Investing in ETFs: Beginner’s Guide

In order to better understand exchange-traded funds (ETFs), it’s helpful to first familiarize yourself with some common investment terminology as many of these terms are often used to describe ETFs and their strategies. Getting started with investing can seem intimidating and overwhelming (seemingly by design), which is why this guide aims to be as straightforward and informative as possible. Now, let’s get into it!

• What is an investment?
• What is an asset class?
• What is an index?
• What is a benchmark?
• What is a sector?
• What is a portfolio?
• What are exchange-traded funds (ETFs)?
• What are the benefits of ETFs?
• What’s the difference between passive ETFs and active ETFs?
• What should I consider when selecting an ETF?
• What is an ETF prospectus?
• How do I buy an ETF?

What is an investment?

An investment is an asset or item that is purchased with the hope that it will appreciate in value or generate income (bring in money on a reoccurring basis). The most common types of investments are stocks, bonds, ETFs, mutual funds, real estate, commodities, cryptocurrencies, and art. Investing involves taking on risks in the hopes of generating a profit in the future.

What is an asset class?

An asset class is a group of similar types of investments that have similar characteristics and behave similarly in the marketplace. Common asset classes include:

1. Equities (stocks)
2. Fixed income (bonds)
3. Cash and cash equivalents
4. Real estate
5. Commodities (oil, copper, etc.)
6. Alternative investments (hedge funds, private equity, venture capital, etc.)
7. Cryptocurrency

What is an index?

An index is a tool that tracks the performance of a group of assets. For example, an index that tracks a basket of stocks will move up or down depending on how those companies perform in the stock market. These indexes help us learn more about the economy and can inform investment decisions. Indexes are often used to track the performance of a group of assets in a standardized way and measure the overall performance of the market or a particular segment. Standard & Poor's 500 Index and Dow Jones Industrial Average are examples of broad-based stock indexes that track the overall market by including the largest stocks. There are also specialized indexes that track specific market segments, such as the Russell 2000 Index, which tracks only small-cap companies. Commonly followed U.S. stock market indexes include:

1. Standard & Poor's 500 Index (S&P 500) – Contains the 500 largest listed companies on U.S. stock exchanges. Most investors look to the index to assess how the overall U.S. stock market is doing.
2. Nasdaq Composite Index – Contains over 3,000 U.S. listed companies on Nasdaq’s stock market. Commonly referred to as ‘The Nasdaq’ by the media. Roughly half of the index consists of a technology-related companies.
3. Dow Jones Industrial Average (DIJA) – Contains 30 large blue-chip U.S publicly listed companies that are selected by a committee. The DJIA is one of the oldest and most commonly followed equity indexes.
4. Russell 2000 – Contains 2,000 of the smaller publicly listed companies (less than $2B in market value) on U.S. stock exchanges. Some investors look to the index to assess how smaller companies' stocks are doing overall.

What is a benchmark?

A benchmark is something that we use to compare other things to. For example, if you want to know if you are taller than your friend, you might use measuring tape to compare both of your heights. In the same way, people use benchmarks to compare how their investments are doing. Even though almost all benchmarks are indexes, not all indexes are used as benchmarks. This is because indexes are created for different reasons by different organizations, while some benchmarks are chosen by people who want to compare their fund’s performance to something (like portfolio managers) or by people who do the comparing (like pension plans or consultants). This means that not all indexes are suitable for use as benchmarks. Every ETF has a benchmark index against which its performance is compared over different time periods (one, five, ten years).

What is a sector?

Sectors are broad segments of an economy, such as technology, energy, or healthcare. These sectors can be divided into sub-sectors or industries, like cloud computing, semiconductors, or biotechnology. Sector-specific indexes follow a representative group of companies in the sector or sub-sector; therefore, they can be used to compare a single stock’s performance to the overall index within the single stock’s industry. These indexes can be a useful tool for benchmarking data, analyzing economic trends, and informing investment decisions.

What is a portfolio?

A portfolio is a collection of different investments. It can include investments like individual stocks, ETFs, cryptocurrencies, and cash. It's up to you (and a financial advisor, if you have one!) to determine how to design your portfolio based on your investment goals, risk tolerance and retirement plans.

What are exchange-traded funds (ETFs)?

ETFs are a type of investment fund that holds a collection of assets and can be bought and sold on exchanges like stocks. While many ETFs track an index passively, such as the S&P 500 or the NASDAQ Composite, there are also active ETFs available with holdings selected by a portfolio manager (more on this later). The value of ETFs fluctuates in real-time during normal trading hours, just like stocks. Also, like stocks, each ETF has a unique ticker used to identify it.

What are the benefits of ETFs?

1. Convenience: ETFs can offer easier accessibility to various asset classes and investment strategies as they are listed on exchanges and can be bought and sold throughout the trading day, just like individual stocks.
2. Low fees: ETFs typically have much lower expense ratios (aka annual fees) than traditional mutual funds.
3. Transparency: ETFs are required to report holdings daily, providing investors with greater transparency and insight into daily fund investment changes.
4. Diversification: ETFs often hold a basket of stocks; therefore, investors can gain exposure to a certain market or sector without taking on the same potential level of risk and volatility of holding a single stock.
5. Tax efficiency: ETFs are generally more tax efficient than mutual funds because they generate fewer capital gains (which means you can keep more of the potential investment profits).
6. Liquidity: ETFs are typically highly liquid, meaning investors can easily enter and exit their positions (buy or sell the ETF) in response to market conditions or investment objectives.

What’s the difference between passive ETFs and active ETFs?

Passive ETFs (aka index ETFs)

Passive ETFs, also called index ETFs, seek to replicate the performance of certain indexes. A passive ETF tracks the performance of an index and generally only makes changes to the fund whenever the index changes. The most well-known index ETF is the SPDR S&P 500 ETF Trust (Ticker: SPY), which tracks the S&P 500 and therefore the performance of the 500 largest U.S. companies. ETFs that track the S&P 500 give investors a way to gain exposure to the broad U.S. equity market through one product. Investors are also able to get exposure to specific sectors, countries, and themes through specialized index ETFs, including some that offer niche exposure.

Active ETFs

Active ETFs allow investors to buy into a selection of securities chosen by a professional fund manager or a team of managers who seek to outperform their benchmark index. Active ETFs typically have higher expense ratios (annual fees).

What should I consider when selecting an ETF?

When choosing an ETF, there are several things to look at. These include the ETF's investment objective, fees and expenses, performance history, and alignment with your own investment goals. Ultimately, the right ETF for you will depend mostly on your individual investment needs and objectives, as well as your age, income, and retirement plans. Investors might consider the following items, which are found in the ETF's prospectus:

1. Asset class: ETFs invest in various asset classes, from stocks and bonds to commodities and currencies. Investors should determine which asset class works best with their investment goals and select ETFs concentrated in that asset class. For example, if you seek capital growth or appreciation, you are most likely to consider an equity-based ETF. If you seek income generation (generating money on a reoccurring basis) or capital preservation (avoiding money loss), you are most likely to consider a fixed-income ETF.
2. Benchmark: Investors should select ETFs that track benchmarks appropriate for their investment goals. For passive ETFs, its benchmark is the index and underlying assets the fund is designed to track. Active ETFs are required to disclose the indexes they select to benchmark their performance to, as Active ETFs seek to outperform their benchmark (aka drive a higher investment return).
3. Expense ratio: The yearly cost that investors pay for the management and operation of a fund. This fee is deducted from the fund’s assets, reducing the potential return on the ETF investment. The expense ratio includes various expenses, such as the management fee paid to the investment advisor, the cost of buying and selling securities in the fund, and other administrative expenses. Some ETFs have higher expense ratios than others based on the complexity of the investments in the fund and the level of services provided to investors. It’s important for investors to consider the expense ratio when choosing an ETF because it can have a significant impact on the overall returns of the fund. For example, a fund with a high expense ratio may underperform a similar fund with a lower expense ratio, even if the underlying investments are similar. Therefore, investors should compare the expense ratios of different peer group ETFs before deciding which one to select.

What is an ETF prospectus?

A prospectus is a legally required document that provides comprehensive information about the ETF. It gives you information about what the ETF is for, what kinds of risks it has, and how much it costs to be a part of it. The prospectus also tells you what kinds of things the ETF has invested in, like stocks and bonds, and the countries and industries in which it may be invested. The prospectus also includes information about the ETF's management team and the investment advisor responsible for managing the fund. Lastly, the prospectus tells you about the rules that the ETF has to follow and what rights you have as a person who owns part of the ETF. Before investing in an ETF, you'll want to invest the time in reading and understanding the prospectus. Even though it is typically a lengthy document, you'll thank yourself later!

How do I buy an ETF?

1. Choose an ETF: First, decide which ETF you want to buy. Research the ETF and consider the fees and risks associated with the investment by reading the prospectus (just another friendly reminder).
2. Open a brokerage account: Choose a trading account (Robinhood, Fidelity, E*TRADE, etc.). You’ll need to provide personal information and deposit money into your account.
3. Place the order: Once your account is set up, search for the ETF ticker to place an order and select to buy. This can be done online or through the trading app. Most brokerages do not charge additional fees or commissions for stock or ETF trades anymore. Check with your broker on how to place orders.
4. Monitor performance: Finally, monitor the performance of your ETFs over time to make sure it’s meeting your investment goals.

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