How to invest in ETFs (traded funds)

Exchange-traded funds or ETFs are an easy way to start investing. ETFs are quite easy to understand and can generate impressive returns without much expense or effort. Here's what you should know about ETFs, how they work, and how to buy them.

What is an ETF?

ETFs vs Mutual Funds

It is a common questionWhat is the difference between ETFs and mutual fundsbecause the basic principle is the same.

The main difference between the two types of investment instruments is how they are bought and sold. Mutual funds are traded once a day and you typically invest a fixed dollar amount. Mutual funds can be purchased through a broker or directly from the issuer, but the bottom line is that the transaction is not instantaneous.

On the other hand, ETFs are traded like shares on major exchanges such asNYSEmiNasdaq. Instead of investing a fixed dollar amount, you choose how many shares you want to buy. Because they trade like stocks, ETF prices fluctuate continuously throughout the trading day, and ETF stocks can be purchased whenever the stock market is open.

Image credit: Motley Fool

Fundamentals of ETFs

Before we proceed, there are a few terms you should know before buying your first ETFs.

Passive vs Active ETFs:There are two basic types of ETFs.PassiveETFs (also known as index funds) simply trackstock index, as.ActiveETFs employ portfolio managers to invest their money. The main conclusion: Passive ETFs wantgameindex performance. want active ETFsknockindex performance.
Expense Rates:ETFs charge feesexpense ratio. You will see the spend rate as an annual percentage. For example, a 1% spending fee means you will pay $10 in fees for every $1,000 invested. All things being equal, a lower spend rate will save you money.
DRIP dividends:Most ETFs pay dividends. You can choose to receive ETF dividends in cash, or you can choose to automatically reinvest them throughdividend reinvestment planthe DRIP.

Understanding ETF taxes

If you buy ETFs with a standard brokerage account (not an IRA), be aware that they may generate taxable income. Any gains from the sale of ETFs will be taxed in accordance with Artcapital gains taxrules, and any dividends received are likely to be taxable as well.

Of course, if you invest in ETFs throughIRA, you won't have to worry about capital gains ordividend taxes. In a traditional IRA, money in the account is considered taxable income only after it is withdrawnIRA wheelinvestments are in most cases not taxable.

How much money do you need to invest in ETFs?

ETFs do not have minimum investment requirements – at least not in the same sense as mutual funds. However, ETFs trade stocks, so unless your broker offers that optionbuy fractional shares of sharesyou need at least the current stock price to get started.

Image credit: Getty Images

Pros and Cons of ETFs

Advantages of investing in ETFs:

ETFs provide exposure to a variety of stocks, bonds, and other assets, often at minimal cost.
ETFs take the guesswork out of investing in stocks. They allow traders to track market performance over time, which has historically been quite good.
ETFs are more liquid (easier to buy and sell) than mutual funds. Online brokers make it easy to buy or sell ETFs with just one click of the mouse.
Investing in individual bonds can be extremely complicated, but a bond ETF can make the fixed income portion of your portfolio much easier.

Possible disadvantages of ETFs:

Because ETFs hold a variety of stocks, they don't have as much return potential as buying individual stocks.
ETFs are usually cheap, but not free. If you buy a single stock portfolio yourself, you don't have to payeveryoneadministration fees.

How to start investing in ETFs

Open a brokerage account.
Choose your first ETF.
Let your ETFs do the hard work for you.

Step 1: Open a brokerage account.

You will need a brokerage account before buying or selling ETFs. Most online brokers now offer commission-free stock and ETF trading, so cost is not a major consideration. The best course of action is to comparefeatures and platform of each broker. If you are a new trader, it may be a good idea to choose a broker that offers a wide range of educational resources such asTD Ameritrade(NASDAQ: AMTD),e*trade(NASDAQ: ETFC), LubSchwab(FOR THAT 3,54%), but there are some other great brokers to choose from.

Step 2: Choose your first ETF.

For beginners, passive index funds are usually the best bet. Index funds are less expensive than their actively managed counterparts, and in fact the funds are more actively managedNObeat your benchmark in time.

With that in mind, here is a list of ETFs and a brief description of what each one invests in for beginners who are just starting to build their portfolios:

Top 10 ETFs for Beginners

ETF Examples: Top 10 ETFs for Beginners

Vanguard S&P 500 ETF(LOT 0,98%) -- Major US companies
Schwab, an American mid-cap ETF(SCHM -0,17%) - American medium-sized companies
ETF Vanguard Russell 2000(NYSEMKT:VTWO) -- Smaller US companies
Schwab International Equity ETF(SCHF -0,22%) -- Largest non-US companies
Schwab Emerging Markets Equity ETF(DIAGRAM -0,11%) -- Companies from countries with developing economies
Vanguard ETF with a high dividend(VYM -0,64%) — Stocks that yield above-average dividends
Schwab U.S. REIT ETF(SCHH 0,3%) -- Real estate investment funds
ETF Schwab US Aggregate Bond(SCHZ -0,25%) — Bonds of all kinds and all maturity dates
Vanguard Total World Bond Fund(BNDW -0,34%) - Includes international bonds and US bonds of various lengths and maturities.
Trusted by Invesco QQQ(QQQ 2,62%) — Tracks the Nasdaq-100 index, which is heavily focused on tech and other growth stocks.

You may notice that this list is heavy on Vanguard and Schwab. There's a good reason for that: both are dedicated to giving Americans access to the stock market at minimal cost, so ETFs for both appear to be some of the cheapest on the market.

Expert questions and answers on ETFs

Dr A.S. ASA Seddik Meziani

Professor of Accounting and Finance at Montclair State University

The Motley Fool: Are ETFs Good for Beginner Investors?

Dr A.S. ASA Seddik Meziani:ETFs are an easy way to invest. They are considered an ideal entry point for novice traders thanks to their simplicity, low initial cost, simple fee structure, and ease of trading. Also, apart from the share price of an ETF, there is no minimum amount to invest, unlike mutual funds. Any broker can turn an investor into a new ETF holder through a direct brokerage account. Investors can easily access the market or sub-market they want to be in. This can easily be done with an ETF that tracks it.

The Motley Fool: Is an ETF considered safer than an index fund to limit risk? Or vice versa?

Dr A.S. ASA Seddik Meziani:To be clear, many ETFs are "index funds" in the sense that they also track an index, just under different terms. That said, most ETFs can be used for risk mitigation as they are often inherently diversified through underlying baskets of securities that offer a wide range of asset classes. Like index funds, however, they cannot completely eliminate risks such as market or counterparty risk and credit risk inherent in the structure of an ETF.

The Motley Fool: Are ETFs considered safer than stocks? Why or why not?

Dr A.S. ASA Seddik Meziani:ETFs are generally considered safer to hold than single stocks due to the wide range of underlying assets that provide diversification benefits. It is generally safer to hold a group of stocks than just one. In other words, ETFs eliminate exposure to the risk of individual securities.

The Motley Fool: How do ETFs help with diversification? Is it possible to over-diversify an ETF portfolio?

Dr A.S. ASA Seddik Meziani:Diversification is a widely accepted framework for investment management. ETFs help with diversification, especially if the underlying portfolios span multiple asset classes. But, like everything, diversification also has its limits. Exercise in moderation. The role of diversification is to reduce investment risk. However, going too far can lead to portfolio bloat and over-diversification. It occurs when the additional benefit of reducing risk through diversification begins to be offset by the marginal loss of expected return. Owning more stocks just to have more stocks and not thinking about how the risk of each additional stock balances out with the risk of existing stocks is not a good investment strategy.

Frequently asked questions about ETFs

What is an ETF?

An exchange-traded fund or ETF allows investors to buy multiple stocks or bonds at once. Investors buy shares of ETFs and the money is used to invest according to the stated purpose. ETFs are traded like stocks on major exchanges such as the NYSE and Nasdaq. Instead of investing a fixed dollar amount, you choose how many shares you want to buy. Because they trade like stocks, ETF prices fluctuate continuously throughout the trading day, and ETF stocks can be purchased whenever the stock market is open.