What to Look for When Buying ETFs
Exchange-traded funds (ETFs) haven’t been around as long as other investment options, such as mutual funds, stocks and bonds, but that doesn’t mean they should be disregarded. ETFs are low-cost, well-diversified investment options that give investors access to a pool of securities to meet their individual goals.
The key to buying new investments — or anything really — is to understand what you’re getting into. Only when you educate yourself can you be comfortable with a new investment option. Whether you use a financial advisor, or are making your investment decisions on your own, asking the right questions is a crucial part of the learning process. The last thing investors want is to put hard-earned money into an investment portfolio or retirement account without understanding where the money is going. Here are the five most important questions to ask when buying ETFs:
1. What Are the Costs?
As with most things in life —especially when it comes to spending money — cost is a deciding factor when choosing where to invest. The good news is that the vast majority of ETFs are passively-managed investments, which means that the fees are much lower compared to actively-managed vehicles. However, the management fee does vary per ETF, so it’s important to ask about the costs before adding them to your portfolio.
Other variable costs that exist when purchasing ETFs include commissions charged by the advisor or broker, expense ratios and the bid-ask spread which is the difference between the highest price a buying investor is willing to pay for the ETF and the lowest price a seller is willing to accept to let the security go.
2. What Do ETFs Invest in?
An ETF is a portfolio of underlying investments, similar to a mutual fund, and it tracks an index. These two factors combined make it very easy to understand which securities are held within the ETF as well as its performance benchmark. If an ETF tracks the S&P 500, for example, then it is comprised of a proportionate ratio of the stocks on the S&P 500.
It’s important to note that past performance is never an indication of future potential performance. However, looking at the securities and benchmark can give an idea of potential fluctuations. From there you can decide if you’re comfortable and want to invest.
3. Is One ETF Better Than Another?
As with most investments, the answer to this question depends on your investment objectives, time horizon and comfort level with risk. In general, ETFs are inexpensive, tax-efficient and liquid investment options — that makes them attractive for investors. It’s hard to say that one ETF is better than another.
With all other factors being equal, some investors consider reputation and longevity when it comes to investing in ETFs and the firms that offer them. Research your ETF options before investing any money to ensure you’re comfortable with the asset allocation and level of risk. Important information such as the index benchmark and asset allocation can be found in an ETF fact sheet.
4. How Do ETFs Fit into My Portfolio?
ETFs can help diversify an investment portfolio and, if they are passively managed and have low management fees, lower the overall cost. Diversifying an investment portfolio through proper asset allocation that fits with an investor's risk tolerance can help achieve short and long term financial goals while maintaining a comfort level with risk.
Vanguard offers investors an Investor Questionnaire which is a series of questions to help determine the appropriate asset allocation for each portfolio. When discussing the importance of an asset allocation. If an ETF follows a bond index, it most likely invests the majority of assets in fixed income. If you are a risk-adverse investor who prefers a potential stable income over aggressive growth then this may be the investment option for you.
5. Are ETFs Best for Short-Term or Long-Term Investing?
ETFs may have a reputation for being suitable for day-traders and short-term investors, however the exact opposite is true. There is an ETF for everyone. ETFs are for all types of investing, based on an individual's goals and risk tolerance. For example, if you have a long-term strategy, an equity ETF may be suitable and if you have a shorter time horizon such as 1 to 3 years, a fixed income ETF may be more appropriate.
The price of an ETF changes throughout the trading day. Although investors should not try to time the market, it is generally considered best practice to not buy or sell ETFs at the beginning or end of the day. You should purchase an ETF if its investment style aligns with your investment objectives and if you are comfortable with the level of risk. It’s never a good idea to buy an investment because you think you're getting a good deal or because you got a hot tip.
All investing is subject to risk, including possible loss of principal.
Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.