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How to invest in ETFs

How to Invest in ETFs

 

 

Finding a reputable review about ETF or Exchange Traded Funds, local or worldwide can be a difficult process, especially finding a complete list from a trustworthy reputable source.

 

 

A Quick Overview of how to invest in ETFs:

 

Below is an in-depth review regarding ETFs to help you make an informed decision before trading

 

 

What is an ETF?

ETF or exchange-traded funds are funds that are passively managed marketable securities which track an index, commodity, or a pool of bonds. One main characteristic of ETFs is that they can be traded on stock exchanges as shares, with their prices fluctuating during the day.

ETFs do not produce a positive alpha, which is the difference between the fund and the benchmark performance. Instead, they follow their index and as a result, the alpha will always be zero.

Due to the rise in Robo-advisors, the popularity of ETFs increased in the last few years. There has also been an increase in competition and low management fees which have contributed to their popularity.

 

History of ETFs

The ETF industry was born from the market crash which occurred in October 1987. Their initial goal was to provide liquidity and mitigate volatility for participants in the financial markets.

During the past two decades, ETFs have become a favorite investment vessel for individual investors as well as asset managers. Today, on a global scale, there are around 6,870 ETF products on around 60 exchanges in addition to more than $5 trillion assets that are under management.

 

ETFs versus Mutual Funds

ETFs are compared with mutual funds more than they are with any other financial asset. In contrast with ETFs, mutual fund managers are actively seeking securities to beat the designed benchmark. ETFs have higher daily liquidity than mutual funds in addition to lower fees, which makes them more attractive for individual investors.

 

Underlying Index

There are massive variations in the index compositions between indices that track the same asset class, with the structure and performance of ETFs reflecting these differences. Where small-caps are concerned, for instance, IJR tracks the S&P 600 Small-Cap Index while IWM follows the Russel 2000 Small Cap Index.

As the name would suggest, the S&P 600 contains 600 constituents while the Russel Index consists of 2000 members. There are many similarities and overlaps between these two, however, there are also large variations in their returns as well as their risks and sector exposure.

Where the emerging market space is concerned, there are indices offered by MSCI which includes South Korea in their list while indices that are run by the FTSE exclude South Korea, including it on their developed country list.

Investors who are constantly looking to manage their exposure to a specific asset class through ETFs must consider the differences between the indexes as well as the suitability thereof against their entire portfolio.

 

Fees

Fees involved refer to the costs associated with the management of the fund, which translates to transaction costs, exchange fees, administrative, legal, and accounting expenses. These fees are deducted from the performance of the fund.

These costs are reported in the fund prospectus as an expense ratio which can be as low as 0.8% and as high as 2% and more. This percentage represents the total amount of management fees over the value of all the assets which are under management.

 

Liquidity

ETF liquidity is crucial in volatile markets and flash sales when investors which to exit their position. ETFs are driven by the assets under management, daily volume, and the bid/ask spread. Larger funds are also known to provide more liquidity as well as a lower spread.

The cost to buy or sell the fund will be determined by the liquidity as well as the spread. The spread will subsequently determine the premium that the investor will be subjected to in purchasing the funds on the stock exchange.

The discount refers to what the investor will need to give up selling their ETFs. The lower the spread, the smaller the difference will be between the purchase and sale price. Funds that have a smaller spread will therefore have lower exit costs.

 

Exchange-Traded Notes

These are a spin-off from ETFs. Exchange-Traded Notes, more commonly referred to as ETNS, are debt instruments that are structured and promise to pay the return on the assets being tracked.

This structure is especially popular for trading in oil, commodities, and volatility and they offer flexibility as well as easy access for investors to trade in and out of products.

Long-term investors are advised against ETNs, volatility (VIX) ETNs, inverse, and leveraged (2x and 3x index) ETFs as well as ETNs. While these increase both the popularity as well as the liquidity, they are not appropriate where long-term investment or retirement planning is concerned.

They are more suitable to short-term investors and traders and they incur a much higher cost in addition to having a higher risk profile.

 

Smart Beta ETFs

These are also a type of investment that has experienced an increase in popularity. While the name given to it was for marketing purposes, this type of ETF uses either a single- or multi-factor approach where investors select securities from a pre-defined pool such as the S&P 500, Russell 2000, MSCI world index, and numerous others.

Single Factor ETFs such as Low Volatility and High Dividend are those which focus solely on one characteristic. They offer investors a low-cost alternative to investing in a portfolio associated with income generation or stocks that are less volatile.

Multi-factor ETFs are a hybrid consisting of both active wells as index management. Providers of ETFs established an in-house index that follows the rules of their multi-factor model. This model works to select securities from an index that follows certain parameters to subsequently outperform the index.

The fund will only buy the securities which are provided by the model and multi-factor ETFs are known for competing directly with mutual funds as they use the same techniques in security selection.

However, multi-factor ETFs have a lower cost, improved transparency, and a much easier entry point.

 

Currency Hedged ETFs

Currency Hedged International ETFs is another spin-off that has not yet gained a substantial amount of popularity. The goals of these ETFs are to track a foreign equity index by neutralizing currency exposure.

These ETFs are attractive to investors who are interested in international markets concerned with FX risk. Some of the more popular funds in this category consist of HEDJ, which tracks developed markets in Europe, and DXJ, which follows exporting companies in Japan.

 

Important concepts regarding ETFs

 

Passive versus Active

There are two basic types of ETFs, passive ETFs which are also known as index funds, which simply track a specific index, and active ETFs, which hire portfolio managers to invest money.

While passive ETFs aim to match the performance of an index, active ETFs aim to beat the performance of an index.

 

Expense Ratios

ETFs, as with any other type of investment, charge certain fees such as the expense ratio. This is listed as an annual percentage and a lower expense ratio will save the investor more money than one which is higher.

 

Dividends and DRIPs

Most ETFs pay dividends and the investor can choose to have their dividends paid in cash or they can choose to have them automatically reinvested. When choosing reinvestment, it is known as a dividend reinvestment plan or a DRIP.

 

How to invest in ETFs

 

Set up an investment account

To purchase ETFs, an investment account is required. This can be done either through a bank that offers the option for investment, or more commonly, by registering a brokerage account. Investors have the choice of choosing an account that offers comprehensive services, access to a financial advisor, and the option of having the advisor purchase ETFs on behalf of the investor.

Those who feel confident enough to do things themselves, and who would like to save on fees, can open their own investment account and proceed to choose their own ETFs to purchase. For beginners who are new to investing, numerous brokers offer demo accounts along with training materials and resources to help investors get started in investment.

 

Use a Robo-advisor

Investors who are just starting, and who are not yet confident enough, can make use of a Robo-advisor. Robo-advisors are based on a digital platform that makes use of algorithms to assist investors in choosing and managing their investments.

Robo-advisors offer similar services as a full-service account manager, but it is based on software, which may cancel out human error.

 

Decide on an ETF

After deciding which route to take with purchasing ETFs, the investor who chooses to buy their own ETFs can proceed to research the ETFs that they may want to buy. This process, however, can be overwhelming to beginners, and beginners should choose low-cost ETFs to start with.

 

Decide on the amount of capital to invest

This will involve deciding how much the investor can afford to spend and how they want to invest their money. A lump-sum payment seems like the best financial option, especially for those who wish to avoid fees and commissions which are associated with trading ETFs.

However, this is not an option for everyone and luckily there are numerous more cost-effective strategies to pursue.

 

Fund the account

Before an ETF can be purchased, the investor must fund their account by depositing money into the investment account. This can be done by making use of the transferor deposit options offered by the provider of the account, whether a bank or a broker.

Depending on the payment method used, such as bank transfers, it may take a few days for the money to reflect while debit and credit card payments can be immediate.

 

Make a purchase

Once the account has been opened and funded, the investor can spend some time researching ETFs before they execute their order. This involves searching for the ticker symbol of the ETF that the investor wants to purchase.

The ticker symbol can consist of letters that represent the security that the investor is trying to buy. In addition to this, when purchasing an ETF, there are a few things that the investor must consider, including:

  • Ask Price – which is the lowest price that the seller will accept for the ETF.
  • Bid Price – which is the amount that the buyer is willing to pay for the ETF.
  • Quantity – the number of shares that the investor wants to purchase.
  • Order type – which is responsible for providing instructions about how the investor wants to purchase the ETF. Two of the most common types of orders are a market or limit order.
  • Market order – which allows the investor to buy the ETF immediately at the market price. When using this, the order will be filled quickly but there is no guarantee on the price.
  • Limit order – which allows the investor to specify the price that the investor is willing to pay for the ETF, with the order only being fulfilled when that price, or lower, is reached. The price may be guaranteed but should there not be a price that matches this, or lower, the order will not be executed.
  • Time in force – which allows the investor to define how long their order should remain active before it expires.

 

What is the best way to invest in ETFs?

There is a wide variety of ETFs available and it may be difficult to determine which ETFs are the best for the individual investor. Thus, the answer will be different for each investor depending on their personal preference, interests, risk tolerance, level of experience, and more.

However, there are some characteristics that investors can consider when purchasing ETFs.

 

Commission-free ETFs

Trading costs are the fees involved when purchasing and selling ETFs and these may accumulate over time depending on the investing strategy used. If the investor aims to keep fees as low as possible, they should choose commission-free ETFs.

These are offered by most brokers and they can save investors a lot of money.

 

The advantage of diversification

As the investor gains confidence and experience, and they begin to buy more ETFs, they must ensure a diversified ETF portfolio. This means that the investor does not pool all their funds into a specific sector, asset class, or industry.

ETFs differ from individual stocks in this regard as they are a basket containing various shares, ensuring an even spread across industries, classes, and sectors. This also translates into lower risks. Investors can also diversify their portfolios by looking at small, mid, and large-cap companies and even consider international ETFs and emerging markets.

 

 

Pros and Cons

✔️Pros

  • Low barrier to entry – which means that there is no minimum amount required to start investing in ETFs. All investors need to ensure is that they can cover the price of one share along with any associated commissions or fees which may be charged.
  • There is diversification – Rather than attempting to purchase every security individually, which could be time-consuming, costly, and tedious, investors can quickly and easily purchase one ETF which contains a variety of securities.
  • Easy to buy and sell – ETFs can be traded daily much like stocks, which allows for them to be bought and sold quickly at any given time during the day.
  • They are tax-efficient – ETFs do not involve taxes until the investor decides to sell their ETFs at a profit. This allows for the investor to have control of when they would like to sell and pay the required taxes.

 

❌Cons

  • Trading costs – while one of the main benefits of ETFs is that they typically have lower fees than other investment vehicles, investors may still have to pay fees when trading ETFs as opposed to holding them over long-term. However, some brokers offer zero-fee trading.
  • Volatility – ETFs do not guarantee immunity to volatility. While ETF purchases are more stable than buying individual stocks, there are still risks involved with swings in the market. This can be reduced by purchasing ETFs which track an entire market, rather than buying ETFs in one market.

 

Author Details

Louis Schoeman

Louis Schoeman

Featured Forex and Stocks writer

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