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Consider Trading ETFs

E xchange-traded funds (ETFs) are becoming an increasingly important investment vehicle and alternative to mutual funds. They’re an affordable and convenient way to diversify investments in your portfolio, but be sure to consider the many types of ETFs and their pros and cons to find an ETF that helps you meet your financial goals.

Key Takeaways:

  • Exchange-traded funds (ETFs) bundle stocks, bonds, options, and other investment vehicles into one tradable investment option.
  • The large variety of ETF types spans industries, geographical regions, and investment options.
  • Trading ETFs involves reviewing an ETF’s size, expense ratio, exchange location, and subsequent taxing as well as how it’s managed and the fees involved.
  • Advantages of trading ETFs include instant diversification and saving money on buying and brokerage fees, while disadvantages include fees related to actively managed ETFs.

What Are Exchange-Traded Funds?

Image via Flickr by free pictures of money

Exchange-traded funds (ETFs) are made up of various securities, including stocks, commodities, assets, bonds, or a mixture of different investment types that are traded on an exchange. This mixture allows investors to become instantly diversified without having to purchase numerous investments. Their share prices vary throughout the day, providing investors multiple opportunities to buy and sell as prices change. And these investments are traded during the day — just like stock shares are.

ETFs have many characteristics for investors to weigh, such as:

  • They can be made up of domestic or international underlying investments.
  • They can be passively managed, which means the components are automatically chosen and match an index or part of a market, or they can be actively managed where an individual or team of fund managers determines trades to outperform an index or market.
  • Most ETFs are set up as open-ended funds, which do not limit the number of investors.

ETFs are an excellent match for beginning investors looking for a broad range of opportunities with low costs and low minimum investment.

Types of ETFs

With the large variety of bundling options, there are many different types of ETFs to choose from, including:

  • Stock ETFs: This type of ETF tracks stocks in an industry or an entire index. Stock ETFs provide diversification in a simple, low-cost, and tax-efficient tool that’s easy to trade.
  • Bond ETFs: Government bonds, corporate bonds, state bonds, or municipal bonds may comprise bond ETFs, and assets often change as bonds mature. Their risks include a rise in interest rates, which decreases a bond ETF’s value.
  • Industry ETFs: These ETFs are for a particular industry, such as banking, technology, energy, consumer staples, or real estate, and include domestic or global securities.
  • Commodity ETFs: Providing easy access to commodities like oil and gold, commodity ETFs typically go up in value when stocks and bonds decrease in value.
  • Currency ETFs: These are typically passively managed and invested in a single or multiple foreign currencies to speculate, diversify, or hedge against currency value risks. Currency ETF values are affected by interest rates, global economic conditions, and political stability.
  • International ETFs: Focusing on international markets or a country-specific benchmark index, international ETFs may specialize in emerging or frontier markets in developing countries. Investors can use this vehicle to take advantage of strong global growth but may encounter higher expense ratios investing abroad.
  • Inverse ETFs: Also known as a ‘short ETF’ or ‘bear ETF’, an inverse ETF is specifically designed to do the opposite of the index or benchmark it’s tracking, thus profiting from a decline in the index’s or benchmark’s value. It’s similar to shorting a stock, which is selling before the value of an underlying benchmark and then buying it at a lower price.

How To Buy and Sell ETFs

Here’s what you need to know about trading ETFs:

1. Open a Brokerage Account

ETFs trade through online brokers and traditional broker-dealers, just like regular stocks. Find a brokerage firm you trust, and open an account to begin researching opportunities with an adviser and purchasing an ETF that works for your portfolio. Consider brokerage fees, the trading platform, which markets are available, the ease in opening an account, and the security of trades to help you find the brokerage that’s best for you.

2. Review the Size and Expense Ratio of Various ETFs

On your own or with an adviser, research various countries and sectors where investors believe the market plans to go up. Then, explore both large and small ETFs to see the potential. Larger ETFs are more liquid, which means they are more heavily traded by investors. ETFs with over $100 million in assets under management (AUM) are usually more liquid. Small ETFs may cost more than investing in the individual stocks within them.

Then, consider expense ratios, which show the annual fee of the ETF. Expense ratios under 0.1% are very good.

3. Consider the ETF Type and Exchange

Review the ETF’s domicile — the country of origin — and its trading currency to understand taxes or additional fees you may face. ETFs may be traded on several exchanges, so it’s best to choose the exchange with the lowest commission. And be mindful of currency conversion, but it’s usually best to buy an ETF that uses the same currency as the brokerage.

4. Choose Between Passively or Actively Managed Funds

Determine whether the ETF is passively or actively managed, and weigh the extra cost versus the potential returns when considering an ETF.

Passively managed ETFs have:

  • Lower overhead because they match an index or part of a market.
  • Automatically chosen components.
  • Good diversification.
  • Low turnover.
  • Low management fees.

Some ETFs that are passively managed could contain all stocks in an index. However, ETFs don’t always track an index and have passive management.

On the other hand, actively managed ETFs have:

  • An active manager who buys undervalued securities and sells overvalued securities, seeking to take advantage of market inefficiencies.
  • Potentially higher returns since they’re actively researched and traded to outperform an index or market.
  • Higher expenses.

Actively managed ETFs can outperform indexes and markets, but investors need to balance the higher returns with the higher fees as well as be aware of their short-term and long-term strategies.

5. Purchase an ETF That Helps Your Financial Goals

There are many types of orders you can place when purchasing your ETF to better manage your trading activities, including:

  • Market orders are the most common and are executed at the current best price and take effect right away.
  • Investors may also choose limit orders where they set a buy price and a length of the request.
  • Stop orders and stop-limit orders secure profits and minimize losses by automatically executing trades or placing them on hold.

6. Set a Stop-Loss Price for Short-Term Opportunities

Short-term buyers should consider a stop-loss price, a threshold where they would cut their losses. They should also set a target price where they can sell for a profit.

7. Monitor the ETF’s Performance

Brokers suggest that long-term buyers monitor investments monthly to yearly. Value is easy to look up using ticker symbols.

Advantages and Disadvantages

ETFs, like all investments, have positive and negative traits to consider before making an investment decision.

Advantages

Consider these positives to trading ETFs:

  • Diversification: Investors have the ability to bundle various investments into a diversified portfolio, making ETFs an ideal asset for new and veteran investors alike.
  • Hedging risk: Investors can focus on certain industries while limiting risk through an investment vehicle that is already diversified.
  • Lower fees and expenses: Investors only have to initiate one transaction to purchase an ETF, which saves broker fees. Also, ETFs generally have lower expenses for operating and managing the fund because they track an index. Plus, ETF investors have access to many stocks across industries and have low expense ratios and commissions.
  • Cost-effective: By bundling different types of securities instead of purchasing individual ones, investors save money on upfront purchasing costs. ETFs also offer more cost savings and liquidity than other funds, holding hundreds or even thousands of different stocks in either similar or diverse industries.

Disadvantages

Here are some disadvantages related to various ETFs:

  • Potential for higher fees: Actively managed ETFs have higher fees, so choosing passively managed ETFs can help you lower those costs.
  • Possibility for limited diversification: Because some ETFs focus on one industry or sector, these investment options have limited diversification than their multi-industry counterparts. And with this limited diversification, dividends are lower. However, they’re often still more cost-effective than buying each investment individually.
  • Transaction delays: Certain ETFs have less liquidity than other investment options, which may lead to slower transactions. Monitoring your ETF and consulting with your adviser can help you stay on top of necessary order transactions.
  • Less control over volatility: ETFs that follow indexes closely will go up or down with those indexes regardless of how they are managed.

Dividends are lower since ETFs track the broader market and have a lower overall dividend yield. ETFs in some sectors or foreign stocks may be limited to large-cap or narrow index of stocks. Investors would have a lack of options and access to potential opportunities to invest in smaller companies.

Investing in ETFs is another great option for a variety of investors, and learning all you can about these potentially high-earning security bundles can help you make smarter decisions for your portfolio. Consider ETFs when formulating your investment plan.