Beginner’s Guide to ETFs

We cover exchange-traded funds.

Updated: May 18, 2024
Matt Crabtree

Written By

Matt Crabtree

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A low-cost index fund is the most sensible equity investment for the great majority of investors.

Warren Buffett (Source).

Though a hassle, it’s useful to be acquainted with the standard financial vocabulary in order to better comprehend exchange-traded funds. That’s since many of these phrases are often used to explain their approaches. We’ll start there. 

To that purpose, this guide is written with the intention of demystifying the investment process and providing as much useful information as possible to those who are just getting started in the field. Let's jump right in!

With your beginner’s guide to ETFs.

Key Things Beginners Should Know about ETFs 

  • An ETF is a collection of assets that trade on an exchange (like shares do).
  • Unlike mutual funds, which only transact one time a day, after the market closes, ETF shares move up and down throughout the day as it is purchased and sold.
  • Exchange-traded funds may hold a wide variety of assets, from equities and commodities to bonds and even overseas markets.
  • Compared to purchasing the stocks separately, ETFs have lower cost ratios (annual fees) and broker charges.
Exchange Traded Fund

UK Index Funds vs Mutual Funds

The concept of an exchange-traded fund (ETF) is similar to that of a mutual fund in that it is a sort of pooled investment vehicle. In contrast to mutual funds, exchange-traded funds may be bought and sold on a stock market just like any other stock. 

ETFs are designed to mirror the performance of a certain index, industry, commodity, or other asset class. It could be designed to follow the price of anything from a single commodity to a wide range of assets. Exchange-traded funds may be designed to mirror a wide variety of investing modalities.

The SPDR S&P 500 ETF (SPY) tracks the S&P 500 Index. To this day it is still active and was the first-ever exchange-traded fund.

Beginner’s Guide to ETFs — Overview of Related Common Terms 

1. What exactly is an “investment”?

An investment is a trade made with the expectation of profit or appreciation in value (bringing in money on a reoccurring basis). Stocks, bonds, ETFs, mutual funds, real estate, commodities, cryptocurrency, and art are some of the most popular investment options. An investor takes on risk with the expectation of future financial gain.

2. Simply put, what does it mean to speak about “asset classes”?

When it comes to market performance and volatility, assets of a certain “asset class” tend to behave similarly across the board. Examples of typical asset categories include:

  • Equities (i.e. stocks and shares) 
  • Fixed income (i.e. bonds)
  • Real estate 
  • Physical money and other liquid assets
  • Commodities (wheat, oil, gold investments, etc) 
  • Others (private equity, hedge funds, venture capital, etc.)
  • Crypto

3. Defining an “index”.

In finance, an index is a measurement of how a certain collection of assets has been doing collectively. For instance, the performance of the stocks comprising an index will determine the index's direction.

These indices provide valuable insight into the state of the economy and may guide strategic financial planning. Indexes are often used to monitor a standardised collection of assets' performance and gauge the market or a market sector as a whole. 

Broad stock indexes, like the London Stock Exchange or FTSE (the UK’s most popular indices), S&P 500 Index, or the Dow Jones Industrial Average, measure the performance of the market as a whole by including the biggest companies in the market. The Russell 2000 Index, for example, follows exclusively small-cap stocks in the market. 

The following are some of the most widely watched stock market indices in the United States:

📰 In the U.S., the 500 biggest publicly traded firms make up the Standard & Poor's 500 Index (S&P 500). When gauging the health of the U.S. stock market as a whole, most investors turn to the index.

📰 The Nasdaq Composite Index includes more than 3,000 publicly traded businesses from the United States. The Nasdaq is a popular name for this market in the press. Half of the index is made up of IT firms.

📰 The 30 big, blue-chip U.S. public firms that make up the Dow Jones Industrial Average (DIJA) are chosen by a committee. The Dow Jones Industrial Average (DJIA) is a very popular and long-standing equities market benchmark.

📰 The Russell 2000 is an index tracking the performance of 2,000 of the smallest publicly traded firms in the United States, as defined by having a market capitalization of less than £1.66 billion. As a proxy for the performance of equities of smaller firms, the index is used by certain investors.

Best Index Funds to Track

4. Defining a “benchmark”.

To compare anything to something else, we need a standard. As an example, you may use a measuring tape to determine whether or not you are taller than your acquaintance. Similarly, investors use benchmarks to assess the performance of their portfolios. It's important to note that not every index is used as a benchmark, despite the fact that almost all benchmarks are indices. 

ETF performance

The reason for this is that certain benchmarks are selected by those who want to compare the performance of their fund to something else (such as portfolio managers), while other benchmarks are produced for specific purposes by specific organisations (like pension plans or consultants).

Since not all indices are created equal, only a few should be used as standards. Each ETF tracks its performance relative to a certain index across a range of time intervals (one, five, or ten years, for example).

It’s more important to do big things well than to do the small things perfectly.

Ray Dalio, Principles: Life and Work (Source)

5. When describing a “sector”, what do you mean?

Sectors are large economic subsets like the IT industry, the energy market, or the medical care industry. Cloud computing, semiconductors, and biotechnology are all examples of industries that fall within this broad category.

Stock performance within an industry may be compared to that of the industry as a whole by using sector-specific indexes, which track a representative collection of businesses within the sector or sub-sector. Data benchmarking, economic trend analysis, and investment strategy all benefit from these indices.

6. Can you explain what a portfolio is?

I sure can. Put simply, a portfolio is a group of investments. Individual equities, exchange-traded funds, virtual currencies, and fiat currency are all fair game. Depending on your investment objectives, level of comfort with financial risk, and desired retirement date, you (and your financial adviser, if you have one) will have to decide how to construct your portfolio.

With all of that jargon digested, I think you’re ready to learn about ETFs now and how they can put your extra savings to work!

What Are ETFs?

Exchange-traded funds, or ETFs, are a form of investment vehicle that hold a portfolio of assets and trade on stock markets. 

Many ETFs passively follow an index like the S&P 500 or the NASDAQ Composite, but there are also active ETFs that have assets handpicked by a fund manager. ETFs, like stocks, experience real-time price fluctuations during trading hours. Additionally, similar to stocks, they are identified by a ticker symbol.

“ETF” refers to an “exchange-traded fund”. When you invest in an ETF, you are essentially buying a basket of stocks, commodities, etc.

Basket

You could compare an exchange-traded fund (ETF) to a shopping basket, only instead of butter and eggs, you invest in stocks and bonds. Not only that, but you may save money by buying the whole basket instead of the individual contents one by one.

Exchange-traded funds are similar to individual stocks in that they are bought and sold during the trading day on an exchange. The assets held by certain funds may include equities, bonds, a specific market sector (such as healthcare, medicines, or telecommunications), or indices like the LSE, Dow Jones, etc.

★ Find out: Stock Market Basics for Beginners

Positives of ETFs

✔️ Listed on stock exchanges: ETFs may be purchased and sold during the trading day like regular stocks, making it simpler to get exposure to a wide range of asset classes and investing techniques.

✔️ Reduced costs: Compared to conventional mutual funds, ETFs often have substantially reduced expense ratios (also known as yearly fees).

✔️ Transparency: Investors may see the daily changes in an ETF's holdings since the funds are obligated to declare their holdings every day.

✔️ Diverse: Because ETFs contain a diversified portfolio of equities, investors may receive exposure to a market or industry without taking on the greater risk and volatility associated with owning a single company.

✔️ Tax benefits: Because they produce fewer capital gains, ETFs are more tax-efficient than mutual funds (which means you can keep more of the potential investment profits).

✔️ Liquid: Because of their high level of liquidity, investors may quickly and easily join and exit positions (buy or sell the ETF) in reaction to changing market circumstances or to achieve specific investing goals.

Passive ETFs vs. Active ETFs

The happiest people discover their own nature and match their life to it.

Ray Dalio, Principles: Life and Work. (Source)

Index Funds (aka “index ETFs”)

Exchange-Traded Funds, that are passively managed, aim to mimic the performance of a certain index. Passive exchange-traded funds are those that only make adjustments to the fund once the underlying index is altered. 

SPDR S&P 500 ETF Trust (Ticker: SPY) is the most popular index ETF because it mimics the S&P 500 and, by extension, the performance of the 500 biggest U.S. corporations. S&P 500-tracking ETFs provide investors with a simple and efficient approach to obtaining exposure to the entire U.S. equities market. Additionally, investors may get exposure to a narrow market by purchasing specialist index ETFs.

Active ETFs

With active ETFs, investors may purchase a portfolio of stocks hand-picked by a professional fund manager or team of managers in an effort to exceed the fund's corresponding index. In general, the cost ratios of active ETFs are greater (annual fees).

1. Beginner’s Guide to ETFs: Researching an ETF

There are a number of factors to consider while picking an ETF. Your individual investing objectives should coincide with the fund’s investment aim, fees, and past performance. Ultimately, your age, income, and retirement plans will be the most important factors in determining the best ETF for your specific financial requirements and goals. 

A prospectus, which is a legally mandated document, contains extensive details on the ETF. You’ll find details on the ETF's purpose, potential dangers, and associated fees. Learn more about its potential investments (including stocks, bonds, nations, and sectors) by reading the prospectus. 

The management team and the investment adviser in charge of the fund are both described in the prospectus. Finally, the prospectus details the obligations of the ETF as well as your rights as an ETF shareholder. Spend some time reading and comprehending the prospectus before putting money into a fund. It may be tedious work now, but you'll be glad you did it in the end!

The prospectus for the ETF lays a lot of this out and includes information that may be of interest to investors, including:

#1 Asset class: Exchange-traded funds (ETFs) may be used to invest in a wide range of asset classes, including equities, bonds, commodities, and currencies. If an ETF's focus is on a certain asset class, it may be a good fit for an investor's needs if that class is consistent with their investment objectives. 

If you want your money to increase aggressively, you can look into an exchange-traded fund that invests heavily in stocks. A fixed-income ETF is a good option if you want to generate income (money that comes in regularly) or protect your capital (money that you don't want to lose).

#2 Benchmark: When choosing an ETF to invest in, it's important to choose one that follows a benchmark that aligns with your long-term financial objectives. In the case of passive exchange-traded funds, the index and underlying assets that the fund is meant to monitor serve as its benchmark. Since active ETFs aim to beat their benchmark, the indexes they choose to compare their performance to must be made public (aka drive a higher investment return).

#3 Expense ratios: The annual percentage of a fund's assets spent on administration and management is known as the expense ratio. The possible return on an ETF investment is reduced by the amount of the charge, which is taken from the fund's assets. In addition to the management fee paid to the investment adviser, the expense ratio also includes the cost of purchasing and selling assets held by the fund and other administrative costs. 

Due to factors such as the ETF's investment portfolio complexity and the number of client services offered, some ETFs have greater cost ratios than others. When deciding on an exchange-traded fund, investors should think carefully about the cost ratio since it may have a major effect on the fund's performance. 

For instance, even if the underlying assets of two funds are identical, the performance of the former may suffer if its cost ratio is higher. Therefore, before choosing an ETF, investors should examine its cost ratio relative to that of its peers.

📚 Read my guide on how to get dividend payments.

2. Beginner’s Guide to ETFs: Finding Your ETF

We must consult our means rather than our wishes. 

George Washington (Source)

It’s time to open a brokerage account. Pick a trading platform, such as Robinhood, Fidelity, E*TRADE, etc. In order to open an account, you must first supply identifying information and fund it. Most online trading sites, retirement account provider websites, and trading applications like Robinhood provide access to ETFs. 

Most of these platforms allow you to purchase and sell ETFs without paying any commissions to the platform providers. Even if an ETF doesn't charge a fee to buy or sell, it doesn't guarantee accessing the product won't cost anything. Platform services have the potential to stand out from the competition by providing superior ease of use, quality of service, and breadth of available goods and services.

For instance, exchange-traded fund (ETF) shares may be purchased with a few taps of a smartphone app. Not all brokerages operate in this way; some may need additional documentation from investors or have other requirements. However, several reputable brokerages provide comprehensive instructional information to aid novice investors in learning about and researching ETFs.

Study Your Exchange Traded Funds

Researching ETFs is the second and most crucial step in investing in them. 

Nowadays, investors may choose from a large range of exchange-traded funds. Researching ETFs may be challenging since they are not like standard investment options like stocks or bonds.

Buy-Sell

When choosing an ETF, it's important to take the big picture into account, especially in terms of the sector or business. Some research-related questions are as follows:

  • How long do you plan to hold onto your investments?
  • Do you want to invest for growth or income?
  • Do you have any preferred industries or financial tools?

Think About Your Trading Plan

Investing in ETFs for the first time? You might try dollar-cost averaging, or spreading out your investment fees over a period of time. This is so due to the fact that it guarantees a disciplined (as opposed to haphazard or erratic) approach to investing and helps to level out results over time.

It's a great resource for teaching the ins and outs of exchange-traded funds to newbies. Investors may branch out to more complex tactics like swing trading and sector rotation as their experience and confidence grow in the market.

Comparison of Online and Conventional Brokers

Pick an exchange-traded fund and make an order: When you're ready to purchase an ETF, log in and do a search for the ticker symbol. Both the website and the trading app will allow you to accomplish this. Buying and selling stocks and exchange-traded funds often do not incur any extra costs from a brokerage. For information on placing orders, contact your broker.

Exchange-traded funds (ETFs) are available for trading via both online and brick-and-mortar broker-dealers. Investopedia has compiled a list of the finest ETF brokers so you can see who the industry leaders are. A retirement account is another common place to buy exchange-traded funds. Robo-advisors, such as Betterment and Wealthfront, provide an alternative to traditional brokers; they invest mostly in ETFs.

3. Beginner’s Guide to ETFs: Buying Your ETF

You've finally decided to put in an order for several ETFs after studying them and opening a brokerage account. Now get some money into your account. In order to buy an ETF, you must first fund your brokerage or robo-advisor account.

Your checking or savings account, or a check, may be used to deposit funds into your account. It's important to remember that this procedure may take several days, but that once the funds have been deposited, you'll be ready to begin investing.

When buying an exchange-traded fund, you must first provide the ticker symbol for that ETF. If you want to purchase a certain security, you'll need to know its “ticker symbol”, which is a string of letters. For instance, the Vanguard S&P 500 ETF may be of interest if you are searching for an ETF that follows the S&P 500. You may identify this exchange-traded fund by its ticker symbol “VOO”.

You'll also need to know the following in order to invest in an ETF:

  • The “ask” price is the lowest amount a seller is prepared to take for an ETF.
  • In the case of exchange-traded funds (ETFs), the bid price is the highest price a potential buyer is willing to pay.
  • The “bid” price. How many shares are you looking to buy? We'll pretend you have £100 to spend. Simply divide £100 by the ETF's price per share to get an idea of how many you can afford to buy. For example, if each share is £40, then £100 divided by £20 would buy five shares.
  • Type of order — The “order” specifies the ETF buying instructions. The most typical orders are either market or limit orders.
  • Using a market order, you may purchase an ETF instantly at the current market price. The expedited processing time of a market order is one of its main advantages. The future cost, however, is notoriously difficult to estimate.
  • You may set the maximum price (limit order) you're ready to pay for an ETF using a limit order, and the order will be executed only at that price or above. The cost, therefore, is certain. Your order will not be fulfilled if the requested pricing is unavailable.

Setting the time in force for your order will determine how long you’ll own the ETF before it expires.

Oil Price

Shares of ETFs may be bought and sold via a brokerage account in the same way that equities can. Investors who like greater control over their finances may choose a regular brokerage account, while others who prefer a more hands-off approach may prefer a robo-advisor. Even though the investor may not have a say in the matter, robo-advisors often use ETFs in their portfolios.

Keep an eye on progress: Finally, ensure sure your ETFs' long-term performance is in line with your expectations. We’re almost done with our beginner’s guide to ETFs.

When buying an ETF, if you come across any additional terminology you don't understand, just check them up on the brokerage site, Google them, or contact the brokerage for clarification. When you've finished placing your purchase and double-checking that everything is accurate, click the “buy” button.

To Sum Up

Empty pockets never held anyone back. Only empty heads and empty hearts can do that.

Norman Vincent Peale

Mutual funds and ETFs are both excellent additions to a diversified portfolio. They make it simple to amass a diverse investment portfolio with little outlay of time, money, or both.

With this form of long-term investment planning, you may invest in exchange-traded funds (ETFs) via a robo-advisor, a self-directed online brokerage account, or the services of a financial adviser, among other options.

For investors on a tight budget, exchange-traded funds (ETFs) provide a diversified portfolio of stocks and bonds at a reasonable price. When investing, one should not purchase individual stocks but rather acquire shares in a fund that aims to replicate the performance of a broad market index. However, it's important to remember that investing in an ETF has certain other costs.

Related Guides:

FAQs

How much does an ETF cost?

How does an ETF differ from index funds?

When did the first ETF begin trading?

Should you put your money into ETFs?

Is it actually advisable for a beginner to invest in ETFs?

Where do ETFs fall short?

What time frame is recommended?

Is ETF income subject to taxation?

Do ETFs provide monthly income?

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