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An exchange-traded fund (ETF) works a lot like a mutual fund but trades like a stock on the open market. It can track stock indexes, such as the S&P 500 and the Russell 2000, or bond indexes, such as the Barclays Capital U.S. Aggregate Bond Index. Buying shares in an ETF means you are buying a basket of securities that tracks the yield and return of the fund’s index.
However, ETFs generally don’t try to outperform the index. Rather, they seek to mimic its performance. If the underlying index rises or falls, you can expect the ETF to rise or fall in a similar fashion.
The basics of ETFs
ETFs make it possible for you to track the performance of an entire index, which may include hundreds of stocks or bonds, by owning a single ETF. That means your investment is more diverse than owning a specific stock or bond. ETFs that track major indexes generally trade at higher volumes than some individual stocks, making them more liquid.
You can buy ETFs on margin (buying with borrowed money) or sell them short (selling borrowed securities) just like you can virtually any stock. Or you can buy and hold them with the goal of achieving long-term gains.
In addition to stock and bond indexes, ETFs track stock sector indexes, such as those tied to technology, energy, health, real estate and utility companies. ETFs also follow fixed-income indexes for corporate and municipal bonds, Treasury securities with different maturities, and various commodity indexes, including those that track gold and silver. ETFGI, a global ETF research firm, said that there were more than 7,600 ETFs available worldwide with assets of more than $5 trillion as of the end of November 2018.
How ETFs are managed
Since ETFs are intended to match the performance of a specific index, they generally follow an investment style called passive management. That means the ETF manager changes the portfolio only when the index it follows changes.
For example, if the S&P 500 adds or drops a stock, ETFs that track that index will make similar changes. But a manager won’t make changes to improve an ETF’s performance or to outperform the market. This helps investors avoid “managerial risk,” or the risk that a fund’s manager will make a poor decision.
Costs and fees
As ETFs typically don’t trade to outperform an index, the administrative costs of operating the fund usually are lower than those of an actively managed mutual fund. Nasdaq says that ETF administrative costs are less than 0.20% per year — compared to over 1% for some mutual funds.
Because most ETFs are passively managed, they don’t have to incur the costs to actively trade securities. And since it’s likely that there are fewer transactions, the funds don’t make quite as many capital gains distributions to shareholders unless there are changes in the underlying index. As a result, that can mean fewer income tax consequences for investors.
Buying exchange-traded funds: getting started
Buying an ETF is fairly easy, and it is much like buying a stock.
1. You need an account with a broker
You may need to open a new account if you don’t have an existing one. The firm may charge you its standard commission for making a trade, so you generally can expect that discount brokers will be less expensive than full-service brokers. In fact, some discount brokers offer commission-free ETF trades. So if you plan to be an active trader, consider looking for one of those firms to minimize your trading costs.
2. Research and decide which ETF you want to buy
Do some simple research on the current price to make sure you can afford the purchase. How do you choose the right ETF? The strategy you follow is not much different than choosing an individual stock or mutual fund. Much of the decision has to do with your time horizon.
Younger investors with many years until retirement or whatever other goal they are saving for may want to concentrate on stock ETFs that track an index and offer long-term growth potential. Older investors or those who have already retired may want to focus on ETFs tied to bonds and other fixed-income investments with the idea that they are safer and may offer more stable returns.
Find an index that you believe meets your long- or short-term goals. Chances are a company offers an ETF that tracks that index.
Of course, you’ll then need to do some research on particular ETFs. Let’s say you want to buy an ETF that tracks the Russell 2000. With more than one company sponsoring ETFs that tracks this index, here are some questions you may want to answer to help you decide between the available investment choices:
- Does the sponsor have a good reputation?
- What is the expense ratio of the fund?
- How good of a job has the ETF done in tracking its index?
- Is the ETF’s trading volume sufficient to make it easy to buy and sell the fund?
- Perhaps most importantly, is one sponsor’s ETF performing better than the others?
3. Place an order
Once you’re ready to make a trade, either jump online to your trading account or instruct the broker to buy X shares of ABC ETF for you.
There are, however, some additional ordering instructions you may wish to give your broker when you ask them to buy (or sell) an ETF on your behalf or if you execute the trade yourself using the internet:
- Market order: You ask your broker to execute the order at the best possible price given current market conditions.
- Limit order: You won’t agree to buy the shares unless you can get them for a particular price.
- Stop order: You ask the broker to execute the trade when the security you are buying or selling reaches a specific price.
- Immediate or cancel: You ask the broker to cancel the order if they can’t execute it immediately.
- Good till canceled: This order remains active until it is executed or you tell your broker to cancel it.
- Day order: The order expires if your broker is unable to execute it by the end of the current trading day.
So, for example, let’s say you want to buy 100 shares of ABC ETF, which is currently trading for $15. But you want to buy it only if you can get it for $14.75 per share. This is a good opportunity to use a limit order.
You also can tell the broker that the order is good till canceled. Or you can make it a day order, meaning that if the broker can’t get it for $14.75 a share that day, the order is canceled. If after a week you are unable to get your price on a good-till-canceled order but still want to own ABC ETF, you can make it a market order, meaning you will get the 100 shares at the current market price.
Are ETFs right for you?
Thus far, the characteristics of ETFs might sound almost too good to be true. They are diverse like mutual funds but trade easily on major stock exchanges. ETFs take the guesswork out of selecting individual securities because they represent a specific index of stocks, bonds or commodities. And because ETFs tend to be passively managed, fewer trades mean lower costs and fewer income tax consequences.
There are, of course, some disadvantages. Since ETFs typically seek to meet but not exceed the performance of the index they track, you might miss out on big jumps in the stock or bond markets. But depending on which index the ETF is tied to, the portfolio might be less risky, which many investors find attractive. And of course, not all indexes go up. Some go down, but so do other segments of the market, including stocks and mutual funds.
Buying an ETF that tracks a popular stock or bond index is a great way to mimic the performance of that index with an element of safety because the fund isn’t trying to exceed that performance. While ETFs are a relatively new investment, they can be a great way to put together a diverse portfolio of stocks, bonds or commodities.
And since they track popular indexes, they often are professionally developed to track a particular sector of the market (or in some cases the entire market). All things considered, ETFs can be an effective way for investors to follow the market at a relatively low cost.