An ETF tracks a specific market index and does not try to outperform it. ETFs run on autopilot and require only minor adjustments to keep them in line with the index they track. Therefore, the expenses ETFs incur are much lower. In contrast, actively managed funds (i.e., majority of mutual funds) attempt to outperform a benchmark index and often invest significant resources into research in an attempt to do so. In the medium and long term, most actively managed funds are unable to outperform their benchmark. It can be explained by the difficulty of consistently “outguessing” the market and the extra expenses due to administration and research that add to a fund’s management cost directly impacting net returns. (Related: What is an ETF?, What type of investor are you? and Active vs Passive Investing).
ETF’s provide the best of both worlds between a stock and mutual fund. They have the diversification benefits of mutual funds, and they trade at the ease of a stock. This means that they are traded throughout the day at prices that change based on supply and demand and are a cost-effective way to get involved with fund-like instruments. A fund is a pool of people whose investment are spread across a range of assets on the investors' behalf by a fund manager. (Related: What is an ETF?)
How do ETFs work?
An ETF provider considers all the assets available on the market, including stocks, bonds, or commodities, and creates a basket of them by owning the underlying assets. A unique ticker is attributed to the basket (SPY for S&P 500) and the ETF is designed to track the underlying asset’s performance.
Investors can buy a share of that ETF through an exchange, but they do not own the fund’s underlying assets. Investors in an ETF that tracks a stock index get lump dividend payments, or reinvestments, for the stocks that make up the index.
Buyers and sellers trade the ETF throughout the day at market-determined prices, similar to a stock.
A quick note on tax
ETFs provide tax-efficiency advantages to investors that are typically only taxed upon selling the investment, compared to a mutual fund, which is usually taxed over the investment course. It is because mutual funds have more turnover (especially those that are actively managed) due to the number of buys and sells required to outperform the market
performance, and such transactions can result in capital gains.
It would be best if you invested ideally with a tax-efficient vehicle such as an IRA, ISA or a SIPP, so you don’t pay capital gains tax.
How to invest in ETFs?
There are two main ways to invest in ETFs and how you do so primarily comes down to investor preference:
1. For hands-on investors, opening a brokerage account can be done online like a bank account, and many brokerages have no account minimums, transaction fees, or inactivity fees.
An example of some well-known brokerage accounts is Charles Schwab Corporation, Vanguard, Fidelity and Betterment. Please see the link to a brokerage account comparison, and please note that your place of residence will impact what accounts you can open.
If the above sounds too daunting,
2) For hands-off investors, invest via Robo-advisors, which are online investment advisors that build and manage a portfolio for you, often using ETF’s due to their low cost. There will be a small annual fee, usually around 0.25% of your account balance.
I have linked two comparison websites below for further research - Robo-advisors and Compare the Platform.
Historically the market average of the popular S&P 500 index is 8% per year (Source: Investopedia).
In summary,
ETFs aren’t an all-purpose solution, and like any financial product, you will need to assess them on their own merits. It is essential to shop around for ETFs as fees will be different between companies (management and commission fees), how easily you can buy or sell ETFs, and their investment quality.
I believe that ETFs are an excellent solution for getting average market returns on your investment and that gaining these types of returns is possible with only a little time or expertise. This makes it an ideal set and forget investment.
Information provided by goBuoyant is general in nature and does not take into consideration your personal financial situation. It is for educational purposes only and does not constitute formal financial advice. Remember, the value of any investment can go down as well as up.
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