Investing in financial instruments used to be an expensive endeavor. First, you’d go to a stockbroker with a pile of cash and hand it over to them. Then they’d either farm it out to a mutual fund or act as an intermediary for you, carrying out trades on the financial markets – charging fees, of course.
In the last few years, though, we’ve seen the rise of a consumer-friendly financial product called an ETF or “exchange-traded fund.” The idea is pretty simple. Instead of hiring a broker to carry out trades directly on the primary markets, ETFs allow retail investors to buy financial instruments on secondary markets without such hefty fees.
If that sounds a little complicated, don’t worry: we’re going to break it all down. Just know this: ETFs give the average Joe access to diversified stocks and bonds conveniently and at a low cost.
Table of Contents
What Is An ETF?
An ETF is a type of high-level, buy-it-all-in-one-go, security that bundles a collection of underlying securities that track an index. For instance, you can buy an ETF that tracks the entire S&P 500 by containing a percentage of each stock on the exchange in the right proportion. Over time, the S&P 500 ETF tracks the overall performance of the index one-to-one, minus a small admin fee. ETF prices fluctuate daily as the value of the underlying securities change.
ETFs, however, are way more diverse than most people realize. Yes – some ETFs track the big indices. But you can also customize them to reflect your risk appetite or investment theories. Thus, ETFs can hold a range of financial securities, including bonds, cryptos, and even gold.
ETFs bypass all the usual gatekeepers on the stock exchange. You don’t have to be a registered trader to purchase them – you can go direct. And you don’t have to research individual companies, either. So-called “smart beta” ETFs let you invest your money according to various themes, like disruptive innovation or “value.”
The price is also much lower than traditional investment strategies. ETFs offer a lower expense ratio than mutual funds – typically less than 0.5 percent, compared to 1.5 to 3 percent.
Positives and Negatives of ETFs
ETFs are one of the cheapest ways to invest in equities, bonds, crypto, commodities, and precious metals. You simply buy the fund, and then the people who manage it follow a set of simple rules applied robotically. Going back to the S&P 500 tracker ETF, managers adjust the fund every quarter to reflect new stocks that have fallen in and out of the index.
Because management is rote, ETFs are generally cheaper than mutual funds where traders are actively managing accounts, trying to generate higher returns. Nobody is sitting down, doing analysis, or thinking hard about how gains might manifest. Instead, most ETFs just follow a set of rules and continue to do so for as long as it lasts. Investors, therefore, don’t have to pay the salaries of traders. The only expense is a small management fee for periodically adjusting the contents of the fund.
You might think that a lack of active management would be bad, but the evidence doesn’t bear this out. Evidence suggests that stock market returns tend to outperform the average managed mutual fund over time. Managers find it incredibly challenging to pick winners in the stock market – and most can’t do it consistently over a long period of time. Mutual funds that outperform the market in the short-term often find themselves heading back to the average in the long-run.
Let’s summarize the pros and cons of ETFs.
Pros
- Access a variety of financial instruments across multiple industries, sectors and asset classes
- Pay lower expense ratios and broker commissions than traditional funds
- Target your investments by themes, segment or strategy, without having to research each firm in your portfolio
- Diversify your portfolio with minimal effort
Cons
- Some ETFs are less liquid than others, meaning that you can experience spread between the bid and ask
- Industry-specific ETFs may lack diversification
- Actively-managed ETFs have higher fees
Please note that not all ETFs are passive. Some are actively managed, meaning that managers try to increase returns via personal insight. However, fees are still usually lower than regular mutual funds.
How to Invest in ETFs
So how does the average person invest in an ETF?
The simplest method is to use a digital trading platform. These apps provide you with all the tools you need to buy ETFs and other financial securities digitally.
They’re mostly user-friendly, meaning that you don’t need to be professional traders to use them. All you do is transfer funds from your regular checking account to your dealer account and then buy financial products directly on the exchange. In practice, this means selecting the instruments you want to buy from a menu of possibilities and purchasing them at a price that allows the market to clear.
Platforms do a lot to help you carry out successful trades, offering helpful tooltips to guide you through the process. But you still have to have your wits about you. The price of securities in the underlying index changes all the time. Thus, so too will the ETF.
Most trading platforms will charge you a fee for carrying out an ETF trade. On some services, this is a percentage of the value of the transaction. A 0.5 percent fee on all trades, for instance, might cost you $50 on a $10,000 deal. Others charge fixed fees per trade – say, $10 per trade. Which type of fee structure you choose depends heavily on the kind of trading you want to do. Suppose you’re going to perform lots of small transactions with ETFs. In that case, you’re probably better off going for a percentage-based fee structure. Those shifting more money around might want to opt for fixed fees.
Therefore, ETFs are a low-cost instrument that anyone can use to acquire capital and start making returns. The number of options available is truly staggering, allowing you to create a portfolio that reflects your risk profile and investment priorities.
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