Learn what ETFs are and how they can help you build wealth

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One of the hardest parts of learning to invest is realizing that the terminology can be a lot to learn – but it’s almost never as complicated as you think.

If you’re learning about investing, you’ve probably heard the term ETF. Many experts and social media influencers will tell you that certain ETFs are great investment opportunities, and maybe they’re right – but what exactly is an ETF?

I’ll break it down for you as simply as possible.

What is an ETF?
ETF stands for exchange-traded fund. These funds have some of the characteristics of stock and some of the characteristics of a mutual fund. Like stocks, ETFs trade throughout the day at market prices that can change. Like a mutual fund, an ETF is a group of stocks or bonds, making it easier to diversify your portfolio and reduce risk.

There are various types of ETFs and you will find ETFs with a specific focus, such as sectors (e.g. technology), currencies (e.g. cryptocurrencies), or commodities (e.g. oil). Before investing in one of these ETFs, be sure to research its niche.

The bottom line: ETFs allow you to diversify and reduce risk by buying multiple stocks in one ‘container’.

How do ETFs work?
Generally speaking, an ETF works much like any investment an investor makes in the stock market – you buy one and the value of the money you put in grows or falls as the investment performs.

ETFs can be actively or passively managed. Actively managed ETFs have a manager who watches the performance of the fund and can actively make changes by selling or buying shares or bonds in the fund. As the funds are actively managed, they usually have higher overheads.

Passive managed ETFs are created and mostly placed separately. As there is no active manager, the overheads are lower. These ETFs are worth considering for long-term investment strategies.

Why do investors buy ETFs?
Investors buy ETFs because of how they balance cost, risk, return, and liquidity. ETFs generally have lower expense ratios than mutual funds and lower risk than equities. (Expense ratios show the relationship between the cost of managing a fund and the value of the fund.)

ETFs also tend to be easier to sell or more liquid than mutual funds. However, this liquidity may vary depending on the type of ETF you own.

What are the pros and cons of ETFs?
When deciding whether to invest in an ETF, consider the pros and cons. We will focus on the general pros and cons here.

When you look at specific ETFs, you will need to create a list of pros and cons specifically for these funds before investing.

Pros
Management approach – ETFs can be actively or passively managed. If you are investing for a long-term goal, passively managed ETFs can help you reduce costs as they have a lower expense ratio.
Specialization – ETFs usually focus on specific commodities, currencies, or sectors. These funds are more likely to be diversified when investing in specific categories.

For example, instead of buying shares of several different technology companies to diversify your portfolio, you can invest in an already diversified technology-focused ETF.

Risk – Because ETFs are already diversified, they are less risky than equities. However, the risks associated with each ETF may vary. Be sure to do your research, especially if you are considering a very niche, leveraged or inverse ETF.
Returns – The other side of risk returns. While ETFs take more risk than mutual funds, they have the potential to generate higher returns than you would expect from a mutual fund.
Cost – ETFs are cost-effective. They have some of the lowest expense ratios. They also tend to be tax efficient.
Disadvantages
Management Approach – There really are no negatives on this point. Be sure to pay attention to how the ETF is managed and consider how it fits in with your investment objectives.
Specialization – While ETFs are diversified within their niche, it may be wise to have more diversity in your portfolio. You only need to look at how the oil and gas markets have changed dramatically over the past few years to see that having a wider diversity in your investments is wise.
Risk – While ETFs are less risky than equities, they do carry more risk than mutual funds. So again, here’s a reminder to research ETFs before you invest.
Rewards – Again, there is no firm focus here. ETFs vary in the potential returns they offer.
Costs – While ETFs are usually cost-effective, you do need to be aware of fees. Sometimes ETF managers will waive fees for a period of time. These waivers can be renewed, but this is not a guarantee.

What is the difference between an ETF and a mutual fund?
The main differences between ETFs and mutual funds are

Trading hours
Stock pricing
Investment strategy
Trading hours
ETFs can be bought and sold during the day. These trading rules can make ETFs attractive to day traders. Long-term investors can also benefit from ETFs.

Mutual funds are only traded at the end of the day. The price of mutual funds may also vary, but the price is set once a day. Fund shares are sold at the end of the day, so the price forecast you initially see may change when your investment or sale is completed.

Share pricing
ETFs trade at market prices. These prices may fluctuate during the day.

Mutual funds trade at NAV or Net Asset Value, which is set once a day after the market closes. Mutual funds are priced in this way because they consist of a variety of investments and the price of each investment fluctuates throughout the day.

Mutual funds sometimes require a minimum number of shares to be invested in the fund. These minimum requirements may prevent some investors from accessing funds as they are difficult to meet.

Investment strategies
Mutual funds often include a wide range of funds as their main objective is to perform as well as the market average. While mutual funds may be large or small-cap, they do not necessarily focus on a specific niche market in terms of the sectors included in the fund. (Large-cap and small-cap refer to the size of the companies included in the fund, not the sectors in which they operate.)

On the other hand, ETFs can be more focused, which means they can perform better than mutual funds. However, it also means that they can perform worse. Some of these risks vary depending on the type of ETF you buy.

How do I start investing in ETFs?
First, you need to open an account with a broker. You can use an investment app such as Robinhood, or you can choose a more traditional broker such as Charles Schwab. Once you have an account, you will need to transfer funds into it.

Once your account is funded, you can start investing. Before investing in a fund, check its history and current performance. Make sure you know what type of ETF it is, how the fund is managed, and what sectors or commodities it invests in.

You can find these reports through your broker. You can also refer to other online resources such as Yahoo! Finance and the ETF Screener from the ETF Database.

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