Investments in the stock market can be risky for new entrants because of high volatility. Performing stocks may lure beginner investors for higher returns but can frequently take U-turns without giving you ample time to come out. Getting setbacks earlier can demotivate you. So, it is better to start investment with safer instruments that have a lower risk profile and are less volatile. In this article we explore ETFs and why they are a good choice for beginner investors.
ETFs have Inherent Diversification
Diversification is suggested to avoid heavy losses in case of unfavorable events and news. Diversified investment means having money parked in multiple stocks of different sectors rather than a few selected stocks. Diversification can be tricky and time-consuming for new investors. Diversification can be easily achieved with the help of ETFs.
Since ETFs are a basket of assets that derive their value from underlying indices, they are self-diversified instruments. Heavy rise or fall in one particular stock will not have a significant effect on ETF value. Instead, they capture broader market movement. They provide returns proportional to index performance rather than particular stock. So, you have to be less worried about diversification if you have invested in ETFs.
ETFs offer Low Investment Threshold
The minimum funds requirement is minuscule for initiating investment in ETFs, unlike mutual funds where you are usually required to make an initial investment of $1000 or more. The investment threshold may be as high as $100,000 for some sector-specific mutual funds. A low investment threshold means you can start your investment journey with very less funds and it is advisable also to grow your portfolio gradually and keep your risk exposure minimum when you are a beginner.
Investment Decision for ETFs Take Less Time and Effort
Before making any investment, it is necessary to assess the fund in these three parameters:
- Risk profile
- Expense ratio
ETFs have a low-risk profile because of inherent diversification and strong regulations. They are also more liquid compared to mutual funds and are available at a better expense ratio. The expense ratio measures the operating cost of the fund. For ETF investments, the expense ratio is usually less than 1% because they are not managed actively thus lowering the fees of management.
Availability of Wide Variety of ETFs
ETFs cover a broad spectrum of markets. They are available in plenty of asset classes like equity (like international stocks ETFs, sector-based ETFs, or even more specifically dividend ETFs which are pools of stocks that have paid dividends in the past), bonds (Bonds ETFs are available in government treasury bonds, financial institutions bonds and even bonds issued by private companies), commodities (gold, silver, crude oil, etc.), and currencies. They are available in almost all-important indices. The number of available ETFs worldwide has grown to 8754 in 2022 from just 276 in 2003 which is almost 3000% as per Statista. In the U.N. itself there are 2,844 index-bases and actively-managed ETFs worth $6.5 trillion.
ETFs Reflect Broader Market Trends
Since the price of ETF is based on an index or a pool of assets having hundreds of companies, they reflect a broader market trend. Your fate is not tied to a single stock or commodity.
ETFs have Low Transaction Cost
Total cost ETF transaction is the sum of operating expenses, commissions, Bid/ask spreads, and discounts and premiums to NAV.
Operating expense reflects the charges of management of the portfolio and is charged at an annual rate. Expense ratios vary from fund to fund and from time to time.
The average expense ratio for equity ETFs is around .16%. The commission is charged by the broker to facilitate the transaction.
Commission charges have come down drastically in the past few years and can be even $0 in the case of discount brokers. They are charged on a flat basis.
Bid/ ask spread can also add significant cost to your trade if you are a frequent trader. This cost is higher in the case of ETFs with lower liquidity and dependent on market conditions.
Discounts and Premiums to NAV can also add to the actual cost of ETFs because ETFs are not traded exactly at the underlying asset’s price but at a slightly higher price (premium) or slightly lower price(discount).
ETF offers High liquidity
ETFs can be easily converted into cash with minimum effort and time because of high liquidity. Thus, providing quick ETFs offers quick access to money when you need it. ETFs are more like stocks and can be traded on brokers’ platforms. You can trigger buy or sell orders whenever you want, unlike mutual funds.
To buy ETF you need a broker account. You can place a buy order from the broker terminal for whichever ETF you have decided to buy. You can buy at market price or place a limit order to buy at a preferred price.
ETF is a good option for long-term investing because you do not need to analyze balance sheets, business news, and management changes of a particular company. You just need to follow an index which is comparatively an easy task.
You can also use ETFs but should only prefer funds with very high liquidity and low transaction fees.
Buying ETF when trading at a high premium and selling when trading at a high discount is a bad idea and can reduce your return.
ETFs with high ask/ bid spread should be avoided as they have less liquidity.
Buying leveraged ETFs can be a risky step.
Make sure to analyze the expense ratio of various available ETFs for the desired sector or index to get the best out of your investment.
State Street SPDR S&P 500 is the biggest ETF in the United States with $426.6 billion assets under management as per Statista report July,2023.
Tax is dependent upon how long you hold the ETF. If you hold it for less than a year then you will be taxed under the ordinary income rate and if you hold it for more than a year then you will be taxed as per long-term capital gain tax.
You can consider buying ETFs over a mutual fund because of their low operational expense and high liquidity. They are also better from a tax viewpoint as you have to pay capital gain tax only on the sale of ETF, unlike mutual fund which creates tax liability even if you are holding it.
Yes, you can buy Bitcoin ETFs in the U.S. They use future contracts of Bitcoin as the underlying asset. Proshares Bitcoin Strategy ETF was the first Bitcoin ETF of the U.S.A. which was approved in 2021.
ETFs do not have a value of their own. They derive their value from underlying assets. If the underlying asset performs well, you will good return and if it doesn’t you can end up having a negative return also.
These four costs are associated with ETFs: operational expense, brokerage, bid/ask spread, premium, and discount to NAV.