How to buy ETFs

An exchange-traded fund (ETF) is a passively managed index fund, which mirrors a specified index through a pre-packaged group of stocks. ETFs track U.S. and international stocks, bonds, currencies, commodities, and precious metals.

ETFs are a good solution for portfolio diversification because investors acquire certain securities, which they can trade like individual stocks. ETFs can be bought and sold at the market price anytime during a trading session and therefore they are a flexible and low cost way to invest. ETFs also offer the opportunity to buy and sell options and buy on margin.

Investors should consider several factors when they buy ETFs because, regardless of being effective tools which manage investment risk, they also have some pitfalls, which require a lot of attention.

For example, ETFs are cheaper and more tax-efficient than regular mutual funds. According to Morningstar, the average expense ratio for U.S.-listed ETFs is 0.4%, while for diversified U.S. stock funds reaches 1.42%. However, commission charged from the brokerage firm may reach $10 per trade which equals 1% fee on a $1,000 ETF trade. Therefore, an investor, who buys and sells frequently, may end up paying more money than if, he had bought a similar commission-free mutual fund. So, ETFs are cheap to own, bur may be expensive to trade them.

Apart from the trading cost of ETFs, typically, investors do not track the stock market on proper timing. This means that, with ETFs, investors may get more tempted to trade because they have the opportunity to buy or sell at any time in the trading day. Morningstar analysts warn investors that the possibility to undermine oneself with trading is very real.

The fact that ETFs follow indexes gives investors the opportunity to get exposure in the market. However, there are ETFs that are not so broad and they only track stocks of companies with large market capitalization. This means that the weights of the stocks in the portfolio are higher and that investors do not actually achieve great diversification. Consequently, the risk of realizing losses is greater than if, certain ETFs offered broader exposure to the market.

Similarly, there are ETFs based on fundamental indexing, which means they track stocks that are weighted by their earnings, dividends or cash flows, rather than by market capitalization. These ETFs may offer investors better long-term performance, however the inherent advantages of ETFs are undermined because investors tend to trade this type of ETFs more regularly.

Conclusively, average investors should never buy ETFs because average investors prefer actively managed funds. On the other hand, investors who follow closely the market and are full-time investors should buy ETFs, but they should also consider the trading costs and high commissions. In general, when buying ETFs, investors should understand what they are buying, how it works, what is the investment horizon and what is the cost involved.