If you like to invest in stocks because of the ease and simplicity, but you also like the diversification that mutual funds can give, then take a look at Exchange Traded Funds as an investment idea. An exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same way a regular stock can. And like stocks with most brokers, there is no charge to trade them. Probably the best known example is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index. This is the bellwether benchmark that exists in the stock market which all investors try to beat. With that said, even the majority of professional money managers cannot beat this target. So if you want exposure to the broader market by actually being the market, you can invest in the SPY.
So how does an ETF differ from its cousin, the mutual fund? The key difference between these two types of investment vehicles is how you buy and sell them. Mutual funds are priced once per day, and you typically invest a set dollar amount. Mutual funds can be purchased through a brokerage or directly from the issuer, but the key point is that the transaction is not instantaneous. Whereas an ETF is an exchange traded fund because it’s traded on an exchange just like stocks. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market. Asset growth in ETF’s has grown enormously over the past twenty years.
ETF’s are a great way to get diversification into your investments while not requiring a lot of money. ETF’s don’t have minimum investment requirements. However, ETF’s trade on a per-share basis, so unless your broker offers the ability to buy fractional shares of stock, you’ll need at least the current price of one share to get started. In addition to the popular SPY ETF, some others that you may consider for investment could include:
- The iShares Russell 2000 (IWM) tracks the Russell 2000 small-cap index.
- The Invesco QQQ (QQQ) indexes the Nasdaq 100, which typically contains technology stocks.
- The SPDR Dow Jones Industrial Average (DIA) represents the 30 stocks of the Dow Jones Industrial Average.
- Sector ETFs track individual industries such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotech (BBH).
- Commodity ETFs represent commodity markets including crude oil (USO) and natural gas (UNG).
- Physically backed ETFs: The SPDR Gold Shares (GLD) and the iShares Silver Trust (SLV) hold physical gold and silver bullion in the fund.
It’s easy to see how with the help of these diverse ETF sectors how you could create a much diversified portfolio. A couple of additional things that you’ll want to consider before investing in an ETF.
Expense ratios: ETF’s charge fees, known as the expense ratio. So for example if an ETF charges a 1% annual fee, you would be charged $10 per year on a $1,000 investment. Not exactly free, but not bad either.
Passive vs. active ETF’s: There are two basic types of ETF’s. Passive ETFs (also known as index funds) simply track a stock index, such as the S&P 500. Active ETF’s hire portfolio managers to invest their money. Just note that the passive funds like SPY will replicate the index, while other active funds will attempt to outperform the index with the help of asset managers. Usually higher fees in active funds as well.
Tax benefits: Investors typically are taxed only upon selling the investment, whereas mutual funds incur such burdens over the course of the investment. Any gains you make from selling an ETF will be taxed according to capital gains tax rules, and any dividends you receive will likely be taxable as well.
ETF’s can be a great addition to your personal investing. Other basic opportunities that will be the discussion of future articles include:
