WTF Is an ETF? (Part 2)
My last column introduced you to the world of exchange-traded funds, or ETFs. They’re cheap and transparent, making them ideally suited for young investors who want to start building their savings.
I hope you now understand how ETFs work; how they’re structured; and how they offer investors thousands of ways to bet on countries, industries, products, and even consumers like you.
Now that you’re armed with that knowledge, here’s the fun part: buying your first ETF. Once you do that, I guarantee that you’ll want to buy more funds as you discover the awesome world of investing.
There’s nothing more rewarding than watching your money grow thanks to the stock market.
But remember: investing isn’t for the faint of heart. It’s risky. But so is driving 90 mph on a rural highway in the middle of the night. But if you pay attention, keep an eye out for signs of trouble, and keep your wits about you, you’ll avoid danger.
Step 1: What are Your Investing Goals?
Ask yourself this: what do I want in an ETF? Naturally, making money and minimizing risk should be your first objective. If that’s your thing, then buy an ETF that will give you broad exposure to the best-performing companies.
But some young investors may want to consider other factors:
Do I want an ETF that may invest in companies that may conflict with my values (maybe gun makers or cigarette companies, for example)? Do I want to invest in companies that mistreat their workers, the environment, or even customers? Fortunately, you can find ETFs that avoid such companies.
Step 2: Do Your Homework
Research is key. The internet is full of websites devoted to investing, which can be overwhelming. Keep it simple.
Start by going to a site like Morningstar. These guys are the real deal. They offer readers straightforward, easy-to-understand advice and analysis along with a deep reservoir of data. Also talk to your family and your work colleagues for a little insight and guidance, as well.
Be Mindful of Cost – There are No Free Lunches
Once you’ve settled on a few contenders, look at the annual expense ratio that each ETF charges. The average is 0.44 percent, but you can do a lot better than that. (I’ll explain later.)
And don’t forget the commissions that brokers levy to buy into an ETF. Most commissions average around $5. That may be a small price, but those charges can add up if you do a lot of buying and selling in a taxable account.
That said, many brokerages will waive commissions if you buy their proprietary ETFs or those of their business partners. That may sound like a good deal, but there’s more to that than meets the eye (or ear). Simply put, there are no free lunches!
Why Commission-Free is Sort of B.S.
If you go the no-commission route, you’ll end up running into some big restrictions. The selection of ETFs is very limited and typically not the best ones (keep in mind there are thousands of ETFs to choose from). Plus, you’ll be slapped with a big penalty if you sell within 30 days of purchase.
I can’t stress this enough – it’s a classic bait-and-switch. You either pay upfront or you pay out on the back-end.
Although you’re not paying a commission, the ETF will charge you a higher expense ratio, which they’ll then charge you every year you hold onto the ETF. Over the course of several years, you could end up paying thousands of dollars in annual expenses. Compare that to a paltry one-time commission at the very start.
Step 3: Time to Buy!
So you’ve done your research and sought advice from family and friends.
“You’ve found an ETF that suits your investment goals. What’s next?”
Let’s say that you have $500 to invest. It’s easy. If you go online, you’ll find about a dozen discount brokers with whom you can open an account. Personally, I use Fidelity for investing in both by my taxable account and my three retirement accounts – two of which offer a select menu of commission-fee ETFs. Once you pick a broker, you’ll need to link your checking or savings account.
But before I go any further – just a quick reminder: most ETFs track an index, the most popular being the Standard & Poor’s 500 index, or S&P 500. My favorite ETF is the iShares Core S&P Total U.S. Stock Market (ITOT). It has a super-low expense ratio of 0.03 percent (that’s 30 cents a year on $1,000) and broadly tracks the top 1,500 U.S. companies – pretty much the whole kit and caboodle of Corporate America.
A Final Thought
There’s no doubt that ETFs are emerging as the Billy Badass of investing. You can’t beat their low-cost simplicity. But the ETF obviously isn’t the only player in town. In my next column, you’ll meet the ETF’s crazy uncle, the mutual fund!