What You Need to Know Before Investing in Exchange Traded Fund
Exchange Traded Funds (ETFs) are rapidly gaining popularity as a cost-effective and hassle-free online investing option. ETFs work similar to mutual funds, but they can be traded like stocks. ETFs track specific index, commodity, asset, or sector stocks, and they are purchased and sold on the stock exchange.
SPDR S&P 500 ETF was the first ETF introduced in the market, and it still continues to be highly active. Essentially, it tracks the S&P 500 index. ETFs can be traded at any time when the stock exchange market is open, and the trading price is determined at the time of the order.
How does ETF work?
An ETF holds different underlying assets, which makes it an ideal choice for the diversification of an investment portfolio. Hundreds or even thousands of stocks can be owned by a single ETF, and the stocks themselves can belong to specific sectors or could be distributed across various sectors. Some ETFs provide US-specific offerings, while some ETFs have a global outlook. The biggest attraction of ETFs is that it is a marketable security. It can be sold short on the stock exchanges. ETFs pay dividends that can be paid to you as cash or can be reinvested using DRIP (Dividend Reinvestment Plan). ETFs have more liquidity than mutual funds.
What are the ETF types?
There are two basic categories of ETF — passive ETFs and active ETFs.
Passive ETFs mimic returns of the chosen benchmark index, which can be a diversified index like S&P 500 or a targeted sector like gold mining stocks. These are baskets of securities whose prices fluctuate depending on the movements in the stock exchange.
Active ETFs require portfolio managers who make decisions about the types of securities to include in the portfolio. This is customised based on investor goals, but it can be expensive.
What are the costs involved?
ETFs are generally cost-effective, but active ETFs incur additional management fees called ETF expense ratio. Many stock broking platform now offer commission-free ETF trading. Even though an ETF owns multiple stocks, buying and selling an ETF is considered a single trade. However, you should evaluate the trading cost, including the bid-ask spread variations. There are no minimum investment requirements.
What are the tax implications?
The tax implications of ETFs are slightly complicated because they involve stocks from different regions. US-based ETFs have tax advantages, which may not be available with foreign ETFs. The actual tax depends on where you live. Generally, you have to pay tax on the gains you receive from ETFs because it is essentially an investment.
How to start as an ETF investor?
There are just three steps to investing in ETF:
- Open a brokerage account – You can find online brokers that offer commission-free trading through a free demat account. Before choosing an online broking platform, you have to understand the features offered.
- Choose your EFTs for trading – You can choose the ETFs you want to invest based on the commodity, sector, or asset you are interested in.
- Let the ETFs make money for you – Similar to other investment options, the best way to earn profits from EFTs is to leave them alone so that you can gain investment growth over a long period of time.
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