10 Questions You Need Answered Before Investing in Exchange-Traded Funds

Exchange-traded funds (ETFs) are investment vehicle that combine characteristics of stocks and mutual funds.

ETF shares trade like stocks and have additional advantages, such as liquidity and tax efficiency. In addition, ETFs are an easy and inexpensive way for portfolio diversification.

Here are the answers to 10 basic questions about ETFs.

What are exchange-traded funds (ETFs)?

Exchange-traded funds are investment funds that hold a portfolio of assets. These assets can be stocks, commodities, currencies or bonds. ETFs are traded like stocks. Many ETFs track an index, such as the S&P 500 or Dow Jones Industrials.

What are the advantages of investing with ETFs?

ETFs are easy to trade like stocks and hold diversified assets like mutual funds. Additional advantages of ETFs are low ownership cost, transparency, variety of choice, tax efficiency and liquidity.

What are the disadvantages of using ETFs?

ETFs have transaction fees. Therefore, frequent trading of ETFs can greatly diminish total returns. Successful ETF investing requires some specialized knowledge. Number of available ETFs can be intimidating for some investors. In 2015, U.S. exchanges listed almost 1,600 ETFs and approximately 4,400 ETFs were available globally.

Where and how do I buy ETFs?

ETFs are sold through brokerage accounts like stocks. Popular national brokerage firms such as Fidelity, Charles Schwab, TD Ameritrade and Vanguard are good choices for your brokerage account. Once you have a brokerage account, it is relatively easy to follow that account’s instructions to buy and sell ETFs.

What are the main differences between ETFs and mutual funds?

Mutual funds are priced just once a day at the close of trading. In contrast, ETF prices change throughout the trading day.

ETF holdings are completely transparent. You always know what an ETF holds. Mutual funds are required to report their holdings only once every quarter. ETFs are much cheaper, more tax efficient and offer more choices than mutual funds.

One downside of investing in ETFs are transaction fees. However, unlike mutual funds, ETFs have no sales charges or deferred sales charges.

What are some common mistakes made when investing with ETFs?

Just like any investment, investing in ETFs involves risk. Some ETF types — inverse ETFs or ETFs that use leverage — are riskier than index, stock or commodity ETFs. These higher-risk ETFs might not be suitable for some investors.

Also, some small ETFs have wide bid/ask spreads because of low daily trading volume. This means that some investors could end up buying at a high price and selling at a low price.

However, you can avoid most of these common mistakes with a little specialized knowledge. Stockinvestor.com provides a variety of articles and resources about general ETF investing strategies and specific investing advice.

Are ETFs for stocks only?

ETFs are very versatile investment tools. In addition to stocks, ETFs can hold commodities, fixed income, bonds, currencies or other assets. The number and variety of currently available ETFs means that almost every asset class publicly traded now is accessible through an ETF.

 Do ETFs pay dividends and interest like mutual funds?

ETFs with stock holdings pass through dividends paid from those stocks directly to shareholders. Additionally, ETFs also pass through any interest from fixed income securities. Like stock dividend payouts, dividend distribution frequency varies depending on the specific ETF. Some ETFs pay quarterly dividends while others pay monthly or semi-annually.

What are the tax advantages of using ETFs?

ETFs offer greater tax advantages to shareholders than mutual funds. Most ETFs are structured like index funds. Therefore, ETFs have an extremely low holdings turnover rate compared to mutual funds. Because most mutual funds are actively managed, buying and selling of assets within a mutual fund tends to create tax events. These tax issue are non-existent when you invest in ETFs.

Are there costs and sales charges when purchasing ETFs?

ETFs have no sales charges, commissions or redemption fees. For most ETFs, a small transaction fee charged by the brokerage firm will be the only cost to buy or sell ETF shares. Some brokerage firms even offer selected ETFs with no transaction fees.

The answers to these 10 questions provide only the absolute basic information about investing in exchange-traded funds. However, this information should be enough to make you consider making ETFs an important part of your investment portfolio.

Check out additional ETF investing articles in the Exchange-Traded Funds section of stockinvestor.com.

Doug Fabian is the editor of three publications: Successful ETF Investing, ETF Trader’s Edge, and Fabian’s Weekly ETF Report. Doug was previously known as one of America’s top mutual fund advisors, but in recent years he has made a revolutionary 100% shift to exchange traded funds (ETFs). He regularly appears at seminars around the country.