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What is an ETF and Why They Are Important For Investing

investments. Here's what you should know about an ETF.

What is an ETF and Why They Are Important For Investing

If you’re taking a deeper dive into your investments, you may be wondering, what is an ETF? It’s a good question. And one, you should know the answer to make informed decisions about your investments.

Knowing what an ETF is and how they work can help you decide whether they’re a good fit for your investment strategy. As with any investment, there are pros and cons to an ETF. Here are the ins and outs of the funds.

What is an ETF? (the Simple Answer)

An Exchange Traded Fund or ETF is a type of fund—or a basket of securities— that can be bought and sold on an exchange like the stock market. It’s like everyone in your neighborhood chipping in money to buy an investment. Everyone who puts in money owns a share of what you purchased in ETFs that would be the purchase of things like stocks or other securities.

ETFs have similarities to stocks and mutual funds and are used to invest your money. Like individual stocks, you can buy and sell ETFs throughout the trading day. Also, like stocks, ETFs have stock or ticker symbols which are letters that abbreviate a stock’s name. They are similar to mutual funds in that they’re a way for fellow investors to pool their money in a professionally managed fund.

There are currently hundreds of funds to choose from to fit your financial needs and goals. They can contain a mixture of securities such as stocks, bonds, and/or other types of investments.

Related: Spousal IRAs: What Military Spouses Should Know

Why You Should Know What an ETF Is

You should know about ETFs because if they’re in alignment with your investment goals and strategies, they can be a valuable investment option. ETFs are a more popular investment option because they are easy to buy and sell like stocks but offer greater diversification similar to mutual funds. But before you start putting your money in—anything—you should have a basic understanding of how they work and how you want to apply them. With any investment, if you don’t understand it in good times, you’re probably not going to realize when things are going wrong.

Another reason to understand ETFs is that over time, goods and services become more expensive due to inflation. As a result, money loses value and can no longer buy as much as it used to. Inflation isn’t something you can avoid, but it also isn’t something you have to fall victim to.

Investing helps grow your money so that it outpaces inflation and can pay for your future goals. This is why a long-term investment strategy is such a critical key to your financial success. Investing in exchange-traded funds can help you pay for goals such as your children’s education and retirement.

Types of Exchange Traded Funds

Just like mutual and index funds, there are a boatload of ETFs. They come in MANY different ways. They can vary in the assets they hold and how they’re managed. For example, the different types of funds based on their underlying asset are:

  • Bond – Income-producing bonds that trade like stocks
  • Equity – a basket of securities that track a specific set of stocks
  • Commodity – natural or agricultural resources like oil and wheat
  • Currency – a basket of different currencies or a one like the U.S. dollar

They can be either index-based ETFs that are passively managed or and actively managed ETFs. The more popular type is an index-based ETF that replicates or copies an existing index like S&P 500.

There are a plethora of funds to choose from. Some mimic large indexes with hundreds of diverse securities like the Dow Jones. Others are a basket of commodities like energy and coffee or a basket of bonds. Remember, you want to invest in ETFs that align with your investment goals

How Do They Work?

How an ETF works depends on the type of ETF you invest in. In most cases, it will be an indexed ETF. In that case, they take a passive approach to invest because they mimic or track an index. Indexes are portfolios that represent an economic market or segment of the market.

For example, the S&P 500 is an index made up of the 500 largest US-traded companies. An ETF that mimics the S&P 500, such as the Vanguard S&P 500 (VOO), will have the same 500 securities within the S&P.

ETFs distribute your money across various companies, industries, and parts of the world. This is also known as diversification and can help reduce investment risk.

ETFs gather the money from their investors to purchase the various mix of investments. When you buy ETF shares, you own portions of all the securities within said ETF. And as the value of shares grows, and/or if the ETF produces income, your money will grow as well. Also, be aware that your investment can drop in value if the ETF loses value.

How They Start

  1. The fund manager or sponsor—who owns the underlying assets—creates the fund and outlines its goals and characteristics. The underlying assets can be things like an index, stocks, or bonds.
  2. The fund provider sells shares of the fund to investors like you and me.
  3. ETF owners can buy and sell their shares throughout the trading day.

How to Invest in a Fund

You invest in ETFs through a brokerage account. Brokerage accounts are found at banks and financial institutions like Vanguard, Charles Schwab, and Fidelity. The Thrift Savings Plan (TSP) does not have ETFs, nor do most 401ks.

To begin, first look into the type of fund that fits your financial goals. Next, compare them to similar funds based on investment objectives, fees, and risk. Next, open an account with the firm that offers the ETF you want and buy the number of shares you want.

Related: Everything You Should Know about the TSP

How an ETF Compares to a Stock

ETFs and stocks both trade based on share prices throughout the day on an exchange. Beyond that, these two differ when it comes to diversification.

When you invest in a stock, you own a share of only one specific company. Compare this to investing in ETFs, which helps diversify your money and reduces risks.

ETFs vs. Mutual Funds

Mutual funds, like ETFs, pool investors’ funds to purchase securities. However, unlike most of the ETF passive strategies, mutual fund managers take an active approach. This means they select securities and trade them in an attempt to beat the market.

ETFs also usually cost less than mutual funds. There are no minimums to invest in ETFs. Thus, you only need to be able to cover the cost of one share. The management fees are lower, and they usually have no added sales fees.

Mutual funds generally require an initial $1000-3000 investment. And to compensate for all the active trading, they also charge higher management fees. Mutual funds also usually charge an added sales fee, which is often called a sales load.

Lastly, ETFs offer more flexibility. They trade throughout the day, and their share prices change as investors buy and sell them on the market. This gives investors more opportunities to buy shares at lower prices.

Mutual funds do not trade as often. Trades happen only once per day, after the close of the market at 4 pm EST. The trade price is also determined at that time.

ETFs vs. Index Funds

Like ETFs, index funds are investment tools that aim to mimic an index. They are collections of securities, and like ETFs, are passively managed. As a result, both are also low-cost investment options.

Where these two differ is in how they trade. ETFs trade throughout the day. Index funds trade after the close of the market, like mutual funds.

ETFs also have no investment minimums compared to index funds, making them easier to buy into.

The Pros and Cons of Exchange Traded Funds

There are pros and cons to consider when investing, so ETF investments are no different. The most significant advantage to investing in ETFs is that you can buy a mixed bag of stocks or securities in one swoop instead of trying to buy them onesie-twosies to get diversification. When deciding if ETFs are a good option for you, remember your financial goals and weigh them against the pros and cons.

Pros

  • Diversification – They have a diversified mix of investments.
  • Easier to trade (liquidity) – More opportunities to trade throughout the day as the market sets the price for the funds.
  • Low buy-in requirements – Compared to mutual funds, the initial investment is less.
  • Simplicity – The funds can be an easier way to build your own portfolio.
  • Low cost – Low expense ratios and management fees make investing in ETFs cost-effective.
  • Tax Efficiency – When held in a taxable account, an ETF is more tax-efficient than mutual funds because most ETFs follow an index and aren’t actively managed, creating fewer taxable events.

Cons

  • Cost – The funds have management fees, so they are a little more expensive than buying stock straight up.
  • Lots of options – There are many funds to choose from. Sometimes this can slow your decision-making process.
  • Commission costs – Flexibility may lead to additional trading activity, resulting ins additional fees and consequences

Here’s the Bottom Line

ETFs are investment vehicles that feature significant advantages and grow your money long-term. There are different types of funds you can invest in based on your risk tolerance and investment goals. ETFs can be used by all types of investors but are great for new investors too.

If you want to “kickstart” your finances in the military, you can get access to my free Financial Kickstart Kit here.

Featured image by Petty Officer 2nd Class Jeremy Laramore