The exchange traded funds (ETF) made their debut in the stock market back in 1993, but didn’t become widely used until another ten years later.
Since then they have become a favorite of investment professionals and small time investors.
They offer many of the advantages of mutual funds, but are unique in the marketplace for how they are purchased.
What is an ETF?
Exchange traded funds allow you to invest in a large number of stocks or other investments all at one time. If this sounds like a mutual fund that is because they act very much the same.
The difference is that an ETF is traded on the stock market just like common stock. Many are created to follow an index like the S&P 500 and allow you to buy into them at a much lower rate than buying index funds.
How to Buy an ETF
As I said above, Exchange traded funds can be purchased just like common stock. This means you can buy them from any brokerage account as long as that account is on the market that you are purchasing the fund from. So if you want to purchase a stock that follows the S&P 500 you only need to have a brokerage that trades on the NY Stock Exchange (which is all of them).
Use a Robo-Advisor
If you are the hands-off kind of investor but want to get involved in ETFs then a great way to go is to invest with a robo-advisor. These types of brokerage accounts do all the investing for you. All you have to do is go in and answer a set of questions so the algorithm can determine your risk tolerance.
One of the most popular robo-advisors is Betterment. Their sign up process is really simple and they have really low fees for the service. Use my Betterment review to learn more about the company and how its services work with ETFs.
Do It yourself
If you are comfortable looking at the information available you can purchase an ETF directly by yourself. As mentioned above, this can be done through pretty much any brokerage account and is as easy as purchasing a stock. Even better news is that you can avoid any commissions from some brokerages on ETF purchase and sales.
No Commission ETFs
Because ETFs are so inexpensive to trade there are brokerages that will allow you to buy ETF shares with no charge at all. The most famous of these is TD Ameritrade.
TD Ameritrade offers over 100 ETFs that you can purchase with no charge. This means when you buy or sell any ETF on their list you do not have to pay any brokerage fees. The cheapest fees on the Internet for online brokerage accounts is $4.95 a trade. So you would save that five bucks on both the purchase and sale of the ETF.
That doesn’t sound like a lot, but if you get into actively trading then you can save a bundle over time. Plus that five bucks is now invested for you and helps pump up your compound interest.
Since ETFs are purchased just like stocks, you just have to calculate how many shares you can afford with the amount of money you have to spend. Let’s say you are going to make a $5,000 investment that you are going to make in one ETF. If the ETF shares are trading at $35.12 and you are purchasing with a $4.95 trading fee, you can purchase 142 shares and still have $8 left over.
ETFs vs Mutual Funds
So if ETFs are so great why would anyone want to purchase a mutual fund? This is a great question and the answer is somewhat a matter of preference.
Both of these types of accounts will follow large indexes or groups of investments. They both give you options on getting into many different types of investments all at once. So the way they react to the market is very similar, especially if you are looking at an ETF that follows an index and a mutual fund that follows the same index
The two differences between an ETF and a mutual fund are fees and initial deposit. Each time you buy or sell an ETF you are subject to fees. So if you are going to be purchasing shares in an index fund ETF a little at a time you are going to rack up fees as you go. Therefore if you are going to do a very large initial lump sum (think rolling over 401k to IRA) then an ETF is going to only cost you fees that one time, and would be the better choice. If you are looking at investing 100 dollars a month then a mutual fund is going to keep your fees much lower.
The other main difference is initial deposit. With an ETF there is no initial deposit you just purchase the shares. So whatever the share price is that day is what your minimum initial deposit will be. Mutual funds allow you to invest with dollar amounts instead of the cost of a share. To buy into the fund they usually require that you have a minimum amount around $3,000. some are more and some are less, but all of them have that initial deposit amount. So if you do not have enough to get into the fund you need to start with an ETF, until you can afford the initial deposit.
Types of ETFs
There are tons of different kinds of ETFs. Since they can follow a stock index, bonds, commodities (think gold or oil), basket of assets or even just a group of hand-picked stocks, ETFs have a lot of varieites. Instead of trying to cover every possible type of ETF here are the top 10 most popular exchange traded funds based on trading volume:
As you can see, there is a wide variety even among the most popular of exchange traded funds. Just by buying into these funds you would be in large cap stocks, small cap stocks, gold, oil, and tech stocks.
It really is a great diversification tool if you are looking for a low cost option.
Exchange traded funds may be one of the newer investment options available but for the last 15 years they have really grown in popularity. If you are worried about jumping in I recommend setting up an account with TD Ameritrade, choose one of their 100+ ETFs that are commission free and start with just a few shares.
This way you can get a feel for how the investments work and start working with this really awesome investment vehicle.