How to Invest in ETFs: A Complete Guide for Beginners

An ETF, or exchange traded fund, is a type of investment fund that pools money from different investors in order to buy a range of assets such as stocks and bonds. ETFs are sponsored or created by financial institutions. These financial instutions buy assets that the ETF will own. ETFs are not typically run by professional fund managers like mutual funds are.

Instead, ETFs are passively managed (most of the time). This simply means that the ETF is designed to track the performace of an underlying market index. A market index measures the performance of a specific sector of the financial markets. For example, the S&P 500 index tracks the performance of the 500 most important companies in the US.

So, an S&P 500 ETF would simply own the stocks of the 500 most important companies in the US. The idea here is to track an underlying market index in hopes of replicating the performance of that index. For example, the S&P 500 typically averages a 10% return over time.

An ETF simply buys the stocks that the S&P 500 tracks in order to try to replicate this 10% return. It is important to note that a market index is not an investment itself. It is simply a measuring stick for how a particular group of assets is doing. An ETF looks at this measuring stick and buys the assets that the measuring stick tracks.

Once an ETF is created, shares of the fund are offered to investors. When you buy a share of the ETF, you do not directly own all of the assets that the ETF owns. You simply own a portion of the ETF itself as a shareholder. The ETF owns all of the underlying assets.  

ETFs are fairly similar to other types of investment funds such as index funds and mutual funds, but they do have one major difference. Unlike other types of investment funds, ETFs can be bought and sold throughout the day just like a stock.

For example, lets say that you bought a share of an ETF at 9:30 in the morning. If you wanted to, you could sell that share the same day at 4:00 in the afternoon. Other investment funds only allow you to buy or sell a share of the fund at the end of the trading day.

The first step to investing in ETFs is to open an investing account. Your investing account will simply hold your ETFs. It is not an investment itself. There are a wide variety of account types available, but to keep things simple we will look at just a few.

Option 1 - Brokerage account: A brokerage account is the most basic investing account that allows you to buy and sell a range of assets including stocks, bonds, and investment funds. The primary advantage to buying ETFs through a brokerage account is flexibility.

There are no limitations on who can have a brokerage account and no limitations on how much you can contribute to the account. You can also access the investments in your brokerage account whenever you need to. In other words, you can buy and sell the investments within your brokerage account whenever you need to.

The downside to holding ETFs in a brokerage account is that you are subject to short or long term capital gains tax when you sell your ETFs for a profit. If you held an ETF in a brokerage account for less than a year and sold it for a profit, you would pay the same tax rate as you would pay on ordinary income - such as income from your job.

If you held an ETF in a brokerage account for more than a year and sold it for a profit, you would pay 0 percent, 15 percent, or 20 percent capital gains tax. If you decide to hold ETFs in a brokerage account, it is better to hold the funds for at least a year before you sell in order to get a more favorable tax rate.

Option 2 - Roth IRA: An IRA, or individual retirement account, is a tax advantaged investing account specifically designed to help you save for retirement. The Roth IRA is one of the most popular types of individual retirement accounts and works like this.

You make contributions to a Roth IRA with dollars that have already been taxed. However, when you take money out of a Roth IRA when you retire, you don't pay any taxes. If you are a long term investor, or are looking to save for your retirement holding ETFs in a Roth IRA can be very beneficial thanks to the tax advantages of the account.

Since the Roth IRA offers tax benefits, the IRS does put some restrictions on the account. First, your income must be below a certain level to open a Roth IRA. If you file your taxes as an individual, your income has to be $146,000 or less if you want to make the full contribution. If your tax filing status is married filing jointly, your income has to be $230,000 or less if you want to make the full contribution. (Rules for 2023-2024).

Secondly, there are limitations on how much you can contribute to a Roth IRA. You can only contribute $7,000 per year, or $8,000 if you are 50 or older. You can start withdrawing money from your Roth IRA once you are 59 and a half, and have held the account for at least 5 years.

If you try to make an early withdrawal, you can incur a 10% penalty and be subject to pay additional income taxes. The exception to this rule is that you can withdraw the base amounts that you have made to a Roth IRA without incurring a penalty since you have already paid taxes on those dollars. However, you can't make easly withdrawals of any of the profits that you have made from your investments within your Roth IRA.

Related - How Do I Set Up a Roth IRA?

Which one of these account should you have?

It can be beneficial to hold your ETFs in a Roth IRA if you qualfiy. It will allow your ETFs to compound and grow tax free, and then you don't have to pay taxes when you pull the money out of the account in retirement. The good news is that you can have both a brokerage account and a Roth IRA at the same time.

If you want to have the flexibility to buy and sell ETFs when you want, and withdraw the money at any time, it may be beneficial to hold some of your ETFs in a brokerage account. Keep in mind that you will have to pay either short or long term capital gains tax when you sell your ETFs for a profit within a brokerage account.

Where can you open these accounts?

You can open both of these account types at almost all online brokers. The process for opening these accounts if pretty straightforward. Simply go to the website of your chosen broker and click on the option to open an account.

Select to open either a brokerage account or Roth IRA depending upon what you want. From there, you can fill out an application. Expect to have to provide information such as your name, address, contact information, income, social security number, and government ID.

Once you have opened your investing account, you can start to research and compare potential ETFs to invest in. There are hundreds, if not thousands of available ETFs that you can choose from which can make this step feel quite overwhelming.

The good news is that almost all online brokers offer free research tools to help you sift through all of the options.  With that being said, you can typically filter out the following criteria in order to find better ETFs.

1) Expense ratios - An expense ratio is a fee that an ETF charges to cover administrative costs. This will typically show up as a percentage. For example, an ETF that charges a 0.1% expense ratio would charge you a $1 fee for every $1,000 that you had invested. In general, you want to look for ETFs that have an expense ratio well below 1%.

2) Commissions - A commission is a fee that you would pay to the online broker when you buy or sell shares of an ETF. Most online brokers do not charge commissions anymore, but it is still a good idea to keep an eye out for it as commissions can eat away at your returns.

3) Performance - It is important to make sure that your fund has performed well in the past. You can look at the 10 to 20 year time horizon for a fund as that will give you a better idea of its true performance than just a single year. Keep in mind that past performance is no guarantee of future performance, but it is still worthwhile to review it when researching ETFs.

4) Age of fund - The age of the fund is simply how long the fund has existed. A fund that has a 20 year track record of strong performance may be a better choice than a fund that has only been around for a couple of years.

5) Holdings - The holdings of the ETF is what the fund invests in. For example, you might find an ETF that invests in stocks of large US companies, or international companies. Looking at the holdings of an ETF will give you a better idea of what assets you are getting exposed to when you buy shares of an ETF.

Ulitmatiely, the ETFs that are right for you will vary greatly depending upon your age, risk tolerance, time horzion and financial goals. However, you can use the filters above to narrow down your options. In general, you could consider ETFs that are 10 plus years in age, have strong performance during that time, and have low expense ratios and commissions to keep your costs down as you invest.

After you find ETFs that you want to invest in, you need to execute a trade to buy shares of the ETF. This might sound complicated, but it is rather simple. Go to the website of your online broker and find the section that allows you to execute a trade.

When you execute a trade, you are simply buying or selling an investment through your broker. In this case, you are buying. In the trading section, you can enter the ticker symbol of the ETF that you want to buy. A ticker symbol is simply a series of letters or numbers that represent a specific investment.

For example, the Vangaurd Growth ETF ticker symbol is VUG. If you wanted to invest in this fund, you could simply enter the ticker symbol VUG in the trading section of your online broker. Once you have entered the ticker symbol, you can enter the number of shares you wish to buy, and execute the trade.

As an example, this is what it will look like inside of your broker - in this case, Charles Schwab.  

ETFs have two primary costs. First, is the share price of the ETF itself. This will vary by ETF, but in general you can pick up a share of a good ETF for under $100 which is affordable for most investors. The second cost is the expense ratio of the ETF.

The expense ratio of an ETF is a fee that is charged to cover administrative and operating expenses. This fee is expressed as a percentage. For example, an ETF that charges a 0.25% expense ratio would charge you $2.50 for every $1,000 you had invested in the ETF.

We should also note that you could potentially incur a commission fee. A commission fee is paid to the broker every time you buy or sell shares of an ETF. You can avoid this cost by investing in ETFs that brokers do not charge commissions on. The good news is that with most online brokers this has become the norm.

1) The Schwab US Dividend Equity ETF (SCHD): This ETF can be a good option if you want to invest in an ETF that will pay out dividends. It has an annual dividend yield of 3.47% and an average annual return of 11.22% over a 10 year time horizon. The ETF has a low expense ratio of 0.06% and primarily holds large-cap value stocks.

2) The Vanguard Mid Cap Growth ETF (VOT): This ETF could be a good option if you want exposure to mid cap stocks that have potential for growth as that is what the fund primarily holds. The ETF has a low expense ratio and a 10.05% average annual return over a 10 year time horizon.

3) The iShares Core S&P 500 ETF (IVV): This ETF can be a good option if you want broad exposure to the stock market as this ETF tracks the S&P 500 index. It has a low expense ratio of 0.03% and an average annual return of around 12% over a 10 year time horizon.

Important note: Keep in mind that these ETFs are only examples of what you could invest in and should not be taken as strict financial advice. The ETFs that are right for you could be different. We recommend speaking with a licensed financial advisor if you need help choosing ETFs.  

1) Diversification - ETFs allow you to get exposure to lots of different stocks all at once, which lowers your risk. You do not directly own all of the assets that the ETF owns, but you own a share of the ETF itself. Since the ETF owns a predetermined set of assets, you get exposure to all of these assets. Investing in an ETF  is much easier than trying to build an investing portfolio comprised of individual stocks.

2) Trades like a stock - ETFs trade throughout the day just like a stock does - when the market is open. This gives you more flexibility and liquidity than index funds and mutual funds which can only be bought or sold at the end of the trading day. If you are a long term investor this won't matter as much if you simply plan on a buy and hold strategy.

3) Low fees - Compared to actively managed mutual funds, ETFs are an affordable investment option. Most ETFs keep their expense ratios (fees) below 1% per year. However, there are many ETFs that offer expense ratios lower than that. For example, the Spider S&P 500 Index ETF (SPY) charges only a 0.09% ETF per year.

4) Low minimum investment - Mutual funds (and some index funds) often require you to have large minimum investments in order to buy shares. This can sometimes costs you thousands of dollars for a single share. ETFs often have much lower minimum investment requirements which can make them a better option if you have a small investing budget.

1) Potential commissions - There are some brokers that will charge you a commission every time you buy or sell shares of an ETF. This could range up to $25 per trade which can eat into your profits every time you make a trade. If you plan on buying and holding ETFs this is not as big of a deal.

2) Typically won't beat average returns - Since ETFs typically invest in a predetermined mix of assets based upon a market index, the fund typically won't beat the returns that that underlying index provides. In other words, you are typically stuck with the average returns of the underlying index that the ETF is tracking. Mutual funds are a better bet if you want an investment with the potential to beat average returns.  

The bottom line is that ETFs are a low cost investment option that allow you to gain exposure to lots of individual assets by owning a single share of the ETF. ETFs are easy to invest in. You simply need to open an investing account through an online broker, research ETFs, and execute a trade.

For most investors, ETFs are a good option as a long term investment. Since these funds own a range of individual assets, they will typically recover from market crashes given enough time. With that being said, you need to understand what you are investing in and make sure it aligns with your financial goals. Speaking with a licensed financial advisor can help you make a more informed decision.