The Modest Wallet is a free digital publication delivering its readers simple personal finance solutions. We regularly partner with brands that have products and services that will help our readers. When you buy through links on our site, we may earn a small commission at no extra cost to you. For more information, please read our full disclosure.
The online investment space can often feel like the Wild West. Whether it’s stocks and shares, mergers and acquisitions, applying leverage, or exchange-traded funds (ETFs) – the industry is jam-packed with confusing terminology.
Nevertheless, it is important that you have a firm understanding of what an ETF is, not least because they are arguably one of the most utilized and comprehensive asset classes in the financial spectrum.
As such, we’ve created the complete beginner’s guide to ETFs. Within it, we’ll discuss everything that you need to know. This will include how they work, the type of assets that they track, the fees that you will need to consider, and more.
Let’s get started:
What is an ETF?
In its most basic form, an exchange-traded funded, or simply ‘ETF’, is an investment vehicle that tracks an asset, or group of assets. In doing so, it allows investors to speculate on the price of an asset that would otherwise be difficult to trade.
Let’s take gold for example. Ordinarily, if you wanted to invest money in gold, you would be required to purchase physical jewelry or bars, and subsequently store it in a safe environment. Moreover, attempting to sell it at a later date would not only be a logistical nightmare but hugely expensive.
By instead investing in an ETF, you have the option of speculating on the value of gold at the click of a button, with no requirement to actually purchase or store the underlying asset.
It is important to note that ETFs are not just reserved for commodities like gold, silver and oil. On the contrary, there are literally thousands of ETFs in existence, covering virtually everything that has real-world value.
Whether it’s real estate, stock market indices, interest rates, foreign currencies or legal marijuana, you can be all-but-certain that an ETF exists.
A further advantage that ETFs offer over traditional assets like stocks and shares is that they allow you to ‘go shot’ with ease. In other words, if you believe that the value of an asset is likely to go down, you can facilitate your speculation via an ETF.
So now that you have an idea of what an ETF actually is, in the next section of our guide we are going to find out how they work.
How Do They Work?
Before you invest in an ETF, it is important that you have a firm grasp of how they work. First and foremost, by investing in an ETF, you do not actually own the underlying asset.
For example, if you purchased an ETF is the US real estate market, you would not have a legal right over the properties that make up the ETF. Instead, ETFs are launched merely to track the price movement of the respective asset, or group of assets.
Nevertheless, from the perspective of the investor, this doesn’t really matter. You see, if you were to invest in a crude oil ETF, it is likely that you would be doing so because you felt that the value of oil was likely to go up or down, and thus, you’d hope to make a profit.
The fact that you don’t have physical access to the oil is neither here nor there, not least because ETFs operate in a highly stringent regulatory arena.
In terms of how the ETF tracks the price of assets, this is usually based on the Net Asset Value (NAV) of the underlying assets. Let’s say for example you purchase an ETF in the NASDAQ-100 Index.
For those unaware, this particular index is tasked with tracking the price movement of the 100 largest US companies listed on the NASDAQ stock exchange. In doing so, you have the chance to invest in 100 companies at the click of a button, as opposed to placing 100 individual trades.
In order to provide a single price, the ETF will track the real-time share price movements of the 100 US companies it is tasked with tracking. However, this isn’t as simple as taking the current share price of each of the 100 companies, as some companies will have a much larger market capitalization in comparison to others.
Think along with the likes of Apple, Facebook and Google.
With this in mind, the ETF is likely to implement a weighting system. Without getting too technical, the ETF will give greater weight to companies that have a higher market capitalization, with the view of demonstrating a much more accurate reflection of the wider index.
Ultimately, as the value of the underlying assets goes up and down, as will the price of the ETF.
Where do ETFs Come From? Who Offers Them?
There is often a misconception that ETFs are offered by the same institutions behind traditional stock exchanges like the NYSE or NASDAQ. However, this couldn’t be further from the truth.
On the contrary, ETFs are provided by traditional financial institutions, such as the likes of Vanguard, Fidelity, and BlackRock (iShares). These institutions often have trillions of dollars in assets under management, and as noted earlier, are heavily regulated.
Now, although we noted that by investing in ETFs, you do not actually own the underlying asset, this isn’t the case for the institutions that facilitate the ETF.
In order to ensure that your money is backed by real-world assets, institutions will typically purchase the respective assets that constitute the ETF, with the view of tracking the underlying prices as accurately as possible.
For example, let’s say that you invest in an ETF that tracks the Russell 2000, which is an index that tracks the share price movement of 2000 small-cap US companies. Large ETF providers will often purchase the company shares themselves, as they have the financial and logistical means to do so with ease.
Other asset classes, such as oil, are not as straightforward. As it wouldn’t make any sense for the ETF provider to physically purchase billions of dollars worth of oil barrels, they will instead invest in options, futures and forward contracts.
Nevertheless, irrespective of how the ETF provider chooses to inject investor funds into the underlying asset, the price of the ETF itself is executed on a second-by-second basis, during standard market trading hours.
So now that you know that ETFs are provided by well-known financial institutions, in the next section of our guide we are going to explore how you can invest in one.
How do you invest in them?
Without attempting to confuse you further, it is important to note that in most cases, you will need to invest in an ETF via a third-party broker, as opposed to doing it directly with the ETF provider. The reason for this is that ETF providers do not have the required framework to facilitate small buy and sell orders, as they are best suited for institutional-grade money.
With that being said, investing in an ETF via an online broker is now super easy. In fact, competition is extremely fierce, meaning that the costs of investing are now at record lows.
First and foremost, you will need to go and open an account with your chosen broker. If you’re a first time user, then you might want to consider the likes of eToro. The online broker not only offers a user-friendly platform, but it also accepts multiple payment methods. This includes debit/credit card deposits, as well as e-wallets like PayPal and Skrill.
Most importantly, the eToro platform facilitates the buying and selling of more than 145 individual ETFs. As such, you can choose to speculate on the price going up and down.
Once you head over to your chosen online broker to open an account, you will initially need to provide some personal information. This is industry-standard and will require information pertaining to your name, address, nationality, date of birth, and social security number (if applicable).
Before you can invest in your first ETF, you will also need to verify your identity. Standard anti-money laundering (AML) laws dictate that you will need to upload a copy of your government-issued ID, and you might also need to supply proof of your current address.
As soon as you’ve done this, you can then proceed to deposit some funds. If you go with eToro, you’ll need to make a deposit of at least $200.
Once you’re all set-up with a fully funded account, you can then navigate through the ETFs that the broker offers. At this point, you will need to determine how much you want to stake, and perhaps, more importantly, whether you want to buy or sell the ETF.
If you buy the ETF, this means that you think the price will rise. If you sell the ETF, you are speculating that its value will go down.
When you’ve finalized the trade, you can sell your ETF at any time, as long as it’s during market hours.
What Fees are Involved?
As we have discussed extensively in this guide thus far, ETFs are provided by established financial institutions. In return for facilitating the respective ETF index, these institutions will charge a fee. This is where things get a bit confusing.
Traditionally speaking, ETFs charge something called an ‘Expense Ratio’. This is expressed as a percentage of the amount of money you have invested in the ETF and is charged on an annual basis.
According to the Wall Street Journal, the average Expense Ratio charged on ETFs is 0.44%. As such, a $10,000 investment would cost you a mere $44 per year. In the grand scheme of things, this offers excellent value, especially when you consider the ease at which you can invest in complex financial vehicles.
However, the somewhat oversaturation of the online broker space has meant that it is now possible to invest in ETFs without paying any fees.
This is the case with the previously mentioned eToro, who do not charge an Expense Ratio on any of the ETFs they offer, nor do they charge any commissions or annual maintenance fees. Instead, the platform makes its money from the spread.
Note: The spread is the difference between the ‘Bid Price’ and ‘Ask Price’. The smaller the spread, the more cost-effective it is for the investor.
Do ETFs pay Dividends?
Whether or not an ETF pays dividends will depend entirely on the specific asset or group of assets that the respective ETF is tracking. For example, if the ETF is tracking a group of shares listed on the NASDAQ, it is likely that the ETF will pay dividends as and when they are distributed, if applicable.
However, this will only be the case if the ETF provider actually owns and holds the underlying shares. If they don’t, they won’t be eligible for dividends, and thus, you won’t receive them.
On the other hand, if you are investing in a non-stock-based ETF, such as oil, gold or real estate, then naturally you won’t have the opportunity to earn dividends.
Ultimately, if earning dividends is your primary investment goal, then ETFs might not be the best way to go about it. Instead, you might be best to purchase the stocks and shares directly.
If you’ve read our guide from start to finish, then you should now have a firm understanding of what an ETF is, how they work, and most importantly, whether or not they meet your investment goals.
Overall, ETFs are a highly useful financial vehicle, not least because they allow you to speculate on assets that would otherwise be challenging to invest in. Whether its a real estate market, commodities like oil and gold, or an entire stock market index, ETFs can facilitate this at the click of a button.
The great news for you as an investor is that it is now possible to invest in ETFs on a fee-free basis, meaning you are no longer required to pay an annual Expense Ratio.
Download our FREE
“Stock Market Playbook” eBook
Learn everything you need to know to invest your first $500 in the stock market and become a do it yourself investor
Founder of The Modest Wallet, Ricardo is an entrepreneur and investor who enjoys working out, spending time with his family and friends, travelling and creating great content. He’s passionate about helping others achieve their financial goals.