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.

Key Takeaways

  • The first exchange-traded fund (ETF) appeared in Canada during the early 1990s, but interest in the area has grown rapidly since those early days.
  • ETFs are traded on stock markets. This means you can buy or sell them throughout the day, whereas this is only possible once a day with mutual funds.
  • As most ETFs track an index and don’t require active management – known as passive management – their costs are generally low. Reducing expenses over time can boost your overall wealth.
  • ETFs can help provide diversification in your overall portfolio by giving you access to many assets within one fund.
  • There are different types of ETFs, including passive, active, inverse, and leveraged, as well as those focused on currencies, commodities, and specialty investments.

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.

Of course, there are risks involved with this approach. If their predictions fail then their losses will also be amplified, so such complicated ETFs must only be embraced by experienced investors.

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.

Types of Exchange-Traded Funds (ETFs)

Stock ETFsBond ETFsSpecialty ETFsSustainable ETFsCommodity ETFsCurrency ETFs

Invest in Stock ETFs

ETS can be a great way to get exposure to the equity markets in a diversified way, which means spreading your risk without having to buy individual company shares.

For example, you can buy an S&P 500 ETF that will track the combined performance of around 500 leading US companies.

Invest in Bond ETFs

A bond ETF will invest in various fixed-income securities. These can be corporate bonds, which are issued by businesses or governments around the world.

For example, some ETFs give you exposure to high-yield products, US Treasuries, or investment grade corporate bonds.

Invest in Specialty ETFs

These are ETFs that focus on specific industries or markets. They typically give you access to a relatively small part of the overall market, such as energy or real estate, according to Vanguard.

“Though many of these narrowly focused funds and ETFs have the potential to grow, you should be equally prepared to experience wide swings in the value of your investments—including potentially large losses,” it stated.

Invest in Sustainable ETFs

Sustainability has become one of the world’s most influential themes in recent years – and this isn’t likely to change anytime soon with governments committed to becoming greener.

There is tremendous interest in environmental, social, and governance (ESG) risks and capturing the financial benefit of embracing a more sustainable economy.

Therefore, putting money into a sustainable ETF, such as those with exposure to the carbon transition climate change, could be a wise investment for the future.

Invest in Commodity ETFs

Commodity ETFs that invest in precious metals, such as gold and silver, as well as agriculture products and hydrocarbons, have been popular for years.

While you can access this area in the various ways we have already mentioned, such as physical and synthetic approaches, you need to do your research, advises Fidelity.

“Your investment decision needs to be based on far more than just the name of the ETF,” it pointed out. “Just because a fund’s name includes ‘oil’, ‘natural gas’, or ‘gold’,  you can’t be sure how that fund accomplishes exposure to that particular commodity.”

Invest in Currency ETFs

Currency ETFs can track the performance of a single currency or a basket of currencies, depending on their stated aims and objectives.

It’s important to bear in mind that currency ETFs can be affected by a wide variety of factors, including interest rates and geopolitical turbulence.

In recent years, we have seen the introduction of Cryptocurrency ETFs that provide exposure to the movement of Bitcoin and other cryptocurrency assets.

However, currency ETFs – covering both single currency and crypto – are complicated and only suitable for those with a thorough understanding of the area and a high tolerance to risk.

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.

How to Buy an ETF

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:

ETF Name Total Return 2023 Management Fee
VanEck Crypto & Blockchain Innovators ETF 254.88% 0.65%
Global X Blockchain ETF 246.95% 0.50%
XBT Provider Bitcoin Tracker 161.28% 2.50%
Grayscale Future of Finance ETF 127.74% 0.70%
ETC Group Digital Assets and Blockchain Equity ETF 122.31% 0.60%
Source: Morningstar Direct, as of December 31, 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.

Do your own research and always remember your investment decision depends on your attitude to risk, your expertise in the ETF market, the spread of your portfolio, and how comfortable you feel about losing money.

The information in this guide does not constitute investment advice and is meant for informational purposes only.

FAQs

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Rob Griffin

Rob is a seasoned journalist with over three decades of experience spanning across business and finance journalism. Before embarking on a freelance career in 2002, he contributed his expertise to the business desks of notable publications such as the The Guardian, Yorkshire Post, Sunday Business (now Business Post), and Sunday Express. Throughout his freelance journey, Rob has been a regular contributor to a wide range of national newspapers, consumer magazines, trade publications, and websites. His work has appeared in titles such as The Independent, Citywire, Daily Express, FT Adviser, and Sunday Telegraph, covering an array of subjects from market trends…