Investing in ETFs: The Definitive Guide

Investors have poured more than $5 trillion into ETFs, with the last trillion taking less than a year to accumulate.

It's no wonder why. ETFs, or exchange-traded funds, offer several great advantages for individual investors and can be part of any investment strategy, no matter how basic or complex it may be.

For investors just getting started, ETFs provide a low-cost way to create a diversified portfolio of stocks, bonds, and other investment vehicles.

In this article, you'll learn:

• How ETFs work
• Why you might want to invest in ETFs
• The different types of ETFs
• Advantages of ETFs over mutual funds
• Popular ETFs you should consider for your portfolio
• How to buy an ETF

How ETFs work

An ETF is like a cross between a mutual fund and a stock.

A mutual fund pools money from multiple investors to invest in a portfolio of stocks, bonds, and other investable assets. The money is managed by a portfolio manager, and investors pay the mutual fund company directly.

Like a mutual fund, an ETF allows you to buy a small slice of a portfolio of stocks, bonds, or other investable assets. Typically, that portfolio is aimed at tracking a stock index just like an index mutual fund, although managed ETFs -- where a portfolio manager is actively working to meet a certain investment goal -- also exist. The values of the securities in the basket constantly vary, and the number of units of each security can vary as well. When the values of all the assets in an ETF (or mutual fund) are all added up, you get the net asset value.

When a person goes to buy a mutual fund, they pay a price equal to the net asset value per share at that day's market close directly to the mutual fund company. But exchange-traded funds, as the name implies, are traded directly on a stock exchange -- a market where stocks are traded -- much like a stock. That means a person can buy or sell shares of an ETF during regular market hours, whereas you can only buy shares of a mutual fund at the end of the day. They'll usually end up paying a price very close to the net asset value per share because that's how much the underlying securities are worth.

There are instances when new ETF shares are created or redeemed, which impacts the total number of shares outstanding. By comparison, mutual funds simply create new shares whenever investors put more money into the fund, in aggregate, than they withdraw. A mechanism to create new shares or remove shares from the market helps ensure efficient pricing.

Only authorized participants, usually large financial institutions, can request "creation units." A creation unit consists of a specified number of ETF shares, typically ranging in size from 25,000 to 200,000. Authorized participants can also redeem creation units for the underlying securities, cash, or other assets. The ability of authorized participants to redeem units for the securities held in an ETF means shares trade very close to their net asset value -- otherwise, big banks would be able to take advantage of the market inefficiency and print money. That means individual investors will always get a fair price for their ETF shares.

Why you might want to invest in ETFs

An ETF can provide an easy way to invest in the markets without having to research individual companies and construct a well-balanced portfolio. Not everyone has the time, energy, or desire to do so, and ETFs provide a simple way to gain access to a well-diversified set of assets.

Image source: Getty Images.

Even investors that like researching stocks can benefit from ETFs. For example, if they don't know anything about investing in bonds -- debt notes that typically pay fixed interest -- they could buy a bond-market ETF. If they want to diversify into foreign equity investments, they could buy an ETF for that market without doing extra research.

Basically, ETFs allow investors to get a lot of the benefits of investing with just a small percentage of the work to be successful.

Types of ETFs

ETFs were started in the early '90s, and the earliest ETFs simply tracked market indexes like the S&P 500. But now, you can buy an ETF for pretty much anything. Here are a few types of ETFs you can buy.

• Market ETFs: This is what most people think of when they think of ETFs. These are simple index funds that track a certain index like the S&P 500 or Nasdaq-100. The S&P 500 is a list of 500 of the largest U.S. stocks. The Nasdaq-100 is the top 100 stocks on the Nasdaq exchange.
• Bond ETFs: These are also typical ETFs designed to provide exposure to different types of bonds, including U.S. Treasurys, municipal bonds, corporate bonds, high-yield bonds, international bonds, and more. Bonds provide a good way to diversify a portfolio and mitigate the ups and downs associated with investing.
• Sector ETFs: If you want to buy a basket of stocks in a specific industry, a sector ETF can offer it without having to research each individual company. Examples include REITs, biotech, and oil, among others.
• Commodity ETFs: A commodity ETF allows average investors to gain exposure to common commodities markets like gold, soybeans, or orange juice.
• Style ETFs: Some people like a certain strategy when investing. A growth investor looks for companies with a high potential for earnings growth. A value investor looks for stocks that trade below what they believe their fair value is. There are dozens of different styles. If you want to invest in a basket of large-cap value stocks or small-cap growth stocks, you can do so with a style ETF.
• Foreign market ETFs: Foreign market ETFs can hold a basket of stocks that track a foreign exchange like the Nikkei in Japan or the FTSE in the U.K. They can alternatively hold a basket of stocks from various countries with similar economies, like "emerging markets."
• Inverse ETFs: These types of ETFs are designed to return the opposite of what the underlying market index returns. This presents an alternative to short-selling an ETF, which can be more risky due to the unlimited downside of short-selling. Short-selling is when you sell a stock first (by borrowing shares from a stock broker) with the plan to buy it back at a lower price later.
• Alternative investment ETFs: These ETFs allow average investors to gain exposure to a particular investment strategy, such as low market volatility (when there aren't a lot of ups and downs), currency carry (using different currencies to earn a higher interest rate), or covered call writing (a type of options trade designed to earn additional income on stock holdings).
• Actively managed ETFs: A fund manager actively manages the basket of stocks in an attempt to outperform the underlying index. These ETFs generally have much higher fees, and don't always beat the market index.
• Leveraged ETFs: Designed to return a multiple of the index it's tracking. So, if the index returns 1%, a leveraged ETF with 2x leverage would, theoretically, return 2%.

Leveraged ETFs: Stay away unless you know what you're doing

Leveraged ETFs certainly sound appealing. These ETFs often use debt and other financial instruments to reduce the amount of capital needed to invest in an index, thus achieving the same returns with less cash invested. That's called leverage.

If the long-term trend in the stock market is for stocks to increase in value, investing in an ETF with 2x or 3x leverage would theoretically return two or three times as much. Unfortunately, these ETFs do a much better job tracking short-term, day-to-day results than they do with long-term results.

To understand this, it's best to use an example.

Assume a triple-leveraged S&P 500 ETF tracks the S&P 500 perfectly. If the index goes up 10%, the ETF value will go up 30%. If the S&P 500 then goes down 9% from there, the index will be back to about breakeven. But this results in a 27% decline in the triple-leveraged ETF, resulting in only 95% of the original value.

As seen in the example above, leveraged ETF investors get hurt more on the downside than they gain on the upside from leverage. That math is exacerbated by the fact that these leveraged ETFs generally carry higher expense ratios. An expense ratio is the percentage of assets paid to the fund company for managing your money. Since leveraged ETFs are more complicated to manage than many other ETFs, they charge a higher expense ratio.

So if you think you can generate market-thumping returns just by investing in a leveraged ETF long term, think again.  

Advantages (and disadvantages) of ETFs over mutual funds

ETFs have several major advantages over their mutual fund counterparts, including:

• Lower costs: ETFs generally have expense ratios less than or equal to their mutual fund counterparts. For example, the Vanguard Total Stock Market ETF (VTI -0.59%) has an expense ratio of 0.04%. The Vanguard Total Stock Market Index Fund Investor Shares (VTSMX -0.24%) has an expense ratio of 0.14% and the Admiral Shares (which have a $10,000 minimum investment) have the same 0.04% expense ratio.
• Buying and selling flexibility: Since ETFs are traded on exchanges, investors can buy and sell shares throughout the trading day. Mutual funds only trade at the market close. Additionally, you can do the same things with ETFs as you can with stocks, such as selling them short (borrowing shares from a broker and selling them first with the hopes of buying back shares at a lower price later), buying options contracts on them (which provide the option to buy or sell shares at a specified price before a certain date), or buying them on margin (using debt to buy additional shares). Those are more advanced investment strategies, but they could prove useful for some investors as a way to increase returns or reduce the volatility of their portfolios.
• Transparency: ETFs provide complete transparency as to what the fund holds on a daily basis, so you always know what you're holding when you own shares of an ETF. Mutual funds are only required to disclose their holdings on a quarterly basis.
• Tax efficiency: ETFs can be more tax-efficient than their mutual fund counterparts due to the way shares are redeemed. (More on this later.)

There are only a few major disadvantages:

• No partial shares: Since an ETF trades like a stock, an investor's initial purchase must be made in full shares. Mutual funds, however, can accept any dollar amount, and they will issue partial shares to get the investor fully invested. ETF investors usually end up with a little bit of cash uninvested, which can be a drag on returns.
• No automatic dividend reinvestment: When you buy a mutual fund, you can elect to have your dividends reinvested automatically. That way, you're never sitting on cash, which earns no return. That's not always the case with ETFs. Some brokers may provide a dividend reinvestment service for certain ETFs, but there's no guarantee. That service may also come with fees.
• Commissions: Mutual funds don't charge a commission to buy shares. The mutual fund company makes money just by investors holding the mutual fund and paying the expense ratio. When you buy an ETF, you may have to pay a commission to your broker for executing the trade. That said, many brokers offer a sizable list of commission-free ETFs that you can buy and sell without cost.

The advantages certainly outweigh the disadvantages for ETFs, especially if you'll be investing in a taxable brokerage account.

Why ETFs are more tax-efficient than mutual funds

ETFs are generally considered one of the most tax-efficient vehicles for investments. Most ETFs track an index just like an index mutual fund. That, in itself, makes ETFs tax-efficient because there's very low turnover -- buying and selling activity -- compared to actively managed funds.

Whenever a fund manager buys or sells a security, it creates a taxable event for all the fundholders. That can result in unexpected capital gains -- increase in the value of the underlying assets of a mutual fund -- for individual investors at the end of the year. Since many ETFs don't require very much buying or selling at all, there are very few taxable events.

Here's an example of capital gains taxes:

A mutual fund manager buys shares of a stock for an average price of $10 per share. That stock then doubles in price to $20 per share, and the manager decides to sell the stock. That results in capital gains of $10 per share ($20-$10), which are distributed to mutual fund shareholders based on the number of mutual fund shares they hold. The mutual fund shareholders are then responsible for paying taxes on those capital gains.

ETFs add a second layer of tax efficiency to index funds. Because ETFs are traded on an exchange, when individuals want to sell their shares, they're selling to another buyer. The other ETF shareholders aren't impacted at all by the event. On the other hand, mutual fund investors redeem shares directly with the mutual fund company, which pays out cash. Sometimes the fund manager will have to raise cash by selling shares of the underlying assets, which can result in a taxable event.

Image source: Getty Images.

Popular ETFs you should consider for your portfolio

As mentioned above, there are all sorts of ETFs investors can buy, sell, and trade however they see fit. For most investors, the following list of options should serve your needs.

An S&P 500 ETF
The original ETF, the SPDR S&P 500 ETF, tracks the S&P 500, a list of 500 of the largest stocks in the U.S. stock market. While it might be the original, it's not necessarily the best. It carries a higher expense ratio than some of its competitors.

Data sources: SPDR, iShares, and Vanguard.

A Russell 2000 index ETF
The Russell 2000 index takes the bottom 2,000 stocks from the Russell 3000 index by market capitalization, or the market value of a company's outstanding shares. It's the most common benchmark for small-cap funds, and provides exposure to stocks outside of the large-cap S&P 500 and other large-cap indexes. Small-cap companies are generally smaller with more room to grow earnings (and thus produce better stock returns), but are generally riskier than big well-known companies.

 Data sources: iShares, Vanguard, and SPDR.

Other large-cap stock indexes
The Nasdaq-100 is a list of the 100 largest equities listed on the Nasdaq stock market excluding financial companies. The Nasdaq is historically dominated by technology companies, but more non-tech companies have found a home on the Nasdaq in recent years.

The Dow Jones Industrial Average is a list of 30 weighted blue chip stocks selected by the editors of The Wall Street Journal to represent the overall U.S. economy.

Data sources: Powershares and SPDR.

Total stock market ETFs
Total stock market ETFs can track a variety of different indexes.

The Dow Jones U.S. Broad Stock Market index aims to track every company actively traded in the U.S. stock market. The S&P Total Market index is a close alternative.

The Russell 3000 is a slightly smaller index that also aims to benchmark the entire U.S. stock market. The MSCI US Broad Market index is about the same size as the Russell 3000, and says it captures 99% of the U.S. equity universe.

Since the components of total market ETFs hardly ever change, these ETFs have some of the lowest expense ratios available.

Data sources: SPDR, Vanguard, iShares, and Charles Schwab.

Sector ETFs
For those interested in investing in a specific industry, you can buy a sector ETF. There's a sector ETF for just about any industry you can think of. The following list is just a sample.

Data sources: VanEck, Vanguard, SPDR, and Charles Schwab.

Commodity ETFs
If you want to invest in certain commodities to diversify your portfolio, ETFs provide an easy and effective way of doing so. Diversification is the process of investing in multiple asset classes in order to reduce the volatility in your portfolio. Commodity ETFs do have relatively high expense ratios, though.

Here's a list of a few commodity ETFs you can buy.

Data source: SPDR, iShares, and USCF.

Foreign market ETFs
These ETFs can help provide exposure to non-U.S. equities. Listed below are examples of total international market ETFs, developed market ETFs, and emerging market ETFs.

Data sources: Vanguard, iShares, and Charles Schwab.

Bond ETFs
If you want to gain exposure to certain bond markets, there's an ETF for that. Just like stock ETFs, you can get a total bond market ETF that captures a wide swath of U.S. bonds. Or you can opt for international bonds, high-yield bonds, U.S. Treasurys, corporate bonds, municipal bonds, and more.

Here's a sample of the most popular bond ETFs.

Data sources: Vanguard and iShares.

How to buy an ETF

In order to buy an ETF, you'll need to open a brokerage account. Brokers such as Vanguard and Schwab will let you buy their own ETFs commission-free. Schwab also lists a few other commission-free ETFs. Other brokers will usually have a select list of ETFs available commission-free. Be sure to open an account with a broker that has the most of the ETFs you want on their list, or try to find alternatives you can buy commission-free.

Removing commissions is a key part of an ETF investment strategy, as the fees can really cut into your returns. Even if you're only paying $5 per trade, that's a big percentage of a $100 purchase or even a $500 purchase.

Once you've opened up a brokerage account and funded it, you buy shares of an ETF just like you do a stock. You can use a market order, which will buy shares at the next available market price, or you can use a limit order, which will buy shares at or below a specified price. If the ETF is on the commission-free ETF list with your broker, you'll pay no commission -- otherwise, you'll pay the standard rate.

It's really that easy. Anyone can use ETFs as part of their investment strategy. ETFs are particularly useful for filling in gaps in your portfolio where you either don't have an interest or the time to do the research on individual investments in order to diversify your portfolio. While not completely necessary for a portfolio, ETFs can make things a lot easier for individual investors.