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Should I Invest in ETFs?

ETFs are a great way to diversify your portfolio and possibly bring in some impressive returns. However, ETFs aren’t well-suited for every type of investor and investment strategy. You should understand what securities make up each ETF and how ETFs work before diving into buying and selling.

Image via Unsplash by Austin Distel

Key Takeaways

  • ETFs are securities composed of stocks, bonds, or a combination of securities.
  • ETFs trade on the exchange like regular stocks.
  • ETFs offer many of the benefits of mutual funds.
  • ETFs are great for diversification.
  • Actively-managed ETFs can be costly.

What Is an ETF?

A n Exchange-Traded Fund, or ETF, is a type of security. Unlike a stock share, which is a single unit, ETFs are composed of multiple securities to create a fund. They can be composed of stocks, bonds, or a mix of the two. ETFs often track indexes. For example, one of the most popular ETFs, SPY, tracks the S&P 500. ETFs can be organized around a common industry or diversified across a multitude of fields. They’re highly flexible.

How Do ETFs Work?

While similar in structure to mutual funds, ETFs trade like single stock shares. Online brokers or traditional broker-dealers can buy and sell ETFs on the exchange throughout the trading day, just as they would stock shares. Mutual funds, by contrast, only trade once a day, after the market closes.

Why Should I Invest in ETFs?

ETFs are highly versatile. Since their underlying security make-up can vary, that means each ETF carries different risks and rewards, making them an overall great way to diversify your portfolio using strategies that align with your investment goals. Common types of ETFs include:

  • Bond ETFs: These securities are composed entirely of bonds, which could be governmental, corporate, or municipal.
  • Industry ETFs: As the name suggests, these ETFs track a certain industry, like banking, oil, technology, or others.
  • Commodity ETFs: These ETFs are made up exclusively of commodity securities like gold or crude oil.
  • Currency ETFs: Foreign currencies, like the Euro or Canadian dollar, compose currency ETFs.
  • Inverse ETFs: Unlike other ETFs, inverse ETFs might have any type of underlying security. These ETFs short the stocks to make money.

ETFs vs. Index Funds

While ETFs might look similar to index funds, they have some important distinctions and offer different values to investors. Index funds are a type of mutual fund, specifically designed to mirror a market index like the S&P 500. Index funds are managed passively, which makes them cheaper to purchase and maintain than some other types of mutual funds, which are actively managed.

By contrast, ETFs have far more variety. Some track indexes, like the ETF SPY tracks the S&P 500, but others are composed of industry-specific securities or bonds that don’t. Investors can hand-select ETFs that meet their investing style, risk tolerance, and dividend needs.

Index funds are a lower risk and lower reward fund choice. Many investors use index funds for retirement or other long-term savings goals. Since ETFs offer more variety, some investors use low risk and low reward funds for long-term investing, while others choose higher risk and higher reward ETFs that provide quicker earnings.

ETF Benefits

You can reap some tremendous benefits from investing in ETFs. A few of the top advantages include:

  • Broad opportunities: Since ETFs can be made up of any stock or bond, there are many out there to choose from to best meet your investing goals.
  • Low expense ratio: Expenses for ETFs are usually low, since they track an index. They don’t take much management or operation.
  • Few broker commissions: Commission costs rise and fall with the complexity of the security and trade. ETFs are easy to trade, so broker commissions are usually very cost-effective.
  • Mitigated risk: If you’re concerned about risk, many ETFs are made up of a multitude of securities in many industries. If value drops for one stock in the ETF, the whole ETF will still maintain a good value overall.
  • Diversification: ETFs make it easy to diversify your investment portfolio. You can purchase ETFs composed of diverse stocks, or purchase multiple ETF shares representing various industries and indexes.
  • Targeted investing: If you’re super interested in putting money into the tech industry, investing in a tech ETF is an easy way to put money into a variety of tech companies at once.
  • Flexibility: Since ETFs trade like stocks on the exchange, you have a lot of flexibility in terms of buying and selling your shares throughout the day.
  • Tax benefits: ETFs often have lower capital gains taxes than other securities, like mutual funds. Additionally, taxes are incurred upon the sale of the ETF, not throughout its lifetime.

ETF Disadvantages

Before you embark on ETF investing, however, it’s important to consider the disadvantages you might encounter, which include:

  • Possible higher fees: Passively managed ETFs generally have pretty low fees and commissions. Actively managed ETFs, on the other hand, can end up costing quite a bit in fees and commissions.
  • Single industry risk: Those ETFs that invest in multiple companies in a single industry can suffer devastation should that industry experience an economic blow.
  • Heavy reliance on diversification: Some people love ETFs because there’s a misconception that diversification protects investors from volatility and market fluctuations. While it might cushion some, no ETF or stock is totally safe from market volatility.
  • Low liquidity: Some lesser-known ETFs may have low liquidity, making them a challenge to trade.
  • Dividend taxation: While non-dividend-paying ETFs are a pretty solid tax deal, qualified ETF dividends can be taxed anywhere from 5% to 15%, and unqualified dividends are taxed at your income tax rate.
  • Security control: You lose a lot of control when you invest in ETFs. Say you dislike a specific company’s choices and want to avoid investing with them. You can’t tailor ETFs to meet those needs. You’re stuck either selling the whole ETF or dealing with the underlying security you don’t like.
  • Price disparity: Sometimes, the value of the ETF doesn’t match the actual value of the underlying securities. While this can be advantageous for you, with the ETF valued higher than the combination of its securities, it’s more likely that the ETF will have less value than the individual securities on their own.

Best ETFs to Buy 2020

A s you can see, ETFs are highly versatile investments. The type of ETF and whether or not it offers dividends can dramatically impact your overall investment scheme. Here’s a list of some of the top performing ETFs in 2020, with return info pulled on August 5, 2020. Now, we’re not financial advisors or stockbrokers. This info is for you to use as an educational tool and designed to help you make your own decisions regarding your investments.

Invesco QQQ Trust

This gigantic fund is a powerhouse composed of non-financial securities, primarily in the tech industry. It’s highly liquid, so trading is easy. Invesco QQQ Trust performed well consistently in 2019, and seems to be following that trend for 2020.

  • Ticker: QQQ
  • YTD return: 27.44%
  • One year return: 49.91%
  • Five year return: 144.67%

Vanguard S&P 500 ETF

If you’re looking for diversification and investment in some of the largest American companies, the Vanguard S&P 500 ETF is the way to go. It’s got incredibly low fees, making investing in this impressive fund easy for anyone looking to expand their portfolio.

  • Ticker: VOO
  • YTD return: 3.09%
  • One year return: 16.89%
  • Five year return: 57.93%

ProShares VIX Short-Term Futures ETF

This is one of those inverse ETFs, meaning it gains value as the market loses value and falls into volatility. It lost a substantial amount during 2019 since the market performed so well, but it stands to do well this year with the exceptional volatility the market is experiencing.

  • Ticker: VIXY
  • YTD return: 78.68%
  • One year return: -8.03%
  • Five year return: -89.40%

Vanguard High Dividend Yield

This ETF, managed by the highly reputable Vanguard, offers dividends. The underlying securities that compose the ETF are all high yield, so it should pay out substantially well. It’s got lots of big names in its mix, so it’s highly liquid, making for easy trading.

  • Ticker: VYM
  • YTD return: -12.17%
  • One year return: -2.60%
  • Five year return: 20.47%

SPDR S&P Biotech ETF

It’s all about biotech right now, and the SPDR S&P Biotech ETF is one of the best out there. It has a slightly higher fee than some other options, but at $35 per $10,000, it’s not terrible. Look out for volatility here, though. If the industry goes south, this ETF will suffer the impact.

  • Ticker: XBI
  • YTD return: 19.15%
  • One year return: 39.40%
  • Five year return: 48.92%

iShares U.S. Consumer Services ETF

For those investors looking for a solid, low-risk ETF, iShares U.S. Consumer Services ETF is a good choice. Since many of the companies included in the ETF function in the services sector, they’re somewhat recession-proof. People still need necessities, even when cutting out luxuries.

  • Ticker: IYC
  • YTD return: 4.52%
  • One year return: 13.26%
  • Five year return: 61.37%

SPDR EuroStoxx 50 ETF

The SPDR EuroStoxx 50 ETF features a number of large, international companies (primarily in Europe) and corporations as its underlying securities. If you want to get into international investing, this ETF is a good way to do so.

  • Ticker: FEZ
  • YTD return: -7.09%
  • One year return: 5.69%
  • Five year return: -1.57%

Schwab U.S. Dividend Equity ETF

Another dividend option for those investors hoping to bring some cash in is the low-fee Schwab U.S. Dividend Equity ETF. Composed of large U.S. companies with a consistent history of solid dividend payouts, the Schwab U.S. Dividend Equity is passively managed to cut down on fees and commissions.

  • Ticker: SCHD
  • YTD return: -4.26%
  • One year return: 7.86%
  • Five year return: 42.39%

I nvesting in ETFs is a solid diversification move. These funds offer a ton of mutual fund-like benefits, but with the trading advantages of traditional stock shares. That said, look closely at each ETF before you invest to ensure you’re comfortable with the underlying securities it represents and its risks.