Beginner's Guide to ETFs

Did you know there are more than 2,800 exchange-traded funds (ETFs) listed on U.S. stock exchanges? Given the large number, choosing which ones should go in your portfolio can seem like a daunting task.

In this investing in ETFs for beginners guide, we help you understand what an ETF is, the main characteristics of this type of fund, the costs and fees associated with them and how to know which ones you should add to your portfolio.

What Is an ETF?

First things first, let’s get the basics out of the way. An exchange-traded fund, commonly referred to by its acronym ETF, is a basket of securities that trades on an exchange just like a stock does.

ETFs are hybrid investment vehicles that can offer relatively low-cost and tax-efficient exposure to a variety of assets—equities, bonds and commodities—and investment strategies. Like traditional mutual funds, most ETFs invest in a diversified portfolio of stocks and bonds. However, ETFs differ from traditional mutual funds in that they trade on a stock exchange.

Types of ETFs

As we mentioned above, there are thousands of ETFs on U.S. stock exchanges. As for what ETFs invest in, there are many different types of ETFs grouped under a few main categories. ETFs can contain different types of investments, including stocks, commodities or bonds. Some offer U.S.-only holdings, while others are international. The broad types of ETFs are:

U.S. Equity ETFs
Sector ETFs
Allocation ETFs
International ETFs
Bond/Fixed-Income ETFs
Commodities ETFs

Some ETFs can be classified by specialty categories, such as:

Currency ETFs
Factor ETFs
Sustainable ETFs

Check out our annual ETF guide to help you choose the best type of ETF that’s right for your portfolio.

Active Versus Passive ETFs

The majority of ETFs are passively managed, meaning they track an index. While passive ETFs are typically updated quarterly, an active ETFs has an investment manager who is actively managing the portfolio of securities more regularly. The number of actively managed ETFs has been growing in the last several years.

It’s important to evaluate your own investment management preferences before deciding if you should go with an active or passive ETF for your portfolio.

How Do ETFs Work?

One of the main benefits of ETFs is that they are not overly complicated. Like individual stocks, ETF shares are traded throughout the day at prices that change based on supply and demand. This means that their share price can fluctuate; this is in contrast to mutual funds, which are only traded at the end-of-day net asset value.

Pros and Cons of Investing in ETFs

While investing in ETFs can offer numerous benefits, there are some disadvantages that you should be aware of and factor into your needs.

The advantages of investing in ETFs include:

Tax benefits: One benefit of ETFs is that they tend to be more tax-efficient than mutual funds. There are two main reasons for this. First, most ETFs are index funds, which have fairly low turnover—especially large-cap index funds or total-market index funds that are weighted by market capitalization. Low turnover means fewer opportunities to realize gains when securities are sold from the portfolio, which is a taxable event. An ETF’s structure is the second driver of its tax-efficiency. ETF shares are created and destroyed via in-kind transactions between ETFs’ sponsors and a special kind of market maker known as an authorized participant. As such, ETF managers tend not to have to directly sell positions from their portfolios to meet redemptions, which results in less taxable capital gains distributions to investors.
Trading flexibility: The ability to trade ETFs throughout the day, like stocks, makes purchasing and selling these types of funds flexible. It is easy to move money between specific asset classes—such as stocks, bonds or commodities ETFs—to change your allocation at the click of a button.
Portfolio diversification: Since there is a wide variety of ETFs in every sector, style, industry and country, ETFs are able to provide investors with a convenient way to diversify without having to research numerous individual stocks.
Risk management: Due to the increase in diversification, ETFs offer investors an easy way to mitigate potential market volatility—just make sure that the ETFs you add to your portfolio are indeed filling a hole in your allocation.
Lower expense ratios: Because the majority of ETFs are passively managed, they inherently have lower expense ratios. Compared to some mutual funds, ETFs don’t levy charges (loads) to pay for marketing.

Some disadvantages of investing in ETFs include:

Expense: Even though ETFs tend to be cheaper than mutual funds, the majority of individual stocks are more cost-effective than ETFs.
Tracking error: Be aware of potential tracking errors. In the world of ETFs, tracking error is the difference between the actual return of the fund and the return of its benchmark index. Passive ETF managers aim to keep their fund’s investment performance in line with the index they track, but there are times when returns may be above or below the stated benchmark.
Lower dividend yields: Even though ETFs may be a safer investment than some dividend stocks, an investor who is able to take on more risk may be disappointed with the low dividend yields some ETFs offer.
Lack of liquidity: Not all ETFs suffer from a lack of liquidity; however, investors should be aware of what exactly is in the ETF as well as its overall trading volume.

Every type of investment—whether individual stocks, bonds, mutual funds or ETFs—will have advantages and disadvantages. Before investing, it’s important to be aware of these pros and cons so you can decide if investing in ETFs is the right decision for you.

Are ETFs Good Investments?

To decide if ETFs are good investments, you’ll want to take a look at your own preferences, goals and needs. A few questions to consider include:

How liquid are the individual stocks within the ETF?
What is the ETF’s bid/ask spread? (The difference between the market sell and buy price can cost you)
What type of ETF do you need to further your portfolio diversification? (Look at what gaps you may need to fill)
What is your risk tolerance?
What are your overall goals in relation to your risk tolerance?

In general, ETFs are considered to be low-risk investments because they tend to be more cost-effective than other types of funds and help investors increase their diversification. For many investors, ETFs can help build a diversified portfolio with the potential to mitigate market volatility. However, as we mentioned above, it’s important to also consider the disadvantages before investing in ETFs, which may point you to another type of security that may be a better fit.

Learn guidelines you can use when selecting which ETFs and mutual funds to add to your portfolio.

How Much Do ETFs Cost?

Similar to purchasing individual stocks, the price of an ETF will change depending on its trading activity, market trends and liquidity. Even though ETFs tend to be much more cost-effective than mutual funds, it’s important to understand that there may be some associated fees.

Unlike mutual funds, ETFs do not charge a load—a percentage of the invested amount that is paid as a sales fee. However, since ETFs are bought and sold on U.S. exchanges, they may incur a broker commission, which can vary depending on the brokerage firm you choose.

Additionally, we mentioned above that ETF expense ratios are typically much lower than that of mutual funds. Even though the expense ratio may seem small, any periodic fees add up over time and eat into your return.

Lastly, you will need to be aware of the bid/ask spread, which will be different for each ETF. The bid/ask spread is the difference between the current bid (sell) price and the ask (buy) price. A higher bid/ask spread is consistently associated with ETFs that have low trading volume, which means decreased liquidity for the investor looking to trade at a specific price.

Taxes and ETFs

Before investing in ETFs, it’s important to understand the tax implications of purchasing this type of security. ETFs are subject to the same tax rules as mutual funds. To improve their tax efficiency, ETFs commonly employ two mechanisms, which include:

Low portfolio turnover strategies: Index ETFs are less likely than actively managed funds to trade securities, thus reducing taxable gains that must be distributed to investors.
In-kind redemptions: ETFs that distribute securities to authorized participants can reduce their unrealized gains by distributing securities that were purchased for less than their current value. Since these transactions are in-kind, the ETF does not incur tax when the low-basis securities are distributed.

It is important to note that though these strategies can reduce capital gains distributions to investors while they are holding the ETF, ultimately taxes must be paid on any capital gains when the ETF shares are sold. Thus, these strategies enable tax efficiency through tax deferral, but not tax avoidance.

Additionally, if you plan to invest in ETFs that are dividend-focused, you will have to pay taxes on those payouts. However, you must hold an ETF for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date to qualify to pay taxes on that revenue.

If you are looking to avoid higher taxes on your investments, you may want to consider investing in index funds since they usually realize fewer gains as well as losses.

How to Invest In ETFs

If you’ve read this guide to investing in ETFs for beginners and have decided for yourself that you want to get into this security, there are a few easy steps you can take to learn how to invest in ETFs.

Open a brokerage account: Just as with individual stocks, you’ll need a brokerage account to buy and sell ETFs. Make sure you do your own research about which brokerage firm and type of account is right for you.
Use screening tools: You can use AAII’s A+ Investor ETF+ Screener, which allows you to easily filter through thousands of ETFs to find the right ones for your portfolio.
Conduct research: Once you find a few ETFs you are interested in, do your own research on their performance and financial metrics and examine their annual statements.
Analyze the costs: Find out what costs, fees and tax implications are associated with the ETFs you want to invest in.
Evaluate your allocation: Find the gaps in your portfolio that need to be filled to determine the types of ETFs you need to add to build a fully diversified portfolio.
Place the trade: You can purchase and sell ETFs with your broker by locating the ETF’s ticker on their trading platform.

When you’re ready to start investing in ETFs, you may want to subscribe to a suite of tools like A+ Investor so you can take the confusion out of finding the right ETFs for your portfolio. Learn about A+ Investor’s numerous tools as well as our AAII Platinum bundle today.

Additional Resources for Investing in ETFs

Looking for more resources about investing in ETFs? We’ve got your back! Here are some of our most popular educational articles and screening tools to get you started:

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