How Do ETFs Work?

Exchange-traded funds (ETFs) are bundles of securities that allow investors to diversify their portfolios. Because ETFs feature a selection of securities, investors don’t have to worry about the success of a single security, thereby reducing the overall risk. ETFs function similarly to mutual funds, although ETFs typically generate fewer taxes and lower management fees, making them a cheaper alternative for investors looking to diversify.

Just like a mutual fund, it’s possible for the ETF to either pay investors the interest earned or to have the ETF reinvest the money. It depends on how the ETF is structured. ETFs can also be traded like stocks throughout the day, and their prices fluctuate with the stock market. 

ETFs have developed a reputation for transparency, especially when compared with exchange-traded notes and mutual funds. Investors know exactly what’s in their ETF, while mutual funds and exchange-traded notes don’t always reveal that information up front.

Costs of Joining an ETF

There are costs associated with ETFs, and the expense ratio tells you how much is taken out of the ETF to maintain it. According to Morningstar, on average, ETFs are cheaper than index funds. The average expense ratio for an ETF is 0.44%, which translates to $4.40 in annual fees for every $1,000 you invest. The average traditional index fund has an expense ratio of 0.74%. That said, expense ratios vary depending on the ETF. Make sure that’s information you have before making a financial commitment.

ETFs are also typically cheaper than mutual funds. Actively managed mutual funds require a financial expert to decide whether it’s best to re-invest the interest or distribute the dividends. Managers charge significant fees for their services, even if the mutual fund loses money. ETFs, on the other hand, are usually passively managed.

If an investor wanted to make trades with their ETF, they would need to pay a broker to execute those transactions. ETFs are better for lump-sum investors, rather than investors who want to add to their investment on a regular basis.

Taxes on ETF Capital Gains

ETFs are more tax-efficient than mutual funds. They generally have lower turnover, which means that they hold their securities for a longer time. This results in fewer capital gains. The IRS considers capital gains to be income and taxes it accordingly.

ETFs are classified as either long-term or short-term ETFs. Short-term ETFs are taxed at a higher rate than long-term options.

What Types of ETFs Can I Purchase?

Not all ETFs are alike, and some are definitely more expensive and riskier than others. The more specialized an ETF is, the more risk and expense it is likely to entail.

You can find ETFs — like broad market ETFs — that allow you to follow the market according to a stock market index, like the S&P 500. There are also more niche ETFs, that might invest in a particular sector or commodity. Choose carefully, especially if you have more conservative financial goals. 

1. Broad Market ETFs

Broad market ETFs are designed to mirror the market, not outperform it. Broad market ETFs offer investors full exposure to the US market. The risk to investors is nicely spread out over hundreds of securities.

2. Foreign Market ETFs

Foreign market ETFs bundle indexes of foreign countries together — investors can purchase European, Asian, and Latin ETFs. “Emerging market” ETFs focus on up-and-coming economies, and at the moment, they often feature securities in Chinese and Brazilian markets.

3. Sector and Industry ETFs

Instead of purchasing stocks in an individual company, like Microsoft, investors can buy a technology ETF. This allows investors to take advantage of a booming sector, without relying on the success of a single company. That said, investors should only invest in sectors they understand. Investors who already work in technology and healthcare might find these types of ETFs attractive.

4. Commodity ETFs

Commodity ETFs can offer another step toward portfolio diversification, but investors should take their tax structure into account. According to The Wall Street Journal, ETFs that invest in “collectibles,” like gold, are taxed at a higher rate. The maximum long-term capital gains tax rate is 15%, while the maximum tax rate for collectible capital gains is 28%.

5. Bond ETFs

Investors can choose from bonds in either the US market or the international market. Bond ETFs are more secure investments, although many countries don’t offer high interest rates. Forbes recommends emerging market bonds for investors looking for bond ETFs with higher yields.

6. Inverse ETFs

Buying securities allows investors to bet that a company (or a sector, or a commodity, etc.) will make profits. Inverse ETFs are betting that certain securities will decline in value. Only very experienced investors who plan to place trades on a regular basis should take such a risky stance — the longer you hold an inverse ETF, the more likely you are to lose money.

7. Leveraged ETFs

Leveraged ETFs are set up to multiply the gains (or losses) of an inverse ETF. Technically, a leveraged ETF could yield 2 to 3 times the profit of an investment, but they can produce just as many losses. They’re also taxed differently than most ETFs — once again, the complexities make these better suited to experienced investors who can tolerate a high amount of risk.

8. Dividend ETFs

Dividend ETFs allow investors to invest in multiple stocks that pay dividends. Stocks that pay dividends are a more reliable source of income, since they’re usually offered by well-established, high-growth companies.

9. Currency ETFs

As the name suggests, these ETFs track foreign currencies. Some are straightforward investments, while others focus on swaps, or contracts to exchange assets at a certain date. Although currency ETFs are one of the easiest methods for non-currency experts to invest, this is a volatile sector, and one of the riskier ETFs.

10. Volatility ETFs

When stock prices plunge or shoot up rapidly, the market experiences “volatility.” Investors find volatility ETFs more attractive when they believe the market is about to experience a serious downturn. Needless to say, volatility doesn’t typically last, making these better suited for investors who want to regularly trade.

Lost Money? Investors Have Options

If you invested in an ETF and lost money, get in touch with an attorney at Fitapelli Kurta. Contact us at (877) 238-4175 or info@fkesq.com.

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