Millennials are notoriously cautious when it comes to investing and to say they don’t trust the market is putting it lightly. A 2014 study from State Street found that 40% of millennials prefer cash investments to trying their luck with stocks or pricey mutual funds.
While cash is low-risk, it’s also low return. Exchange-traded funds or ETFs are a good option for bridging the gap. For millennials who want to invest in the stock market without getting burned, ETFs can be a valuable tool for building wealth.
How ETFs work
Exchange-traded funds fuse elements of stocks and mutual funds into one security. Like a mutual fund, an ETF can hold different kinds of assets, such as stocks, bonds or commodities. Many ETFs track an index, like the S&P 500.
The biggest different between an ETF and a traditional mutual fund is how they’re traded. Mutual funds are sold once a day so the price stays fixed for that day’s trading. An ETF is traded on an exchange just like a stock, which means the price can go up or down over the course of the day.
ETFs offer more diversification with less risk
The 2008 financial crisis had a big impact on millennials’ outlook on investing. A large portion of millennials, 36%, say they’d rather try to match the market than beat it, according to a UBS report. That tendency towards toward playing it safe is one reason why ETFs make sense for 20-somethings.
Exchange-traded funds by nature are designed to match the performance of the index they track. If you invest in an ETF that tracks an index with a consistent rate of return, you’re in a better position to see steady growth in your portfolio. While investing in individual stocks has the potential for bigger rewards, they’re also much more volatile. That volatility clashes with the conservative mindset millennial investors tend to gravitate towards.
Because they hold a variety of assets, ETFs are an easy way to mix things up with your investments. Instead of buying a stock here or a bond there, you can get them all in one exchange-traded fund. You can target your investments even more by choosing ETFs that are linked to specific sectors like healthcare or tech. If you’re in your 20s and still learning the ropes of investing, ETFs take a lot of the guesswork out of diversifying.
ETFs are easier on millennials’ wallets
Cost makes ETFs more appealing. Mutual funds, particularly actively managed funds, can come with high fees. ETFs, on the other hand, tend to be more cost-efficient because the assets they hold aren’t swapped out as often. Not only that, but the initial buy-in is usually cheaper. You generally just need enough cash to buy one share.
Having ETFs in your portfolio can come in handy at tax time. When the underlying assets in a mutual fund are sold, earnings are subject to capital gains tax. Because the assets in an ETF don’t turn over as often, you’ll have fewer taxable distributions.
Being able to avoid capital gains tax is a plus for 20-somethings who can’t afford to see their tax bill skyrocket. If you can’t pay, you run the risk of a tax lien, which will show up on your credit report. You can see your free credit report on Credit Sesame.
Choosing an ETF
There are thousands of ETFs to choose from and new ones launch all the time. If you’re just getting started with investing or you’ve been at it for a while and you’re ready to move into exchange-traded funds, you need to know how to pick the right one. Here are the most important factors to consider:
>Asset class – Different ETFs fit into different asset classes. For example, some are focused on stocks while others concentrate on bonds. When you compare ETFs, look at the asset class to determine where a particular fund fits into your overall asset allocation.
>Index – Index ETFs offer the same broad approach to investing but the underlying indices can be very different. Beginners should stick to ETFs that track a well-known index versus one that only tracks a small slice of the market.
>Sector performance – If you’re considering a sector ETF, spend some time studying the trends in the sector you’re interested in. If your focus is on energy, for example, look at the overall energy market and how energy ETFs have performed over the last few years. Have returns been steady or have there been major swings in fund pricing? Looking at the sector’s past track record and recent behavior is a good way to gauge where it might go next.
>Expense ratio – ETFs offer advantages to millennials in terms of cost but don’t assume that the fees are the same from one fund to the next. Look at the fund’s fee schedule to find its expense ratio. This is the percentage of your assets that go towards management expenses each year. The higher the ratio, the more profits investors must hand over.
>Trade fees – The expense ratio isn’t the only cost millennial investors need to be concerned with. If you trade ETFs through a brokerage, the broker may charge a commission every time you buy or sell shares. Discount brokers tend to charge the least but you could still shell out $5 to $10 a trade, which can add up pretty quickly.
>Liquidity – Liquidity refers to how easy it is to convert your ETF shares back to cash if you decide to sell. Ideally, look for exchange-traded funds that have a high trading volume and a high degree of liquidity in case you need to get your money back in a pinch. The kinds of assets held in a particular ETF can give you a sense of how liquid the fund is.
While younger investors’ pessimism towards the market is understandable, it can actually hurt them in the long run. If you’re in your 20s and you’ve been leery of stocks or mutual funds up to this point, investing in ETFs is a cost-effective way to bump up your earnings without exposing yourself to high risk.
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Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here and here.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.