As you start building a portfolio, you’ll likely hear this kind of advice:
“You really can’t go wrong with ETFs.”
“If I could go back 20 years I’d invest only in ETFs.”
This is pretty good advice. ETFs do offer flexibility, diversity, and liquidity for starters.
But at the same time, investing is too complex -- it has too many variables and moving parts -- to be reduced to a simple, one-size-fits-all directive.
Yes, ETFs could work well for you.
But let’s find out for sure by learning how they work, how much they cost, and how you can use them effectively.
What is an ETF?
First things first, ETF stands for exchange-traded fund.
Here’s how ETFs work:
- A fund buys a variety of assets such as stock shares.
- The fund divides the combined value of these assets into shares.
- Investors can trade these shares as they would trade stocks or other assets.
When you buy one share of an ETF, your share includes bits and pieces of all the fund’s assets. This means your single ETF share automatically gives you a diverse investment.
If you were buying shares of individual stock, you’d need to spend a lot more time and money to achieve this kind of diversity. This ability to create instant diversity has helped ETFs grow steadily in popularity since 1993 when they were introduced.
They’ve been even more popular over the past 10 years since mutual funds crashed in 2008, during the Great Recession.
About 4,500 different ETFs trade shares on markets worldwide. In the U.S., you can invest in about 1,700 different ETFs.
What, Exactly, Is Inside an ETF?
ETFs include a variety of assets, but they’re not comprised of a random assortment of assets. Instead, they’re built to represent a market or a specific segment of a market.
The makeup of an ETF helps us define the different kinds of ETFs:
- Index Funds: These funds draw shares from an entire stock index such as the S&P 500. Examples include the Vanguard 500 and the Schwab S&P 500. When you buy shares in index funds, you’re connecting your money to the entire market index. Your ETF shares will gain or lose value each trading day along with the index.
- Foreign Market Index Funds: This kind of fund lets you invest in Japanese Nikkei or MSCI Germany Index without having to become an expert on global commerce.
- Sector (or Industry) Funds: With these ETFs you can invest in a sector of the economy such as aerospace or healthcare. Your shares’ value will perform along with the underlying industry.
- Commodity ETFs: These funds let you earn from commodities such as grain and even gold without the hassle of actually owning the commodity.
- Inverse ETFs: Serious investors hold shares in inverse ETFs as insurance in case the market loses significant value. These funds can actually gain value when the overall index loses value.
- ETNs: Just when we’re getting comfortable with ETFs, it’s time to introduce another abbreviation. ETNs, or exchange-traded notes, which invest in debt, usually from banks. They’re not technically ETFs but similar enough to include here.
This is not an all-inclusive list. You can find even more kinds of ETFs.
Some track currencies, others can even capture a specific style of investing. A broker could help you decide which kinds of funds you’d like to invest in.
Advantages of Trading ETF Shares
Along with the instant diversity ETFs can give new investors, the funds have additional advantages many investors -- especially beginning investors -- will appreciate:
- Lower fees: Brokerage fees for trading ETF shares tend to be less expensive than fees for other kinds of investments. Mutual funds, for example, charge a percentage of your purchase as a loading fee. You can avoid these fees with ETFs.
- More tax-friendly: Since owning an ETF share doesn’t mean you own the underlying assets outright, ETFs tend to be more tax friendly to investors.
- Liquidity: Unlike with mutual funds, you can trade your ETF shares throughout the trading day just like you would stocks.
- Transparency: ETF managers publish the contents of their exchange-traded funds each day, so you can find out exactly what you’re investing in.
- Passivity: You can know how your ETFs are performing just by monitoring the overall performance of the underlying index or sector. You won’t necessarily need phone alerts to keep you connected the way you might with specific stocks.
- Accessibility: To invest in ETFs, you wouldn’t need thousands of dollars to get started. We’ll talk more about how to get started below.
Disadvantages of Trading in ETFs
With so many advantages, it’s easy to understand why people think ETFs can solve almost all investing problems.
I’ve even heard people say ETFs are risk free. Yikes!
Yes, ETFs present less risk than buying individual stock shares, but no investment can eliminate all risks and solve all problems. For example, ETFs:
- Can Limit Growth: An Index ETF will perform at the level of the underlying index. It shouldn’t underperform the index by much, but it also won’t overperform by much. More serious investors often enjoy the freedom of trying to outperform the overall market.
- Can Lose Value: If the underlying index loses value, your ETF shares will also lose value. This can be easy to forget, especially during periods of extended market expansion. Sector Funds or Commodity Funds, which track a specific industry or commodity, can be more volatile.
- Are Relatively New: The rise of ETFs has taken place mainly in this century. As a relatively new investment vehicle, ETFs haven’t withstood the test of time the way many other assets have. We’re not quite sure yet what the rapid growth of ETFs could mean to the overall marketplace.
- Require Some Knowledge: Like all powerful tools, ETFs can cause trouble for people who aren’t quite sure what they’re doing. For example, even with their tax advantages and relatively low fees, you can still spend too much and create a tax problem with ETFs.
None of these are reasons to stay away from ETFs. It’s just good to be aware of potential drawbacks before getting involved.
How to Get Started Investing in ETFs
A generation ago you may have needed to ask if your broker handled ETFs.
Now, more than 25 percent of volume traded on the New York Stock Exchange comes from ETFs, so it would be hard to find a broker who didn’t offer ETF trades.
And traditional brokers are no longer the only place you can get involved in ETF trading.
We’ll take a closer look at brokerage options below. But first, it’s important to understand the costs of ETFs so you’ll know what to expect from a broker or robo-advisor.
Costs of Trading ETFs
ETF shares are fluid. You can’t know the actual cost until you find out how your shares perform.
However, you can and should assess some of the fixed costs associated with ETF trades to get the most out of your investment:
- Commissions: Your brokerage firm will typically charge a commission for each trade. On the surface a commission of $5 per trade, for example, seems reasonable. Over time, these fees add up, and they can take a big bite out of your earnings. A $5 fee on a $50 transaction would be a 10-percent cut. To control these costs, look for commission free offers and buy and sell only when you need to.
- Spreads: The same ETF shares are bought and sold at different prices. The spread determines the difference. If you bought $10 worth of shares at a spread of 25 cents, you could sell your shares back for only $9.75. This small difference can also grow into a noticeable cut of your earnings. Look for smaller spreads and, once again, give your shares some time to grow before selling them so they can close the spread.
- Limit Orders: Usually, a limit order, as opposed to a market order, will be your friend. A limit order lets you buy or sell your ETF shares only when the market reaches a price you specify. Limit orders give you more control over your investments and the amount you’ll earn (or keep from losing). But you have to set reasonable buy-sell limits and pay attention to the market in case it changes quickly and you’d like to change your limits.
Best Places to Start Trading ETFs
You’ll have several options when you’re ready to start buying ETF shares. No matter what route you choose, be sure you’re working with someone you trust.
Some of the best places to start include:
- A traditional broker: You can open an account with a big name brokerage house like Charles Schwab or Fidelity and have access to the markets along with some great online tools and in-person guidance if you need it. Fees tend to be higher, but you’ll usually be in good hands.
- ETF-specific groups: BlackRock and iShares, which is a division of Charles Schwab, specialize in offering a wide variety of ETFs.
- Online discount brokerages: M1 Finance comes to mind here. You’re more on your own but you can also trade for free.
- Robo-advisors: Robo-advising and ETFs are a great match. Robo-advisors use algorithms to build and balance your portfolio. ETFs provide the right combination of fluidity and stability to make an algorithm sing. Betterment, specifically, makes great use of ETFs, and you can save on fees.
- Your existing financial advisor: If you’re already working with a financial advisor you trust, he or she can most likely give you solid advice about ETFs.
How Much Should You Invest in ETFs?
Different advisors will have different advice about how much of your portfolio you should direct into ETFs.
But here’s a general rule of thumb:
The less you have invested, the more you can benefit from ETFs.
So if you’re just starting out, it’s OK to put all of your invested money into exchange-traded funds. Of course, you shouldn’t tie up the rent money or this month’s student loan payment, but that should go without saying.
As you continue to grow as an investor and gain more resources to work with, you’ll want to mix in other types of investments, potentially lowering your ETF shares to about 50 percent of your portfolio.
Many advisors recommend creating an ETF core portfolio which includes shares in the following types of ETFs:
- U.S. Stocks
- U.S. Bonds
- Real estate
- Stock from other developed nations
- Stock from developing nations
- Bonds from offshore markets
You may notice that this core portfolio does not include commodities, sector, or inverse ETFs.
Those tools should supplement a broader portfolio and aren’t a good starting point for getting into the market.
Bottom Line: ETFs Are a Good Place to Start
ETFs have a lot to offer beginning investors.
- You can get into the market a smaller amount of money.
- You can get out of the market without losing a lot in fees.
- You’ll have diversity in your portfolio from the outset.
The key will be finding the right relationship with a broker, robo-advisor, or ETF specialist who can connect you to the market and give you the specific advice you need.
And once you get invested, give your ETF shares some time to grow. ETFs work best as a long-term stabilizing force.
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.
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.