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Exchange traded funds (ETFs) are an easy, inexpensive way to add diversification to your investment portfolio. First introduced back in 1993, ETFs now hold more than $4.4 trillion in the U.S. market alone. Here are five easy steps to help you get started growing your dollars in ETFs.
1. Choose Your ETF Investing Goals and Timeline
Before you start investing in exchange traded funds, decide on the financial goals you’d like to achieve. How you intend to use the returns from your ETF investing will dictate which exchange traded funds make the most sense for your portfolio.
Here’s how to decide how much of the four main types of ETFs you should include in your asset allocation:
- Bond ETFs. When you purchase a bond ETF, you’re investing in hundreds of bonds at once. Bond exchange-traded funds—also referred to as fixed-income ETFs—are less volatile than stock funds, meaning their value remains relatively consistent and may see modest gains over time. This makes them a good option if you have a shorter investment timeline or would like to add stability to your portfolio. If your investing goal is only a few years away, your portfolio should be 70% or more in bonds.
- Stock ETFs. Generally offering more risk than bond ETFs but greater returns, stock ETFs make sense when you’re investing for long-term goals, such as retirement. If you are decades away from your financial goals, your portfolio should be mostly in stocks to give your money the best chance to grow.
- International ETFs. Investing in international stocks and bonds adds even greater diversification to your portfolio. International ETFs give you easy exposure to companies based outside of the United States as well as foreign exchange investments. According to Vanguard, international ETFs should make up no more than 30% of your bond investments and 40% of your stock investments.
- Sector ETFs: If you’d prefer to narrow your exchange-traded fund investing strategy, sector ETFs let you focus on individual sectors or industries. By investing in specific industries, like healthcare or energy, you gain the potential for stronger growth. But this strategy also poses bigger risks—the entire tech industry could experience a slowdown at the same time, for instance, hurting your investment much more than it would if you own a broad market ETF with partial exposure to tech. This is why sector ETFs should only make up a modest portion of your portfolio.
Understanding your timeline is a key part of determining your financial goals for ETF investing. When will you need to start taking money out of your portfolio? If you need money sooner, for goals like a home down payment, consider less risky ETF options. If you’re investing in ETFs for a long-term goal, like retirement, you can afford to take on greater risk with stock ETFs.
2. Research Potential ETF Investments
Even within the categories we’ve outlined above, there are thousands of ETFs to choose from. That makes researching potential ETF investments crucial to make sure you’re picking the best investment for your goals. Here’s what to consider as you’re examining and comparing ETFs within particular categories:
- Underlying Benchmark. Almost all ETFs are index funds. This means they try to copy the performance of a market benchmark index, like the S&P 500, which tracks the performance of the U.S. stock market. When selecting an ETF, pay attention to which index it models itself on. Even within the same category, indexes may contain drastically different companies and securities. Because indexes’ component securities strongly influence the performance of your chosen ETFs, it’s important to be aware of which benchmark index ETFs are tracking.
- Constituent investments. If you only want your investing dollars to go to companies with business practices and causes you support, broad indexes may make investing difficult. That’s because they don’t allow you to screen out individual problematic companies, forcing you to invest in all companies in a particular index. If the investments within your ETFs are important to you, screen for ETFs that follow values-based indexing, like Environmental, Social and Governance (ESG) or Socially Responsible Investing (SRI). These approaches help you invest in sectors and businesses with positive social and environmental impacts. Both ESG- and SRI-based indexes (and associated ETFs) are available.
- Expense Ratio. An expense ratio is what you pay to cover the costs associated with running the ETFs you invest in. While ETFs overall have lower expense ratios than most mutual funds, even seemingly similar ETFs can have widely differing expense ratios. These seemingly small annual fees can dramatically reduce your investment returns, so aim to pick ETFs that match the index you want with the lowest expense ratios.
- Active or Passive Management. The vast majority of ETFs are passively managed, meaning that they aim to track an underlying benchmark index and duplicate its returns. Active ETFs, on the other hand, are actively managed by professionals that personally select the securities within the fund and may attempt to outperform a certain benchmark index. At the very least, actively managed ETFs aim to provide returns regardless of market conditions. To do this, though, they often charge much higher expense ratios than passively managed funds. This is despite the fact that historically index funds have outperformed actively managed funds, meaning you may end up paying more for worse performance.
3. Open an Investment Account to Purchase ETFs
To invest in ETFs, you need to open a brokerage account or another form of investment account. You have many options to choose from, depending on your goals:
- IRAs. Individual retirement accounts are tax-advantaged accounts that allow you to buy and sell investments without paying capital gains taxes. Contributing money to an IRA and investing in ETFs is a great way to save for retirement.
- Taxable investment accounts. As the name suggests, a taxable account doesn’t protect you from capital gains taxes like an IRA or other qualified retirement accounts, but they do allow you to make penalty-free withdrawals at any time. This makes them a good choice for financial goals other than retirement.
- 529 plans. These tax-advantaged accounts are used to invest money to be used for educational expenses. 529 plans provide tax-free growth and withdrawals if used for qualified educational expenses for a named beneficiary.
- Custodial accounts. A special type of trust fund, UGMA/UTMA custodial accounts let you buy ETF investments on behalf of children. When the child you opened the account for reaches a given age, usually between 18 and 25, depending on your state, they become the owner of the account and can use the ETFs for any purpose. Before then, funds can be used in any way that benefits the child account owner. This grants custodial accounts more versatility than 529 plans, which can only be used for educational purposes.
- Robo-advisors. These automated investing platforms build portfolios of ETFs for you based on your financial goals and your ability to take on risk. Robo-advisors charge fees to manage your investments. That’s in addition to the expense ratios charged by ETFs. This means that while they offer great convenience, it may cost you more to invest in the same ETFs than it would on your own. If you’re comfortable with paying a small fee to be a hands-off investor, you can find most of the accounts described above at robo-advisors.
Most major brokerages provide all of the accounts described above. Each broker has its own account registration process and requirements. Before opening a brokerage account, look up the firm’s investment minimums, ETF options and fees to make sure its offerings work for your goals.
4. Make a Plan to Keep Investing in ETFs
Making steady, gradual contributions to your investment portfolio is a great strategy for most investors. Exchange traded funds are well suited to this style of investing as there are no minimum purchase amounts, like with mutual funds. In addition, a growing number of online brokers allow you to buy fractional shares of ETFs. This lets you get started with ETF investing even when you don’t have enough to purchase full shares.
When you make smaller, but regular purchases of ETFs, you’re leveraging dollar-cost-averaging. By making investments at regular intervals—weekly, monthly or quarterly—rather than in one lump sum, you help minimize your chances of accidentally investing all of your money when market prices are high. Instead, by investing the same dollar amount over time, you buy a few shares when prices are high, and more shares when prices are low. This may help you pay less per share on average over time.
Once you’ve started regularly investing, it’s a good idea to review your ETF portfolio once per year. Depending on market changes and your financial goals, you may need to rebalance your allocation, or buy and sell certain investments, to remain on track with your plans. Most robo-advisors offer this service automatically, making them particularly appealing to investors who want to be hands-off.
5. Consider Your ETF Exit Strategy
Investing for the long term is wise, but even with the longest of long-term goals, eventually you reach the point where you’ll need to sell your ETF shares and make use of their investment gains.
When you sell an investment at a profit, you’re doing what’s called realizing a capital gain. This means your initial investment, your capital, has increased in value over what you paid for it. Because that increase in value has never been taxed before, it’s taxable as income. The rate you pay depends on how long you’ve held the investment, with long-term investors who hold an investment for at least a year being rewarded with slightly lower capital gains tax rates.
If your long-term goal is retirement, you can effectively avoid these capital gains taxes while investments are within your tax-advantaged retirement account, like a traditional IRA or a Roth IRA. With a Roth IRA, your investment gains will never be taxed as long as you don’t touch them before age 59 ½. And with a traditional IRA, you won’t be taxed until you start making withdrawals from the account in retirement. Then your tax payments will be based on your current income, not short-term capital gains rates, regardless of how long you’ve held an investment.
Even outside of a retirement account, you can minimize your capital gains by employing tax-loss harvesting. With tax-loss harvesting, you sell off assets that have decreased in value and replace them with similar investments. This lets you claim a loss on your taxes to offset any increases in value you may realize when you sell other shares. This helps you keep less of your money going toward taxes and more staying in the market to grow over time.
Exchange Traded Fund FAQs
What Is an ETF?
An ETF is a fund that generally tries to emulate the performance of a major index. This gives investors the benefit of investing in hundreds or thousands of companies or securities in the form of a single investment.
Are ETFs a Good Investment?
For many investors, ETFs are a good investment. They provide an investor with a simple means for diversification, saving them from buying tens or hundreds of individual stocks. Most ETFs track major indexes, meaning they offer investors returns equal to overall market performance at just about the lowest possible cost. Because ETFs are traded throughout the day, investors also have greater liquidity and flexibility than mutual funds, which can only trade once a day when stock and ETF trading has closed.
What Is the Difference Between an ETF and a Mutual Fund?
ETFs and mutual funds share many characteristics. Both types of funds invest in multiple securities and asset types, making them lower-risk investment choices than single-stock investing. Both ETFs and mutual funds may track indexes, though more mutual funds employ active management in which fund managers regularly trade investments to provide consistent returns. (These attempts at consistent returns also come at a drastically higher cost than index-based funds.)
ETFs also differ from mutual funds because they trade throughout the day, and you can use different order types to control your investment’s pricing. In addition, ETFs typically have lower investment minimums than mutual funds.
What Are the Best ETFs?
Which ETFs make the most sense are dependent on your financial goals. However, because of their low costs and consistently high performance, index funds tend to be useful options for many investors.
According to Morningstar, a leading investment ranking agency, top index ETFs include:
- Fidelity NASDAQ Composite Tr Stk ETF (ONEQ): This ETF tracks the price and yield performance of the NASDAQ Composite Index, a leading index often used to describe the performance of the overall market.
- Invesco S&P 500® Top 50 ETF (XLG): This ETF contains only the 50 largest companies in the S&P 500 Index.
iShares Russell Top 200 ETF (IWL): This ETF aims to track the returns of the Russell Top 200 Index, which measures the performance of 200 of the largest companies by market cap in the U.S.
If you’re not sure which ETFs are best for you, talk to a financial advisor about your financial goals and investment options. Remember to look for low expense ratios at well-regarded fund companies.