Read This Before You Buy an ETF

By Markets Fool.com


Learn more before you press the ETF key. Image:Got Credit, Flickr.

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If you're thinking of investing in an exchange-traded fund, or ETF, you're not alone, as they've been exploding in popularity in recent years. They're terrific for many investors; but they're not all equally terrific. Take some time to learn more about them before you jump in.

To get a sense of how much ETFs have been growing in popularity, know that as of the end of 2014, there was about $2 trillioninvested in them, up from $1.7 trillion the year before. Assets in ETFs tripled between 2008 and 2014.

So what are ETFs? Well, they're like mutual funds in that they offer investors shares of a pooled investment in a variety of stocks, bonds, or other assets.

But they're also like stocks, as you're able to buy a single share, which might cost just $10 or $50 dollars, and shares can be bought or sold throughout the trading day, with their prices fluctuating throughout, too. Mutual funds are only priced once per day, and often have a minimum investment amount, such as $500 or $3,000.

The good
There are lots of reasons to favor ETFs. For starters, many are designed to track various indexes, like index mutual funds. They'll hold the same securities as the index, and will aim to deliver roughly the same performance. Thus, they offer an easy and inexpensive way to invest in an index, with exposure to dozens or thousands of stocks or other securities. Instant diversification!

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ETFs tend to have lower annual fees ("expense ratios") than mutual funds, too, and they offer a tax advantage, because you choose when you want to sell them; therefore, you have the ability to time when you realize gains or losses.

When you shop for an ETF, favor low fees. For some major index-tracking ETFs, fees can be well below 0.20%.

There's also a very wide variety of ETFs, tracking major indexes such as those covering the S&P 500, the entire world stock market, mid-cap stocks, small-cap stocks, emerging markets, and more. Many others are more narrowly focused, for example, specializing in telecommunication companies, environmentally friendly companies, Chinese stocks, high-yielding stocks, mortgage finance companies, healthcare companies, commodities such as gold, and so on. When considering which ETF(s) you might buy, think about which indexes or areas of the stock market you'd like to be invested in, and which ETFs can help you do that for a low cost.

The bad
ETFs aren't perfect, though. Some, especially more obscure ones, are lightly traded and thus end up with wide spreads -- the difference between their buy and sell prices. Some are also structured in ways that aim for extra growth, but offer extra risk and danger, too, such as those that are leveraged, or labeled "inverse." Those are best avoided by most of us.

ETFs also offer us the opportunity to trade in and out of them frequently and easily, making bets on their short-term movements as some do with stocks. That's rarely a recipe for success. Many of those who do best with ETFs will be those who buy broad-market ones and hold on for many years.

Other considerations
When you're evaluating ETFs, look for low fees, and also check out the contents of each one. If you're buying a biotech-focused ETF, see which biotech companies it holds, and if they're what you want. Two biotech-focused ETFs might have meaningfully different holdings, even with some overlap. (Note that holdings can change over time, too.) If you're interested in income, check out the current dividend yield.

ETFs offer instant diversification, so your eggs won't all be in one basket. (Photo: Catherine Bulinski, Flickr)

Think about how the ETF will fit in your portfolio, too. If you already own a bunch of biotech stocks, you might not want to add even more with a biotech ETF. If you own mostly large-cap stocks, you might want to balance them out with an ETF focused on small-cap stocks. If you own mostly America-centric stocks, perhaps consider an international ETF.

Recommended ETFs
Despite there being more than a thousand ETFs out there, you can do quite well parking most of your money in just one or a few inexpensive broad-market ones, such as the SPDR S&P 500 ETF, Vanguard Total Stock Market ETF, and Vanguard Total World Stock ETF. Respectively, they invest you in the largest 80% of the U.S. market, the entire U.S. market, and just about all of the world's stock market.

The right ETFs can do your portfolio a lot of good. Invest in them armed with knowledge about them.

The article Read This Before You Buy an ETF originally appeared on Fool.com.

Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter,has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.