How To Invest in ETFs

Real Vision
December 7, 2021
11:24 AM

ETFs, short for exchange traded funds, are arguably among the most successful investment vehicles of the past decades. In 1993, the S&P 500 Trust ETF was the first ETF to launch in the US. After the turn of the millennium, in 2001, there was about $100 billion tied up in ETF products. From then on, assets under management started to grow heavily. Two years later, in 2003, assets doubled to $200 billion. Today, not even 20 years later, assets managed by ETFs globally make up about $7.74 trillion.

ETF products cover nearly every sector in the economy. Whether it be energy, industrials, health care, financials, real estate, information technology or consumer staples, for each of these sectors one or more ETFs exist. There are also some more exotic ETFs around, tracking industries like esports, cryptocurrencies or cannabis. And there is even a Millennial Consumer ETF.

What is an Exchange Traded Fund (ETF)?

An exchange traded fund (ETF) is a fund that tracks a benchmark index. This can either be a stock index, a bond index, a currency index, a real estate index, a commodity index or something else. An ETF’s goal is to track this underlying index as accurately as possible.

For the most part, ETFs function like index funds. Like these, ETFs offer investors a convenient way of investing in a diversified set of titles (whatever the index tracks) with one single transaction. As an ETF’s name suggests though and unlike normal index funds, an ETF is traded on an exchange like securities. While an index fund can be bought or sold once a day, an ETF can be continuously traded throughout the trading day. The price of an ETF can fluctuate above or below what is called an ETF’s net asset value (NAV) based on supply and demand.

ETFs are issued as shares in a process of creation and redemption. This process can only be executed by so-called authorized participants. In the primary market, they create ETF shares in exchange for the ETF’s underlying assets. These shares are then traded on the secondary market according to its NAV, resulting in an ETF price. As such, an ETF can never really be more liquid than its underlying market. There is constant arbitrage going on between the primary and the secondary market in order to keep an ETF’s price as close as possible to its NAV.

ETF Basics

Passive versus active: Because ETFs are tracking an underlying index, they are usually referred to as passive investment products as there is no investment team that actively manages the composition of the ETF but adheres to a passive investment strategy. As a matter of fact though, there also exist actively managed ETFs. While such an ETF also follows a benchmark index, its managers can decide to deviate from the index by changing the sector allocation for example. Consequently, such an actively managed ETF can either out- or underperform its index. Additionally, there is also an ETF type called smart beta ETFs, which use a combination of both passive and active elements of investing.

Dividends: With equity ETFs, dividends accrue. Holders of such ETFs profit from this as well, either in the form of direct dividend distributions or through the reinvestment of the dividends into the ETF itself. This means that the ETF reinvests dividends into the shares that correspond to the assets of the underlying index. If an investor intends to reinvest the dividends anyways, holding an ETF that reinvests them automatically makes sense because this way, additional costs can be prevented.

(Total) Expense Ratio: An ETF’s expense ratio indicates how much this ETF costs when held for a year as the fees are usually subtracted annually. The expense ratio equals the ETF’s expenses divided by the average assets under management. To get a clear-cut overview on all the ETF’s expenses, considering its total expense ratio (TER) is recommended. In the total expense ratio management, trading, operating as well as legal fees are included. As ETF’s are mostly passive investment products, their costs are rather low compared to other investment vehicles as there is little strategic management and trading happening. For actively managed ETF, the TER is higher. As an investor one should keep in mind though that not all costs are included in the TER. Commissions, broker fees and taxes are not taken into account.

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ETF vs Mutual Fund

Mutual funds are usually actively managed, while ETFs are mostly passive instruments. This means that the former are usually more expensive than the latter. Also, mutual funds are like index funds as they are bought and sold just once per trading day. ETFs on the other hand can be traded on an exchange throughout the day similar to stocks. This also makes them into more liquid investments.

Additionally, ETFs can be more tax-efficient than mutual funds. ETFs tend to realize fewer capital gains than actively managed mutual funds, which is why taxes can be optimized with the former. Apart from these differences, mutual funds and ETF are pretty similar investment products.

Read the guide: How To Invest In Mutual Funds

ETF Pros and Cons

Pros:

ETFs represent a convenient way to set up a broadly diversified portfolio with only a handful of trades as one ETF usually comprises many different securities.
ETFs are traded throughout the day on exchanges. This makes them more liquid than their counterparts, the mutual funds.
Because ETFs are usually passively managed, they are very competitive when it comes to pricing. ETFs are among the cheapest investment vehicles.
When it comes to buying ETFs, there are even commission-free ETFs today.
ETFs can be conveniently bought with a broker.

Cons:

A volatile market environment is not the best scenario for passive ETFs. Volatility means that there are opportunities that an active manager can seize. As a passive ETF just tracks the underlying market, an active manager that does his job well can outperform an ETF with a passive investment strategy.
Most ETFs have a portfolio that just allocates according to an index’s market capitalization. This can create potential cluster risk as an ETF’s holdings are heavily concentrated in a few assets that make up almost the entire index.
As an ETF’s price can diverge from its NAV, there exists the risk that investors pay a premium above the value of the underlying asset.

Watch the video: The Dark Side of ETFs The Truth in ETFs

Types of ETFs

Stock ETF: These ETFs track an index of a particular set of stocks. The index can be based on a sector, an industry or any other theme. There is for example the S&P 500 ETF that tracks 500 of the largest US companies. There is the Ark Innovation ETF that focuses on new technologies and trends in energy, automation and more. Or there is the Invesco QQQ that gives an investor access to Nasdaq’s 100 largest non-financial companies.

Bond ETF: This type of ETF tracks an underlying basket of fixed income investments. As bonds pay a regular income, such an ETF can be attractive to investors searching passive income. The largest bond ETF is the iShares Core U.S. Aggregate Bond ETF with almost 90 billion US dollars under management.

Currency ETF: Traders and investors who want exposure to foreign currencies can hold a currency ETF. They either track a single currency or a basket of currencies.

Leveraged ETF: Because such an ETF uses leverage, potential returns can be higher, while the risk is also amplified. Usually these ETFs aim to deliver two or three times the return of its underlying index. An example is the 2x Russell 2000 Index ETF, which attempts to deliver twice the return of the Russell 2000 Small Cap Index. Generally, these types of leveraged ETF are used by short-term traders.

Inverse ETF: These ETFs are sometimes also called short ETF as they allow a holder to go short the underlying index. This means that an inverse ETF tries to deliver returns that are opposite to its benchmark index. If the underlying index loses 1%, the corresponding inverse ETF gains 1%.

Crypto ETF: These ETFs are fairly new and track cryptocurrencies as underlyings. As of now, there is no official Bitcoin ETF in the US as the Securities and Exchange Commission has not allowed one to exist yet. In Canada or Brazil though, there already are Bitcoin ETFs.
Commodity ETF: With these ETFs an investor can gain exposure to different commodities like agricultural goods, natural resources or precious metals. There are for example gold ETFs that allow you to profit from gold price movements without the need to own physical gold.

How to buy an ETF

Step 1: Decide your ETF investing strategy

In advance to making an investment, it makes sense to ask the following questions, as they will guide you in making the right decision when it comes to your personal investment strategy. If you can answer the following questions with a yes, choosing ETFs might be a good way to invest for you:

Am I looking to invest for the longer term?
Do I want to invest in a diversified portfolio?
Do I want to invest in a collection of assets rather than individual stocks, bonds or financial assets?

Additional questions are:

What sort of sector do I want to invest in?
What sort of asset class am I looking at?
How much risk am I comfortable taking?

If an investor is looking for a low volatility and low risk investment, then a bond ETF might be the right choice. If he is willing to take on some more risk, stocks ETFs do the job just fine. Even greater risk but also greater potential returns are offered by crypto or commodity ETFs. With these ETFs it might make sense to allocate a couple percent of my portfolio at the most. If an investor is focused on the short-term, leveraged ETFs might be an option. If he is bearish on a particular asset class, one can express my view investing into an inverse ETF.

Step 2: Open Brokerage account

ETFs can be bought through various brokers. Most retail investors opt to buy ETFs through an online brokerage such as Fidelity Investments, TD Ameritrade, InteractiveBrokers or Schwab. While these are established brokers with a great legacy, there are some newcomers like Betterment or Wealthfront that also offer ETF investing. These options are also referred to as Roboadvisor. In most cases, Robo Advisors ask you a set of questions to determine your investment preferences and will then automatically select suitable investments. As they offer simple user interfaces and low fees, they are a convenient way to invest in ETFs.

Step 3: Choose ETFs

Here is a list of the most popular ETFs. These ETFs represent no financial advice but have been listed for educational purposes only:

Oftentimes, several ETFs track the same underlying index but are issued by different ETF companies like Fidelity, Invesco, Vanguard or Blackrock. While the underlying assets are the same, TER, liquidity or volume can be slightly different. It therefore makes sense to sometimes compare the ETFs of various providers.

Step 4: Screen your choices

As today’s ETF universe is very diverse, there exist screening tools that allow you to compare various ETFs. A popular tool is justETF. An investor should focus on the following indicators:

Total Expense Ratio (TER)
Overall commissions with a broker
Volume
Holdings of an ETF
Performance of the ETF
An ETF’s trading prices

Step 5: Invest

Once an investor has decided on his investment strategy, has opened a brokerage account, has chosen an ETF and has screened the choice for any potential irregularities, the trade to buy the ETF can be placed.

Step 6: Monitor your investment

Investing in ETFs allows for a hands-off investment approach and daily monitoring is not necessary as most ETF passively invest into a diversified set of assets. Nevertheless, a quarterly portfolio check is advised to stay up to date with the latest market developments and to have a feel for the investment performance.

Depending on an investor’s investment goals, it can make sense to set up monthly deposits into one’s brokerage account, which then can be invested too. This is referred to as dollar cost average investing. This forms a continuous and disciplined investing habit, which is especially important for retirement accounts.

If an investor finds that one of his investments significantly underperforms compared to the respective benchmark then a revision of that investment might be a good choice. The goal isn’t to chase the highest possible rewards by swapping in and out of ETFs continually but to have competitive returns on your investment.

Closing remarks

ETFs are truly the investing success story of the recent years in traditional markets. They offer a low-cost, diversified and easily tradable way to gain exposure to different markets. They are particularly suitable for investors that want to passively invest money in different markets without having to actively manage or care about it every day.

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RELATED CATEGORIES: ETFS, Investing