An exchange-traded fund, or ETF, allows investors to buy
many stocks or bonds at once. Investors buy shares of ETFs, and the money is used to invest according to
a certain objective. For example, if you buy an S&P 500 ETF, your money will be invested in the 500
companies in that index.
Before we get any further, there are a few concepts that are important to know before you buy your first
ETFs.
Passive vs. active ETFs: There are two basic types of ETFs. Passive ETFs (also known as index funds)
simply track astock index, such as the S&P 500. Active ETFs hire portfolio managers to invest their
money. The key takeaway: Passive ETFs want to match an index’s performance. Active ETFs want to beat an
index’s performance.
Expense ratios: ETFs charge fees, known as the expense ratio. You’ll see the expense ratio listed as an
annual percentage. For instance, a 1% expense ratio means that you’ll pay $10 in fees for every $1,000
you invest. All things being equal, a lower expense ratio will save you money.
Dividends and DRIPs: Most ETFs pay dividends. You can choose to have your ETF dividends paid to you as
cash, or you can choose to have them automatically reinvested through adividend reinvestment plan, or
DRIP.
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If you buy ETFs in a standard brokerage account (not an IRA), you should know that they could result in
taxable income. Any gains you make from selling an ETF will be taxed according to capital gains
tax rules, and any dividends you receive will likely be taxable as well.
Of course, if you invest in ETFs through an IRA, you won't have to worry about capital gains or dividend
taxes.
In a traditional IRA, money in the account is only considered taxable income after it
is
withdrawn, while Roth IRA investments aren't taxable at all in most cases.
How much money do you need to be able to invest in ETFs?
ETFs don’t have minimum investment requirements -- at least not in the same sense that mutual funds do.
However, ETFs trade on a per-share basis, so unless your broker offers the ability to buy fractional
shares of stock, you’ll need at least the current price of one share to get started.
ETFs provide exposure to a variety of stocks, bonds, and
other assets, typically at a minimal expense.
ETFs take the guesswork out of stock investing. They allow investors to match the market’s performance
over time, which has historically been quite strong.
ETFs are more liquid (easy to buy and sell) than mutual funds. Online brokers make it easy to buy or
sell ETFs with a simple click of the mouse.
It can be extremely complicated to invest in individual bonds, but a bond ETF can make the fixed-income
portion of your portfolio very easy.
