Investing Basics: How To Buy ETFs
Exchange traded funds, commonly known as ETFs, are a low-cost way to buy exposure to hundreds or thousands of stocks and bonds, making them a favorite of financial advisors and investors alike. Here’s how to start buying ETFs.
1. Open a Brokerage Account
Because you can’t just go to the store to purchase a basket of ETFs, the first thing you need to do is open a brokerage account. Before deciding where to open your account, though, it’s important to consider your goals. Certain types of accounts are better for certain goals.
The main types of brokerage accounts are:
- Taxable: These are “regular” accounts that don’t come with special tax advantages. This makes them ideal for goals happening before you reach 59 ½, the federal retirement age. You don’t have restrictions or penalties when you sell your investments, but you do need to be aware of taxes. You’ll owe them anytime you sell investments for a gain or even when you receive dividend payments.
- Retirement: Tax-advantaged retirement accounts like traditional IRAs and Roth IRAs allow your investments to grow tax deferred—or even tax free, in the case of Roth IRAs. This makes them powerful tools for saving for retirement. However, because of these tax benefits, the IRS imposes special contribution limitations and withdrawal requirements for IRAs. You cannot contribute more than $6,000 per year ($7,000 if you’re 50 or older), and you cannot access funds in your IRA until you’re 59 ½ without paying a 10% penalty—plus taxes on any money that’s never been taxed before.
- 529: If you’re planning to use ETFs to save for college, a 529 account is a good place to start: Money held in a 529 grows tax free and won’t be taxed on withdrawal as long as it’s used for qualified educational expenses. 529s can even now be used for pre-college educational costs, like private school tuition, as well as trade school fees. While you cannot withdraw funds for non-education expenses without incurring a penalty, funds held in 529 accounts can be transferred to another relative penalty free.
- Custodial: If you want a less limited way to save on behalf of a child, you’ll want to check out custodial brokerage accounts. These investment accounts let you invest and manage money on behalf of a child beneficiary. There are no tax benefits for custodial accounts, besides up to about $2,000 of investment income being taxed at the child’s lower rate, but funds can be used much more broadly than 529s. Money in a 529 can go to any expense that benefits the child. Note, however, that once the minor comes of age (usually 18 to 25, depending on the state you live in), they will have full control of the account.
What to Look for in a Broker
Because major brokerages offer most of the main investment account types, you need to consider a few other traits outside of accounts available when deciding where to open a brokerage account, including:
- Fees. Look at how they charge for trading or for maintenance. Many brokers now don’t charge maintenance, administration or stock trading fees—which is important because ETFs trade like stocks.
- Minimum deposit. In some cases, you might have to provide a minimum deposit to open an account, though with ETFs, that minimum is generally only the cost of one share. If you’re just starting out, look for brokerages that offer affordable minimums or no minimum.
- Types of assets. Not all brokers allow you to purchase every type of investment and if they do, they might not allow for fee-free trading. If you’re hoping to use ETFs in your portfolio, but also want to be able to buy other assets, double check that you’ll be able to buy them at your broker of choice.
- Customer service. Find out what type of help is offered and how responsive the brokerage is. Forbes Advisor’s listing of Best Online Brokerages For Beginners includes our top picks best help resources.
- Special features. What other features does the brokerage offer? Do you want access to automatic tax-loss harvesting or portfolio rebalancing? Do you want help with other aspects of financial planning? Make sure the brokerage you choose has the less traditional features that will help you reach your financial goals.
If you want to avoid the stress of picking individual ETFs or keeping up with routine maintenance, you might consider a robo-advisor. Most robo-advisors construct low-cost, diversified portfolios of ETFs and provide automated portfolio rebalancing to keep your investments on track to meet your goals. However, you’ll pay a management fee, usually 0.25% of the money you hold with a robo. With many brokers today, you can manage your portfolio on your own for much less. But for some investors, the convenience of a robo-advisor—and the associated $25 per $10,000 you invest each year—is worth the cost.
2. Decide on Your ETF investment Strategy
Once you have a brokerage account, it’s time to decide how you want to invest in it. First, you’ll need to determine your asset allocation, or what percentage of each type of investment security you’ll want to reach your goals. You’ll generally want to split your investing dollars between conservative bond ETFs and aggressive stock ETFs. Bond ETFs offer more modest returns but provide stability in value. Stock ETFs, on the other hand, have greater growth potential but may experience larger fluctuations in value in the short term.
Those value changes are the main reason why financial advisors recommend you use your timeline as a guide for your asset allocation. The further away your goal, the more time you have to recover from any short-term stock ETF dips. The closer it is, the more you’ll probably want to lock in its value with bond ETFs unlikely to experience fluctuations.
Of course, you’ll also want to consider how willing you are to take on the potential you may lose money for greater gains, a financial concept called risk. If you’re unwilling to take on much risk, even for a longer-term goal, you might invest more conservatively. This simply means you’ll have to contribute more of your own money to reach your goals, instead of relying on investment gains.
Here’s how that might play out for saving for retirement, according to investment management firm T. Rowe Price:
- 20s & 30s: 90% to 100% stocks, zero to 10% bonds
- 40s: 80% to 100% stocks, 0 to 20% bonds
- 50s: 65% to 85% stocks, 15% to 35% bonds
- 60s: 45% to 65% stocks, 30% to 50% bonds, 0 to 10% cash/cash-equivalents
- 70+: 30% to 50% stocks, 40% to 60% bonds, 0 to 20% cash/cash-equivalents
3. Research Your ETFs
Once you’ve decided on an ETF asset allocation, you’ll need to research the ETFs most likely to help you reach your goals. Your brokerage should offer ETF research tools, like a database you can screen for particular indexes or strategies, and you can also use third-party databases, like ETFdb.com.
You’ll want to keep a couple of things in mind as you look for ETFs:
Almost all ETFs seek to copy the performance of indexes. You’ll want to choose indexes that reflect the asset allocation you’re aiming for. Stock-based indexes, like the S&P 500, NASDAQ and Dow Jones Industrial Average, are good starting points for the stock component of your portfolio.
If you want to pursue specific sectors, you might consider indexes that track segments of the market, like large-cap, mid-cap or small-cap companies or international/emerging markets stocks. These may carry more risk than a broad index like the S&P 500 but they may also offer higher returns.
For the bond-based part of your portfolio, look to indexes like the Barclays Capital U.S. Aggregate Bond Index. You may consider indexes that focus on Treasury-backed securities for even less risk. The U.S. government’s history of repaying its debts means these are about the lowest risk investments you can find.
Because ETFs almost always track an index, their fees are much lower than actively managed funds. You’ll still want to keep an eye out for their expense ratios, though. These can vary across providers, and you’ll want to choose the ETFs with the lowest possible operating fees because ETFs tracking a particular index will have nearly identical performance, regardless of their cost. Make sure your brokerage of choice will allow you to trade your selected ETFs fee free as well.
4. Buy the ETFs
If you’re managing your portfolio on your own, and not using a robo-advisor, you’ll need to select and buy the ETFs. In general, the process is like buying a stock.
- Fund your account. You’ll need to transfer cash into your brokerage account to buy your ETF shares.
- Search for the ETF ticker symbol: If you’re using one of your brokerage’s research tools, you may be able to purchase shares directly from the ETF’s entry. If not, you’ll need to go to the trade section of the brokerage and enter the ticker symbol.
- Enter the number of shares you want to buy: Next, indicate the number of shares you want to buy. Many brokers will show you the maximum number of shares you can buy with the money you have in your account. This is helpful because you generally can’t buy fractional shares of ETFs. Because of this, keep in mind that you may not be able to invest all of the money you have ready to invest at a given time. Some may have to wait until you have enough for another full share.
- Confirm the order: Finally, you’ll be asked to confirm the order. In most cases you’ll do what’s called a “market order,” meaning your purchase request goes through at the current price of the ETF instead of holding out for a particular price.
5. Set Up Your Purchase Plan
Most of the time, buying ETFs isn’t a one-and-done thing. You’ll want to buy shares regularly to help you reach your investing goals. Luckily, most brokerages allow you to set up a purchase plan.
Arrange for a set amount of money to be moved from your checking account into your investment account on a regular basis. Then, you’ll provide instructions for the brokerage to buy as many shares as possible with the money in your account.
This strategy of regularly investing a set amount of money is known as dollar-cost averaging, and using it consistently may help you pay less per share over time.
While you’re setting up your plan to buy ETFs, you’ll also want to think about how often you’ll check up on your portfolio. Most experts recommend you look in every six to 12 months to make sure your asset allocation hasn’t shifted too much from bonds or stocks performing particularly well or poorly.
If your holdings have shifted more than about 5% from your desired breakdown, you may want to buy and sell certain investments to bring yourself back to your desired level of risk. This isn’t necessarily a complicated or time-consuming process, but if you’d prefer to set it and forget it with your investment portfolio, a robo-advisor can do this for you automatically.
6. Decide on Your Exit Strategy
We won’t hold onto our stocks forever, so it’s a good idea to think about how you’ll sell your shares. Look for ways to minimize capital gains taxes, such as through tax-loss harvesting, as well as strategies to withdraw from tax-advantaged retirement accounts to minimize tax bills. A financial advisor can help you figure out how to do these in the most efficient way.
Exchange Traded Fund FAQs
What Is an ETF?
An exchange-traded fund (ETF) is a fund containing hundreds or thousands of investments that trades like a stock on an exchange. This means you can buy and sell shares of ETFs at any point during the trading day, unlike mutual funds, which can only be bought or sold once trading has closed for the day.
How Is an ETF Different from a Stock?
A stock represents ownership in a single company. An ETF, on the other hand, can offer exposure to hundreds of companies at once. This provides diversification, which minimizes the risk that any one company’s poor performance will jeopardize your investment.
Do ETFs Pay Dividends?
Some ETFs pay dividends from the dividend-paying stocks they hold. If you plan to use dividend investing as a strategy, make sure your desired index will pay you sufficient dividends. You may want to seek out indexes and ETFs that focus on dividend aristocrats, companies that have historically raised their dividend payments regularly.
What Are the Best ETFs to Buy?
The best ETFs to buy are those that align with your financial situation, goals and timeline. That said, to get you started in your research, these are a few ETFs that are highly rated by Morningstar, a fund ranking agency, and are primarily focused on the whole market and large, successful companies:
- VOO and SPY, which track the S&P 500 and contain shares of 500 of the largest companies in the U.S.
- QQQ, which is focused on the NASDAQ 100 and offers exposure to fewer financial but more tech-aligned companies.