
However, the major difference between the two, apart from the obvious inclusion of an asset manager, is that passive ETFs are looking to meet the performance of an index, whereas an active ETF is looking to beat said index’s performance.
Types of ETFs
Investors can find a unique range of ETFs of various different types. These types of ETFs can exist to offset investors’ risk in their portfolios or increase prices and improve income generation. With all of these in mind, some of the most important ETFs on the market today include:
Leveraged ETFs make use of multiples when investors get returns from the investments that they make. So if an asset were to rise by 1%, and the investor agreed to leverage of x2, then the investor would receive 2%.
However, leveraged ETFs also affect how much an investor could lose, as a loss of 1% in an asset could be as high as 2% for the investor. Although certainly risky, it is one of the fastest ways that many investors are able to make money.
Inverse ETFs, as the name implies, are always looking to profit off shorting stock instead of it rising. They will often make use of derivatives to short a stock, where investors are betting that a specific stock will drop. And if the market declines, the ETF will rise by a proportional amount that reflects the loss.
It is also worth noting that ETFs used to short the stock are exchange-traded notes, which are not the same.
Various currency ETFs are essentially pooled investments that are responsible for tracking the performance of certain currency pairs. Most investors will use this to speculate on the price of other currencies.
Understanding ETF taxes
Purchasing ETFs outside of an IRA account could make your income taxable. Therefore, your dividends will be taxable along with any profit you make when selling an ETF. Taxation occurs according to the US capital gains tax laws.
However, your income, whether it is in the form of dividends or selling assets, is only taxable if you have a standard brokerage account. But if you have an IRA account, you will not have to pay any dividends or capital gains tax.
Another important distinction to mention is that a traditional IRA account will only consider your gains as taxable when you withdraw them. But in the case of a Roth IRA, investments are usually not taxable at all.
Pros and Cons of ETFs
ETFs can be an especially attractive investment option for most investors in the market since it offers a range of benefits over regular types of stock. The most apparent advantage that comes with investing in an ETF is that it can be marginally cheaper than investing in all of the assets that are part of the ETF.
You only need to worry about buying and selling a single stock option, which can also save you from paying increased brokerage fees. Brokers will often charge a commission for each trade that an investor makes, but there are exceptions.
Some might not be charging any commission if investors are looking to trade specific low-cost ETFs.
Other than having to pay brokerage fees, investors will also have to bear the cost of the expense ratio. This is the cost of operating and managing an ETF, which will often differ depending on what type it is.
Passive ETFs tend to have a very small expense ratio since it is tracking only tracking an asset. But active ETFs can have a higher expense ratio since they put more effort into managing and tracking various assets.
- Lack of proper liquidity can greatly affect transactions.
- ETFs that focus on a single industry can significantly limit diversification
- Actively managed ETFs will often charge more in brokerage and expense ratio fees
- Certain ETFs will only focus on specific industries
- Allows investors to better manage their risk through diversification
- Some ETFs can have fewer broker commissions and expense ratios
- Investors can easily access different stocks throughout different industries
Despite many veterans in the field often recommending that new investors should start with ETFs, this can give the wrong impression that it is somehow easy. You need to consider various aspects of the market before you can effectively start trading.
These special conditions are important to keep in mind as you go about trading in the market. These include:
If you invest in an ETF, you can benefit from the gains that the stocks make in the market. However, you can also make a considerable amount through companies that pay out dividends. This is a small chunk of the earnings of the company that they will give to the investor for holding on to their stock.
Investors will be entitled to a portion of the dividends paid or the interest earned. Furthermore, as an investor in said ETF, you can also possibly be rewarded a residual value if the fund eventually liquates.
Indexed-stock ETFs give investors the best of both worlds, as it allows them to take advantage of regular stock indexes while having many similarities with mutual funds. By investing in an indexed stock ETF, you can purchase as little as a single share, buy on margin, or sell short.
They will rarely have a minimum deposit requirement, which allows people to get in as early as they want. But even if they can be very accessible to most investors, not all of them will likely be very diversified.
Instead, some of them could likely be focusing on a single type of asset in the industry. Therefore, they might not be as good of an investment if you are looking to diversify your portfolio. They may have a lot of assets that are highly related to each other or might be concentrated on a specific industry.
How to start investing in ETFs
Over the course of this guide, you have learned about what ETFs mean and how they work. You also learned about various factors and special conditions to consider before you start trading in the market and the many pros and cons of investing in these assets. Therefore, you can now start learning about how you can start investing in the market.
Since many call ETFs an “easy” investing market, it can be very easy for people to become complacent and make bad decisions when making their investments. Therefore, by following these steps, you can learn how to take your first steps in the market and start trading.
Find a Trading Strategy that Suits You
A trading strategy can easily make or break how you are able to make the most of your investments. Therefore, before you start putting money into your different ETFs, you should consider what kind of trading strategy would best suit you.
Spreading out investments across a specific time or focusing on dollar cost averaging can be great strategies for beginners. Not only do they get the chance to trade over a longer period, but they can easily balance out their risk.
But if these two trading strategies are not something that you prefer, then there are plenty of others you can try. However, the reason why many prefer these strategies is that it rewards patience. New investors will not make the mistake of burning the candle on both ends and suffering major losses just months into investing.
Do Your Research Before Choosing an ETF
Other than adopting a good trading strategy, you also want to make sure that you are doing your research before you make any investments. The rising popularity of the market means that there are even more options for people to choose from.
While some could turn out to be a great investment, others might not be. Therefore, you need to find various aspects of an ETF that make it stand out from the rest of the market, which can help you stay away from a possible sinking ship.
When doing your research for your next ETF, you should keep in mind that this is not any regular stock option since it is often a collection of assets, which just means that one of those assets falling could affect the ETFs price.
You should look at the bigger picture when investing in an ETF, as you want to consider the industry itself and the sector. A few good questions to ask yourself before you commit to an ETF include:
- Are there specific financial instruments or particular sectors that you’re interested in?
- Are you making your investments for growth or income?
Find an Investing Platform that Suits You
Now that you understand how to choose an ETF, you need to find a corresponding trading platform that can offer you the specific services that you are looking for. Most online platforms will usually work on a no-commission basis, which can be a very good deal for most investors.
However, it is also worth mentioning that these trading platforms or ETF providers will also likely have higher associated costs. Furthermore, other than costs, what will usually differentiate these online hubs are three major factors: product variety, services, and convenience.
You need to find a balance between the three factors or decide on which factor you are willing to compromise on most. One thing that nearly every trader wants is more convenient since they want to trade wherever and whenever they want.
On the other hand, some investors prefer that their trading platform have extensive educational material to help them make smarter investment decisions.
How to Evaluate the Right ETFs
Since the ETF space continues to grow at an unprecedented rate, it is becoming even harder for investors to tell which one is better. By 2019, total invested assets managed to reach an incredible $4 trillion.
And as the market continues to grow in popularity, bringing in new ETF options, investors need to be more careful when evaluating their investments. You need to be careful that the money you invest in an ETF does not possibly sink to a new low.
So before you choose to put your money into a specific ETF, you should consider various factors. Here are a few ways that you can better evaluate the funds that might be right for you.
The first major factor that is worth considering is liquidity, which can usually be affected by a number of factors. More importantly, ETFs that have low AUM or daily trading averages can have much higher trading costs.
The higher trading cost is a direct result of liquidity barriers that the fund might have in place. Checking the liquidity of an ETF can often be a tiebreaker when struggling to choose between options that have similar strategies.
If you are having trouble choosing between nearly identical ETFs, checking the liquidity of each one is a quick way to break the tie.
When compared to individual stock options that investors can purchase, ETFs hold a very clear advantage. Since they can often hold a number of assets or commodities in a single fund, they can significantly diversify your investment portfolio.
However, it is also important to understand that not all ETFs are good for diversification since they can be greatly concentrated into a single type of asset or commodity. If your goal is to have a more diversified investment portfolio, then choosing an ETF that only focuses on one or two types of assets or commodities might not be the best choice.
Instead of looking for more assets in a single ETF, you should be looking for ETFs with overall fewer assets, but they are better spread out across various industries.
Finally, and possibly the most important consideration that you will possibly be making is that of expenses. Even if there is an ETF that would perfectly fit your investment portfolio or could offer you the dividends that you prefer, if you cannot afford to pay the expense ratio or the brokerage fees, then there’s no point in considering the option.
Fortunately, the increased variety of ETFs that exist throughout the market right now means you can find something that better suits you. Although passive ETFs will have a comparatively smaller expense ratio, you can also find various active ETFs that could offer a cheaper expense ratio.
So when choosing an ETF, you want to consider the expense ratio to see if it is a viable investment.
Why Do People Think that ETFs are Cheaper than Mutual Funds?
While you can find individual ETFs that are just as expensive as mutual funds, which brings this question into a different light, however, as a whole, ETFs are generally cheaper than most other mutual funds since it is using a much cheaper indexing strategy.
According to various reports, as much as 75% of the funds that the mutual funds market manages go back into significantly more expensive active strategies. While they might be very effective, they are not very cost-effective, which makes it one of the reasons why many are moving on to ETFs.
ETFs will usually use more passive strategies, which can make them a much cheaper alternative. Although some prefer using active strategies, they are niche compared to the rest of the market.
Is ETFs More Tax Efficient?
There is a distinction between being more tax efficient and generally having a much lower turnover. Since the indexes are designed that way, capital gains distribution will always be lower. And with lower capital gains in general, the capital gains tax will not be as much.
How are ETFs different from index funds?
An index fund is just another word for a mutual fund that tracks a specific asset. Therefore, this index fund comes with all of the limitations of a mutual fund. In comparison, an ETF is not just more cost-effective, but it also comes with a multitude of new benefits too.
ETFs benefit from stock trading, so investors can buy shares for their preferred ETFs throughout the market.
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