How to Invest in ETFs: Get to Grips with Exchange-Traded Funds

Exchange-traded funds (ETFs) have enjoyed a remarkable spike in popularity, with almost 10 trillion dollars invested in these products by 2022, according to Statista.

The combination of typically lower costs, flexibility, ease of purchase, and high levels of product innovation has attracted investors from across the globe.

But what is an ETF, and how do they work? What are the top ETFs, and should they be considered by newcomers to the world of investing?

Our guide on how to invest in ETFs for beginners and professionals alike will answer everything from what is an exchange-traded fund to which are the best ETFs to buy now.

Table of Contents Table of Contents

1. Key Takeaways
2. What is an ETF?
3. How Do ETFs Work?
4. More Complex ETFs
5. ETF Terms You Need to Understand
6. Types of ETFs
7. How to Buy an ETF: A Step-By-Step Guide
8. How to Trade ETFs vs. Mutual Funds
9. Best ETFs to Buy
10. History of ETFs
11. Expansion of ETFs
12. The Bottom line: Should I Invest in ETFs?
13. FAQs
14. References

Show Full Guide

Table of Contents

1. Key Takeaways
2. What is an ETF?
3. How Do ETFs Work?
Show Full Guide
4. More Complex ETFs
5. ETF Terms You Need to Understand
6. Types of ETFs
7. How to Buy an ETF: A Step-By-Step Guide
8. How to Trade ETFs vs. Mutual Funds
9. Best ETFs to Buy
10. History of ETFs
11. Expansion of ETFs
12. The Bottom line: Should I Invest in ETFs?
13. FAQs
14. References

What is an ETF?

ETFs are baskets of securities, such as stocks and bonds, that are bought and sold on stock markets via a brokerage.

They have become a popular way to track specific markets or indices, such as the FTSE 100 or S&P 500, in a relatively straightforward, cost-effective way.

However, the complexity of these products has increased over the years, and you can now buy active ETFs, leveraged ETFs, inverse ETFs, and many others.

Here, we’ll consider the different types of ETFs that are available, look at what you need to know before investing in ETFs, and give a short potted history of these products.

How Do ETFs Work?

Many ETFs are known as ‘passive’ investments. This means their objective is to replicate the performance of an underlying index rather than trying to outperform it.

They will do this in different ways. For example, physical ETFs aim to hold all – or most – of the underlying constituents of the index being followed.

Synthetic ETFs, meanwhile, will use financial tools called derivatives to get the required exposure without having to directly own each asset.

As passive ETFs don’t need to be run by a fund manager, the costs are normally lower. However, there are also active ETFs in which investment decisions will be made.

An active ETF provides access to specific outcomes, such as outperforming an index or generating income, according to an overview from JPMorgan, the international investment house.

“The first active ETF was launched in 2008,” it stated. “Since then, a lot of innovation has happened in the active ETF market. There are now 18 ETF issuers offering active ETFs.”

According to JPMorgan, fixed income remains the biggest asset class for active ETF allocations, with 47% of UCITS ETF assets aligned to such strategies.

“The active ETF market is already as diverse as the active mutual fund market, ranging from index-like active research enhanced indexing strategies, to higher tracking error unconstrained or even thematic strategies,” it added.

More Complex ETFs

The range of ETFs available has grown enormously. We have already mentioned passive and active ETFs, but there are also other types, such as inverse and leveraged.

Essentially, an inverse ETF works in reverse to a traditional ETF in that the value of a person’s holding will rise should the index it follows fall.

It means investors can make a profit during bad times. It’s an approach that allows them to take a bearish stance in a certain market or sector.

Conversely, leveraged ETFs work best when an investor is confident that a particular index will soar in value as it uses debt to amplify the performance.

Leveraged ETFs, which may use derivatives such as options and futures to achieve their goals, can be used by traders wanting to make short-term investments.

ETF Terms You Need to Understand

There are several terms with which you need to be familiar before investing in ETFs. For example, expense ratios reflect how much an ETF pays for portfolio management, administration, and other costs.

You’ll almost always see it expressed as a percentage of the fund’s average net assets, according to Vanguard, which offers its range of ETF products. The Vanguard ETF list includes products focused on everything from US Treasuries to developed Asia Pacific exposure.

“The average expense ratio across the entire fund industry (excluding Vanguard) was 0.47% in 2022, which equates to $47 for every $10,000 invested,” it stated. “Compare that with Vanguard, where the average for all of our mutual funds and ETFs was 0.08%, or just $8—that’s 83% lower!”

Then there are DRIPs. If you’re invested in an ETF that pays dividends, you can opt to have these payments in cash or automatically reinvested. This is known as a dividend reinvestment plan (DRIP).

Reinvesting in this way can help you build wealth over time. However, whether it’s the best option for you will depend on your financial situation and objectives.

Types of ETFs

There are many different types of ETF funds. Some will give you access to global stock markets, for example, while others offer exposure to currencies around the world.

How to Buy an ETF: A Step-By-Step Guide

If you’re looking at how to invest in ETFs, our step-by-step guide will show you how to buy ETFs and what essential factors to consider before making any investment decision.

Step 1: Choose a Broker

You will need a brokerage account before you can start trading ETFs, and the good news is there are plenty available.

Pay particular attention to the fees charged, whether any minimum deposit levels apply, and the types of assets that can be traded.

It’s also worth looking at their trading platforms to see if they’re easy to use and finding out if they have a decent mobile app and a good customer service track record.

Setting up your account will be straightforward and usually involves choosing a username and uploading two separate forms of identification. You’ll then put money into your account.

Step 2: Set Your Investment Goals

Knowing how much you want to invest will depend on a combination of your investment goals, financial resources, and attitude to risk.

For example, are you looking to build up a set amount of money over the next five years, or do you need to generate an income as soon as possible?

Step 3: Research the Market

The next stage is looking at what’s available in the ETF market. Given the sheer number of funds that are being marketed, the chances are high that you’ll find something that meets your needs.

Whether you want passive exposure to leading companies on the London Stock Exchange or are more drawn to ETFs focused on climate change, there’s plenty of choice.

Take your time to see what’s available and the costs involved.

Step 4: Consider a Trading Strategy

You can consider various ETF strategies. For example, you may want them to provide a more stable investment at the heart of your portfolio.

Alternatively, you may prefer to combine active and passive funds to benefit from both low-cost index investing and the potential gains of more expensive (and riskier) active management.

ETFs can also be used if you want relatively short-term market exposure. While investing in ETFs is usually a long-term game, there may be times when you want to benefit from certain conditions.

For example, if you believe that US equities are spectacularly undervalued and should respond positively to political news, then an ETF tracking these stocks could be interesting.

Step 5: Find and Сompare ETFs

This is the fun part. Choosing which ETFs to put in your overall portfolio can be challenging. There are thousands available, so it will all depend on where you want exposure.

For example, do you want a passive ETF that will constantly track the S&P 500 as a core holding or a more specialized satellite holding that can give you heightened returns in exchange for more risk?

Step 6: Monitor Your Decisions

Just because you’ve made your investment decisions doesn’t mean you can relax and forget all about it!

Successful investing requires you to continually monitor your overall portfolio to ensure it remains suitable for your needs and is performing as expected.

At the very least, it is recommended to revisit your investment decisions once a year. However, it won’t do any harm to keep a closer eye.

How to Trade ETFs vs. Mutual Funds

ETFs are traded on the stock market, which means you can buy – or sell – them at any time during the day. So, what’s the difference between trading ETFs vs. mutual funds?

Well, mutual funds are priced and traded just once a day. This means that investors in ETFs have more flexibility as to when they can invest.

When you buy and sell an ETF, you’ll notice that it has two prices. The ask price is the level at which you can buy, while the bid price is the level at which you can sell.

The difference between the two is known as the bid-ask spread. If the ETF is popular, for example, the bid-ask spreads will be narrower. Closer spreads usually mean a lower cost of trading.

Best ETFs to Buy

So, what are the best ETFs to invest in? With so many funds to invest in across numerous sectors, it can be hard to know where to start.

Crypto and digital assets came top of the performance charts during 2023 and the opening weeks of this year, according to Morningstar data.

However, those involved in natural gas, as well as industrial metals such as rhodium, nickel, and palladium, have struggled.

Here we have the five best-performing ETFs during 2023:

History of ETFs

ETFs have been around for just over 30 years and were initially seen as a way to help institutional investors carry out sophisticated trading strategies.

Their origins can be traced back to 1990 in Canada when the Toronto Index Participation Shares tracking the Toronto Stock Exchange 35 (TSE 35) began trading on the Toronto Stock Exchange.

This proved to be so popular that the concept of an exchange-traded fund subsequently became a reality in the United States, according to Morningstar.

“Over the next few years, the concept wove its way through the regulatory channels and ended in 1993 with what many consider to be the first modern representation of the exchange-traded fund in the US: Standard & Poor’s Depositary Receipts (SPDRs) tracking the S&P 500 index,” it stated.

Expansion of ETFs

The growth of ETFs has been phenomenal. By 2022, global ETF assets hit almost $10 trillion, with 8,750 ETFs trading around the world, according to an analysis by BNY Mellon Investment Management.

It pointed out that ETFs have come a long way from just offering “plain vanilla access” to select indices, such as the FTSE 100 and S&P 500. Today, there are thousands of ETFs available.

“Since their introduction, investors have found plenty of uses for ETFs, given their ability to offer a direct way to quickly invest in a diversified set of securities and asset classes,” it stated.

The fact they can be comprised of different underlying assets, such as stocks and bonds, means they’re used as everything from diversification tools to core holdings within larger portfolios.

The Bottom line: Should I Invest in ETFs?

Exchange-traded funds are worth considering as part of your overall portfolio as they can provide diversification for a relatively low cost.

Investors can use them to get passive exposure to global stock market indices, such as the S&P 500, in a simple, affordable way.

However, plenty of complicated ETFs have been launched over the past decade to access niche areas and enable sophisticated trading strategies.

Therefore, it’s an area that requires plenty of research. Investors – especially beginners – must understand exactly what they’re buying.

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