Exchange-traded funds (ETFs) were invented in the early 1990s in Canada as a more cost-efficient alternative to mutual funds. Today, the popularity of this type of investment fund has grown significantly amongst both institutional and individual investors. And now, many investors are trying to learn how to invest in ETFs.

The first American ETF was created in January 1993 and continues to trade today as the SPDR S&P 500, tracking the S&P 500 index. Since then, over 2,500 exchange-traded funds have emerged in the United States alone.

Similarly, the first British ETF emerged in April 2000, and the London Stock Exchange is now home to more than 1,500 funds.

This surge in popularity among investors boils largely down to two primary factors, cost and convenience. Like a mutual fund, an exchange-traded fund allows instant diversification across multiple asset classes. That includes more complicated financial derivatives. But since a fund manager makes all the critical decisions, ETF investing doesn’t require as much in-depth knowledge compared to DIY investing.

Furthermore, ETF shares are traded like a stock giving more intraday pricing visibility versus a mutual fund that only executes trades after markets have closed. Passive ETFs typically charge a significantly lower expense ratio. And in some cases, this type of investment fund can also be more tax efficient.

Of course, no investment instrument is without its caveats. ETFs have some disadvantages that investors need to consider. Common examples include tracking errors, potentially limited liquidity, and the risk of artificially inflating asset prices. Nevertheless, for many investors, the benefits outweigh the drawbacks.

How to invest in ETFs?

Buying and selling shares in an exchange-traded fund is a relatively straightforward process. That’s why many investment advisers often encourage novice investors to start building a portfolio using these types of funds.

Here are the main steps on how to invest in ETFs:

1. Open a brokerage account

In order to access and invest in the financial markets, an investor requires a brokerage account. These are sometimes referred to as investment accounts.

There are various types of brokerage accounts for investors to choose from, each with its own advantages and disadvantages. One may be more suitable than another, depending on the objectives and personal circumstances of the individual.

• Standard Account – This is the most common type of investment account. Investors deposit capital which can then be used to invest in an array of financial products, including stocks, bonds, mutual funds, trusts, and ETFs. In the United Kingdom, all capital gains and dividends received through investments in a standard trading account are subject to tax.
• Stocks and Shares ISA – This is a special tax-efficient investment account for British investors only. All capital gains and dividends received from investments within a Stocks and Shares ISA are tax-free. However, investors are limited to depositing a maximum of £20,000 per year.
• Self-Invested Personal Pension (SIPP) Account – This is a special tax-deferred investment account for British investors only. Capital gains and dividends received from investments are protected from tax. However, investors cannot withdraw any funds until reaching the age of 55 (57 from 2028). When funds are taken out, they are taxed as regular income.
• Employer-Sponsored Retirement Account – This is a special investment account with certain tax benefits. However, withdrawals from this account are limited until investors reach a certain age. They are designed to be a saving instrument for pensions. The most common type of employer-sponsored retirement account in the United States is a 401(k).

2. Select what type of ETF to buy

One of the most commonly discussed types of exchange-traded funds is the Index ETF. As the name suggests, this is a type of index fund that tracks and replicates the performance of an underlying stock market index. However, there are actually seven different types of these investment funds. And depending on the time horizon, risk tolerance, as well as personal investment goals, an index fund may not be the most suitable.

• Index ETF – Designed to track and replicate the performance of a specific stock market index such as the FTSE 100 or Dow Jones Industrial Average. The fund’s portfolio consists exclusively of the constituent stocks of the index it’s tracking.
• Industry ETF – Aims to replicate or beat the performance of a specific industry. The fund’s portfolio can consist of multiple asset classes such as stocks, bonds, commodities, or other financial derivatives.
• Bond ETF – Aims to provide shareholders with a consistent and regular fixed income stream. These funds typically invest in high-grade debt instruments such as government bonds, corporate bonds, and municipal bonds. However, some cater to higher-risk investors and explore the high-yield bond market as well.
• Commodity ETF – Designed to replicate the performance of a single or collection of commodities like gold, oil, or lumber.
• Currency ETF – Aims to track the performance of a specific domestic and foreign currency pair. Investors often use this type of ETF to hedge against the risk of a depreciating currency.
• Inverse ETF – A specialised investment fund that seeks to generate returns for shareholders by betting against the performance of different asset classes like stocks or commodities. These are typically designed for professional short-term traders and can carry significant risks that may not be appropriate for conservative and novice investors.
• Leveraged ETF – A specialised investment fund capable of adopting any of the other six ETF strategies. This type of fund uses leverage to amplify returns. However, this also works in reverse, amplifying losses. They’re generally designed to help risk-seeking traders capitalise on stock market volatility.

3. Pick an ETF

With the type of exchange-traded fund selected, the investor must decide which fund to buy shares in. There are often multiple funds executing the same strategy or tracking the same index. So, how does an investor determine which one is the best option?

In most cases, it ultimately boils down to management fees. While an ETF typically charges a lower expense ratio than a mutual fund, there are still some costs to cover. Just like other types of funds, ETFs can deploy both passive and active investing strategies. The latter is typically more expensive but offers potentially market-beating returns to compensate for the increased cost.

An investor needs to decide whether passive ETFs or active ETFs are the best options for their investment objectives. And then compare the selection of funds to find the most suitable in terms of strategy and cost.

4. Buy shares in the ETF

With a brokerage account opened, funded, and the ETF selected, investors can now buy shares. And since an ETF is traded on a stock exchange, trades are executed instantly while the stock market is open.

Can I lose money from ETFs? 

Every investment vehicle and asset class carries some level of risk. And exchange-traded funds are no exception.

The amount of risk an ETF investor is exposed to ultimately depends on the type of ETF they are investing in. For example, a leveraged ETF is significantly more volatile than an index ETF. However, there are also other risk factors to consider beyond volatility.

• Tracking Errors – Over long periods, an exchange-traded fund’s performance can slowly drift away from the performance of the index or asset classes it tracks. These tracking errors can arise due to the fund’s annual management fees and other unexpected costs.
• No Control – The fund manager ultimately decides all investment decisions within an ETF. As such, shareholders have next-to-no control over where their capital ends up being invested. Therefore, investors may end up owning shares in businesses or asset classes that don’t align with their ethical or moral principles.
• Illiquidity – It may be difficult to match buyers and sellers for some niche ETFs. As such, selling shares at the quoted market price could prove challenging, resulting in wider bid-ask spreads that will adversely affect the return on investment.

Alternative investments to ETFs

Exchange-traded funds are just one of many financial instruments available to investors to expand their net worth.

Some common alternatives include:

• Stocks – Invest directly into publically traded companies.
• Bonds – Invest directly into buying debt from companies or government institutions.
• Index Funds – Invest in low-cost funds that replicate the stock market’s average performance.
• Mutual Funds – Invest in a basket of financial securities and assets to grow shareholder capital either in line with a benchmark index or attempting to beat a benchmark index.
• Real Estate – Invest in property with a traditional mortgage or through various real-estate financial instruments such as a real estate investment trust (REIT).
• Private Equity – Invest in shares of companies within the private sector. This is typically only available for high-wealth individuals or institutional investors.
• Hedge Funds – Invest capital into a fund that uses complex financial instruments, such as derivatives, to achieve market-beating returns.
• Venture Capital – Invest in start-up businesses. This is exceptionally high risk but, if successful, could generate ginormous returns. This is typically only available for high-wealth individuals or institutional investors.

The bottom line

Investing through an exchange-traded fund is quite a convenient strategy. Apart from having an instantly diversified, professionally managed portfolio, investors can sit back and put their investments largely on autopilot.

Of course, this comes at the cost of annual management fees that can eat into overall returns. And investors still need to perform the necessary due diligence and understand the risks before investing in an ETF.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.