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What Are ETFs & How Do You Invest in Them?

ETFs are investment funds that give investors a simple way to diversify their holdings, often for lower fees than mutual funds. Learn the pros and cons of ETF investing.

By Elliot M. Kass | American Express Credit Intel Freelance Contributor

5 Min Read | November 1, 2021 in Money

 

At-A-Glance

ETFs can help ordinary investors diversify their investment portfolios.

The costs and taxes associated with ETFs are generally quite low and the funds are typically easy to buy and sell.

Most ETFs offer modest returns, but some riskier and more expensive ETFs can provide more profit potential.

People who don’t want to put all their financial eggs in one basket can consider investing in ETFs.


Short for exchange-traded funds, these investments target particular financial markets, like U.S. treasury bonds or the stock shares of high-tech companies, by purchasing a broad array of securities within that market segment. This gives people who buy shares in the ETF a simple way to diversify their holdings (the contents of their investment portfolio). Because an ETF pools funds from many thousands of investors, it can afford to purchase a variety of assets within its category – far more than most individual investors ever could.


Many ETFs also specialize in smaller subsets of larger markets, like utility stocks or municipal bonds, giving buyers more ways to broaden their market exposure.

 

How ETFs Work

ETFs trade like stocks and are listed on exchanges like the New York Stock Exchange (NYSE) and NASDAQ. They are bought and sold through brokers at market prices that may be somewhat higher or lower than the net asset value (NAV) of all the cash and securities held by the ETF. This is similar to shares of stock that may sell above or below the company’s “book value,” or the total amount a company would be worth if it paid all its debts and sold all its assets.


Because they can be traded so easily and due to the diversification they can provide, ETFs have become very popular in recent years. There are over 7,000 different ETFs worldwide,1  more than 2,000 of which are based in the U.S.2  The latter have over $4 trillion in assets under management.3

 

Passive vs Active ETFs

Most ETFs are passively managed investments, so the securities in them aren’t traded often. Instead, they’re generally bought and held for long periods of time. Passive investments typically seek to match the performance of a particular market index, like the Dow Jones Industrial Average.

 
Since these funds tend to require less attention from the fund’s manager, management fees may amount to less than 0.05% of the shareholder’s investment per year – and sometimes there are no fees at all. Less trading also means lower taxes, since a fund only pays taxes when it sells some of its holdings and realizes a gain.


Some ETFs, however, are actively managed, meaning that a portfolio manager (often supported by a team of analysts) actively trades securities to take advantage of price fluctuations and hopefully outperform the market index on which the fund is based. This is commonly known as “beating the market.”


When successful, actively managed ETFs can generate greater returns than their passively managed counterparts; but when they fall short, their losses also tend to be greater. And win or lose, they charge their shareholders higher fees – 0.66% on average in 2019 – and their more frequent trading leads to higher taxes.4

 

The Pros and Cons of Investing in an ETF 

Like any type of investment, there’s an upside and a downside to investing in ETFs. Here are some of the biggest pros:

  • Diversification. ETFs allow investors to diversify their holdings by buying stakes in many more securities – and many different types of securities – than they could on their own.
  • Liquidity. Because the ETF market is huge and the funds can be bought and sold so easily, most of these holdings are considered highly liquid, meaning they can be easily converted to cash. Usually, investors can readily sell their ETF shares and rarely get caught short holding a fund they don’t want.
  • No minimum investment. Unlike many mutual funds, ETFs don’t require a minimum investment above and beyond the cost of a single share of the fund. This makes them a good investment tool for someone with relatively small amounts to invest. For more on mutual funds, read “How to Invest in Mutual Funds.”
  • Advanced trading strategies. Since ETFs trade just like stocks, investors can take advantage of trading techniques like stop orders, limit orders, and short selling. This is especially beneficial for more experienced investors.
  • Lower fees. ETFs generally have lower fees and taxes than other types of funds, and that helps boost their net returns. Many online brokers even allow investors with very small accounts to buy and sell ETFs commission-free.


On the other hand, ETFs also have certain disadvantages, including:

  • Limited control. ETFs limit the amount of control individual investors can exercise over their investments, since they have no direct say over which securities are included in a fund’s portfolio. Someone who wants to buy or sell shares of a particular stock, for instance, would have to do this outside the ETF.
  • Passive means lower returns. Passive ETFs may match, but can never beat, the market. Although they tend to be less risky and have lower fees and less tax liability, their returns tend to be more modest.
  • Active means more risk. While they might beat the market and achieve outsized returns, active ETFs can also fall short and experience greater losses. They also tend to have higher management fees and greater tax liability.
  • Sometimes hard to sell. Some ETFs that invest in less popular market segments can be thinly traded. Especially during periods of market turmoil, these funds can be more difficult to sell.

 

The Takeaway

ETFs are investments that can help investors diversify their holdings. These popular funds trade like stocks and allow even the smallest of investors to participate in a broad range of market segments at a low cost. Their returns, however, are generally modest and investors who buy into them must surrender a degree of control.

Elliot M. Kass

Elliot Kass is a journalist who has covered global business and technology from New York, London, and San Francisco for more than 30 years.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

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