Exchange-traded funds (ETFs) are investments that combine the benefits of stocks and mutual funds. ETFs are made up of dozens or hundreds of shares of securities; you can buy and sell one or multiple shares of an ETF during stock market hours. This lets you invest money in a variety of companies or industries through buying shares in one single security—the ETF. It’s a way to simply and quickly build a diversified portfolio of investments.
ETFs can focus on specific market segments or aim to replicate the returns of an entire stock market index. No matter what your investment strategy is, there’s likely an ETF out there that will meet your needs and goals.
Start by learning how to invest in ETFs and then understand the role they can play in your portfolio.
How to Invest in ETFs in 3 Steps
You can invest in ETFs by following these three easy steps.
Choose the ETF
The first thing you’ll need to know when investing in ETFs is which fund you want to invest in. Some brokerage companies offer their own line of ETFs and benefits to customers who invest in those funds. This may guide you in your choice of which broker to work with.
You can typically find an ETF for any investing goal. For example, index funds aim to track the market at a low cost. There are also industry-focused ETFs that give you exposure to a specific type of company, such as utilities, energy, or tech. There are even ETFs that aim to track the performance of commodities like gold or crypto like Bitcoin.
When reviewing all of your options, be mindful of ETFs that are leveraged. This means they aim to perform two or more times the underlying index or benchmark they track. While they can potentially increase your return on investment, they can also increase losses. So if the underlying index loses 1%, the ETF would lose 2%.
Note
Leveraged ETFs may not be right for beginner investors, so be cautious. These instruments are not designed to be held for the long term. The leverage ETF usually rolls the contracts from month to month when the underlying assets are derivative products such as futures. This results in a natural loss due to attrition, reflecting a decline in net asset value over the long term.
Open an Account
Once you know which fund or funds you want to invest in, it’s time to open an account with a broker or through an investing app. If the fund is run by a company that offers brokerage services, like Vanguard, consider opening an account with that broker.
Once you open your account, link your bank account to it or deposit funds.
Submit a Buy Order
The last thing you need to do to start investing in ETFs is to start buying shares. Decide how much money you want to invest. If you’re using an investing app, for example, you’ll likely need to:
- Select the ETF
- Click “Trade” or “Buy”
- State the number of shares you want to buy or the amount of money you want to invest
- Submit a buy order to purchase some shares
If you’re working with a broker, you may be able to do this online or with someone in person at a branch location (if the company has one).
What You Need to Know Before You Invest in ETFs
Before you invest in ETFs, there are a few things that you should understand.
For starters, investing in ETFs isn’t free. Most ETF providers charge a fee, called an expense ratio, to pay for the cost of managing the fund’s portfolio. Expense ratios are quoted as a percentage of the amount you’ve invested per year. So if you invest $10,000 in an ETF with a 0.25% expense ratio, you’ll pay $25 per year in fees.
Note
ETFs can be a great choice for both beginner investors and advanced traders. Beginners can buy shares in diversified funds that aim to match the market. Advanced traders can day trade ETFs or focus on ones that target specific industries or strategies.
Understand the Risks of Investing in ETFs
The risks of investing in ETFs are similar to the risks of investing in other securities.
ETFs can lose value. If an ETF holds shares of Company XYZ and the value of its stock declines, the value of the ETF will also drop. You’ll have to hold the ETF in hopes that it regains value or sell it for a loss.
You also have to keep track of the fees. Some ETFs, especially actively managed funds, can charge high fees that will eat into your returns over time. For example, some ETFs may charge an expense ratio of 0.35% (i.e., $3.50 per every $1,000 invested), while others could charge over 1%. Be sure to check what type of fund you’re investing in.
In rare cases, the market value of an ETF could diverge from the true value of the securities it owns. This isn’t very common, but it could impact your overall returns and the amount you can sell your shares for.
Pros and Cons of Investing in ETFs
Pros
Easily build a diversified portfolio
Trade shares any time the market is open
Usually a low minimum to start investing
Cons
Fees can reduce returns.
Fractional shares may not be available.
Liquidity problems
Pros Explained
- Easily build a diversified portfolio: When you buy shares in an ETF, you immediately get exposure to each of the securities and companies in the ETF’s portfolio. Buying a share in a single ETF means immediately owning a diversified portfolio.
- Trade shares any time the market is open: You can trade shares in an ETF any time the market is open, similar to trading stocks. By contrast, mutual fund transactions only settle once per day after trading ends.
- Usually a low minimum to start investing: Many mutual funds have minimum investment requirements. With most ETFs, you can start investing for the cost of a single share (or maybe less with fractional shares).
Cons Explained
- Fees can reduce returns: ETFs charge a fee called an expense ratio. This fee will reduce your returns compared to investing in stocks and other securities directly that have no fee.
- Fractional shares may not be available: With stocks, investors can choose the exact dollar amount they want to invest, purchasing fractional shares easily. Depending on your broker, you may be restricted to buying only whole shares in ETFs instead of fractional shares, making it harder to invest precise amounts.
- Liquidity problems: ETF investors trade shares with other investors instead of transacting directly with the fund provider. As with stocks, if no other investor wants to buy shares from you or sell shares to you, you won’t be able to complete the transaction. But with ETFs, there’s also a second layer of liquidity to consider: liquidity of the underlying securities. You’ll also want to consider settlement dates—if you’re selling an ETF with a two-day settlement period to buy shares in a mutual fund that has a one-day settlement period, the transaction may not go through.
What to Watch out for After You Invest in ETFs
Investing in ETFs is a lot like investing in stocks or other securities. The primary difference is that ETFs make it easy to diversify your portfolio while only having to buy shares in one thing.
Just like when you invest in a stock, you should keep an eye on your portfolio after buying an ETF. With most investments, it’s important to have a long-term view. Even if you see short-term losses for one month, the ETF may gain value over the next couple of years.
However, that doesn’t make it safe to set and forget your portfolio. You should keep an eye on the ETF’s performance over time. If your investment goals or strategies change, you can sell your shares in that ETF and redeploy that money into other investments.
Should You Invest in ETFs?
Investing in ETFs can be a good choice for investors with all levels of experience. ETFs make it easy to build a portfolio that is diversified—or one that focuses on a specific type of company or industry.
Like all investing, ETF investing is subject to risk. If you buy shares in an index ETF that aims to track the performance of the market rather than beat it, you may do well in the long run.
Note
ETFs can track and replicate returns of stock market indexes like the S&P 500 or the Dow Jones Industrial Average. Between Dec. 9, 2020, and Dec. 9, 2021, both indexes showed positive one-year returns—27.08% and 18.91%, respectively. If you had owned shares in an ETF that tracked either one, you likely would have seen positive returns, as well.
Of course, there are also high-risk, high-reward strategies surrounding ETFs that beginners may want to avoid. Leveraged ETFs use derivatives to try to multiply the performance of the underlying benchmark or index. You can also trade options based on ETFs. This lets you leverage your portfolio but significantly increases your risk.
Whatever you choose, it may be wise to only invest money you can afford to lose. Consider all of your investment options and then decide if ETFs are the right fit for your portfolio.
Frequently Asked Questions (FAQs)
How can beginners invest in ETFs?
Investing in ETFs is easy for beginners to do. All you need is a brokerage account and cash that you can afford to invest. Once you’ve opened an account through a broker or investing app, choose an ETF and decide how many shares you want to buy. Submit a buy order and you’re all set.
Do I need a lot of money to invest in ETFs?
You don’t need to have a lot of money to invest in ETFs. With most brokerage companies, you only need to have enough cash to buy one share. ETFs range in cost—some may be around $100 per share, others for $50 per share. It all depends on the ETF.
What is the best way to invest in ETFs?
One of the best ways to invest in ETFs may be through a low-cost index ETF. The S&P 500 and Dow Jones Industrial Average are two well-known indexes that ETFs may track. If you can hold shares in an index ETF for a long time, you may see positive returns.
Note
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
