Learn how exchange-traded funds (ETFs) can potentially offer diversification and income
Understand the risks and potential tax consequences of ETF investing
Take your investment objectives, risk tolerance, and time horizon into consideration as you research ETFs
Doing a little shopping for your portfolio this season? Perhaps you should consider exchange-traded funds (ETFs) as a potentially lower-cost investment for pursuing your investing objectives.
But before you jump in and start to pick ETFs, take a moment to do a bit of online shopping and assess the fit, style, and value.
ETFs are baskets of securities that typically track a sector-specific, country-specific, or a narrow- or broad-market index and are thus considered to be passively managed. (In other words, someone isn’t actively choosing which stocks to buy and sell.) They’re listed on exchanges just like stock, so you can conveniently trade them through your brokerage account. Keep in mind that the risks you face when trading equities are the same risks that you face when trading ETFs. And ETFs can offer some potential benefits:
- Diversification. With ETFs, you can distribute investments across sectors, subsectors, and asset classes. You can target specific indices, commodities, or international markets. Potential income. Many ETFs have historically paid dividends, so some investors choose ETFs as an alternative, or an addition, to other income stocks. But remember that dividend payments are never guaranteed.Potential tax benefits. The tax implications on ETFs can be complicated and vary depending on the asset class and structure. In general, an ETF investment isn’t taxed at the investor level until you sell it. Mutual funds, in contrast, incur a potentially taxable event each time a security is sold, and capital gains may be passed through to the investor level. But remember: Taxation can depend on how long you hold an ETF. Speak with your tax advisor about your specific circumstance, as TD Ameritrade does not offer tax advice. And if you’re assessing the pros and cons of ETFs versus mutual funds, it’s important to understand the differences between the two.
As You Shop: Comfort, Style, Value
When you browse your favorite online retailers, say to buy some new loungewear, athleisure attire, or a new pair of shoes, you likely look at three things—comfort, style, and value. Shopping for an ETF involves pretty much the same considerations. Here are some ideas of what you may want to consider when looking for an ETF.
- Comfort level—risks. The risk of an index ETF is typically the same percentage risk as the index it tracks so some of the risks can be significant. The risks of sector-based ETFs depend on the basket of stocks they track, including the weighting of each stock. Because you can choose broad-based indices or narrower industry choices, index and sector ETFs can be a starting point for some investors.Comfort level—complexity. ETFs have gotten more specialized—some would say more complicated—over the years. Experienced investors might consider “hybrid” ETFs that are leveraged, inverse, or sometimes both. Special risks are associated with these funds. Before trading these very distinctive products, be sure to learn the risks, and keep in mind that many are intended for very short holding times, often as short as one day.
- Style—active and passive. Some of the best ETFs can used by both active and passive market participants. For the active trader: Many ETFs can be shorted, hedged (with an offsetting position), or bundled (buying several at one time as a potential cost-saver), and many have options traded on them. Active traders might consider ETFs as a diversifier to help deal with potential “surprises” that can accompany trading individual issues of stock. Passive (“buy-and-hold”) investors might also consider ETFs. Many ETFs are indexed to a benchmark, making them a popular choice among the buy-and-hold crowd. Also, many ETFs are designed for targeted exposure to specific sectors, industries, and geographies.
- Value—taxes, expense ratios, and transaction costs. ETFs are considered by many to be tax efficient, as you’re generally required to pay taxes only on closed positions that realize capital gains. In other words, they are generally treated like stocks for tax purposes. Annual expenses for ETFs are often low, ranging between 0.1% and 0.65%, according to fund-tracker Morningstar.
A Few Shopping Tips
As you look through the investment universe to find the best ETF candidates for you, look at key metrics for each fund you’re considering—performance statistics, ratings, and expense ratios, to name a few. But it may also help to know yourself—your investing objectives, time horizons, and risk tolerance. Here are a few things to consider:
As you pick ETFs, first determine what you’re investing for.
- Is your investment style conservative, aggressive, or somewhere in between?Do you plan to invest for the short, intermediate, or long term?Are you diversifying your portfolio by incorporating various sectors, asset classes, and markets?Are you looking for an alternative way to enter the market?
Do your research.
- Take advantage of the tools and resources offered by most providers.Look at historical performance, analyst reports, and screeners.
Be mindful of expense ratios.
- Look at expense ratios within the actual funds.
Time to Hit the Market?
Ready to start your search for the best ETFs for you? TD Ameritrade clients can start with the TD Ameritrade ETF Market Center, which provides a broad selection of ETF research tools and third-party market insights/analyses. And, it’s home to an extensive list of ETFs, which can provide you with a wide range of potentially low-cost investment opportunities.
Carefully consider the investment objectives, risks, charges, and expenses before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.