How to Invest in ETFs: A Step-by-Step Guide

By Dan Caplinger Markets Fool.com

Exchange-traded funds have taken the investing world by storm. These low-cost funds typically have extremely attractive expense ratios, and they bring tax benefits compared to traditional mutual funds. In many cases, ETFs track indexes that result in minimal asset turnover and greater portfolio stability. Investing in ETFs is easier than ever, and the proliferation of ETFs in the investment community has made it far simpler to find exactly the investment options you want.

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Step 1: Get a brokerage account

In order to buy and sell ETFs, you need to have a brokerage account. ETFs trade like individual stocks, with their shares available during trading hours for the major stock market exchanges.

Which broker you choose can have added benefits. For instance, several brokers that offer their own ETFs, including Vanguard and Schwab, let you trade their proprietary ETFs with no commission. Other brokers, such as Fidelity, TD Ameritrade, and E*Trade, have partnership arrangements with third-party ETF providers under which they charge no commission on ETF trades. Looking closely at each broker's offerings can give you a better sense of which ETFs they have access to and whether the fit is good for your needs.

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Step 2: Focus on fees

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With thousands of ETFs out there, you'll find plenty of options to choose from. One way to distinguish strong prospects from also-rans is to look at their relative costs. Each exchange-traded fund publishes an annual expense ratio, which represents the percentage of total fund assets that goes toward covering the costs that the ETF incurs every year. Smaller expense ratios mean more money staying in your pocket, and the biggest and most efficient ETF providers have expense ratios for their funds that can be less than 0.1%.

Some areas of the financial markets are more costly, and so you might see higher absolute expense ratios in certain areas. For instance, international stock investing involves more logistical challenges, and so expense ratios tend to be higher than for U.S. stock funds. When you compare ETFs from different fund families, however, the least expensive will often end up giving you the best opportunity for the highest returns.

Step 3: Build a diversified ETF portfolio

As with mutual funds, many ETFs hold similar investments, and so owning more ETFs doesn't necessarily translate to having a diversified portfolio. For instance, if all the ETFs you own focus on large-cap U.S. stocks, you might find that the underlying holdings on every one of those funds are almost identical.

Instead, look for ETFs that are in different categories. Incorporating different asset classes, such as stocks, bonds, real estate, and alternative investments, can be a good starting point. Within each asset class, broadening your exposure is also a good idea. For instance, with stocks, having different ETFs that have companies of different sizes, different geographical exposure, and different sector and industry presence will go a long way toward balancing out your portfolio's risk.

Step 4: Figure out how to keep adding to your ETF holdings

Some brokers will allow you to make automatic investments on a regular basis. This is especially handy when your broker offers commission-free ETF trades, because you don't have to worry about the expense of putting small amounts of money to work for you as soon as they're available. Paying even a $5 commission doesn't make sense if you only have $100 per month to invest in an ETF, and if you're in a situation in which you do have to pay a commission, it can be smarter to make less frequent investments so that your commission costs represent a smaller percentage of what you're investing.

Exchange-traded funds can be a valuable building block toward putting together a long-term investment portfolio that will bring you growth and income. By focusing on keeping costs down and finding the ETFs that fit best together with your investing strategy, you'll raise the chances of being happy with your ETF portfolio years into the future.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.