What to know about investing in ETFs

For the uninitiated, the world of investing can feel a little bit like alphabet soup. One of the many acronyms you’ll need to familiarize yourself with as you dip your toe into things is ETF. Short for exchange-traded funds, ETFs can be a great choice for beginners because they allow you to buy into a portfolio of assets rather than just one stock or bond, offering instant diversification.

But ETFs are not only for beginners. In fact, “demand for exchange-traded funds continues to grow as investors seek lower-cost, tax-friendly options to meet their financial goals,” said CNBC. Here is what to know about them.

What are ETFs, and how do they work?

An ETF is a “basket of investments made up of assets such as stocks or bonds, which allows you to invest in many securities all at once,” said NerdWallet. By buying a share of an ETF, you gain ownership of the various investments within it, giving you a small stake in many securities at once. As the name suggests, exchange-traded funds are bought and sold on an exchange, just like a stock.

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It is possible for ETFs to be “structured to track anything from the price of a commodity to a large and diverse collection of stocks — even specific investment strategies,” said Investopedia. For instance, you may purchase an ETF for “income generation, speculation or hedging risk in a portfolio.”

What are the pros of investing in ETFs?

ETFs have a number of potential benefits for investors. For one, they provide built-in diversification, “meaning you get diversification (and lower risk) than if you bought just one or two stocks,” said Bankrate. There is also a range of different ETFs available to choose from, allowing most investors to find a fund that aligns with their goals.

Another major upside of ETFs is that they tend to be low-cost. “Though costs will vary by investment, ETFs typically have lower fees compared with actively managed mutual funds,” another investment product that offers access to a collection of assets, said NerdWallet.

This is true for tax consequences as well, since “ETFs are structured so that they minimize distributions of capital gains, helping you keep your tax bill lower,” said Bankrate.

Are there any drawbacks to investing in ETFs?

There are some risks to ETFs. For one, though generally low, there are still costs involved, namely expense ratios, a fee for the management of the fund. There is also the possibility you may have to sell sooner — or later — than hoped. If the fund closes, “you may be forced to sell earlier than expected — perhaps at a loss,” whereas if you have an ETF that “isn’t traded frequently, it may be harder to unload,” said NerdWallet.

You will also want to verify a fund’s holdings before buying into it, both to ensure ample diversification and that the fund actually focuses on the target as advertised. “If you don’t look under the hood, you may think you’re buying a diversified fund when in reality you’ve bought something extremely narrow and risky,” said Jared Gagne, a CFP with Claro Advisors in Boston, to CNBC.