In recent years, exchange-traded funds (ETFs) have become increasingly popular. ETFs combine many of the traits that investors like in index funds with the ease of trading on the stock market. Choosing the right ETFs for your portfolio can provide you with solid returns--and keep your costs low.
What are ETFs?
Essentially, ETFs are funds that trade like stocks on an exchange. With an ETF, you receive exposure to a collection of investments, much as you would with a mutual fund. There are even index ETFs that track popular indexes--similar to the way index funds follow performances.
It's important to realize that this hybrid quality of ETFs means that you pay expense ratios, as you would with a fund, as well as a transaction fee (commission) as you would for trading a stock. So, if you purchase shares of an ETF, you will pay the transaction fee (as low as $4.95 with some brokers), as well as the expense ratio (which can be as low as 0.04 percent in some cases).
Choosing ETFs for Your Portfolio
If you want to add the right ETFs to your portfolio, you need to consider your situation, and then compare your choices from different brokers. As with all investing, you need to do your own research, and vet any assets before you add them to portfolio. While many consider certain ETFs to carry fairly low risk, you can still lose money investing in ETFs.
1. Figure out what asset classes you want to invest in: Your first step is to determine what asset classes you want to invest in. Consider your investment goals, and your ideal asset allocation to best reach those goals, while providing you with a degree of protection.
2. Look for ETFs that track those asset classes: Once you know which asset classes you want to hold in your portfolio, and percentage of each your portfolio should contain, you can look for ETFs that track those asset classes. There are ETFs that track equities (including foreign indexes), bonds, currencies, commodities, and real estate. Your asset allocation should reflect your investment goals and time frame. Find ETFs that will help you build a diversified portfolio.
3. Identify ETFs with low expense ratios: There are plenty of ETFs out there with expense ratios of less than 1 percent. If your portfolio needs are relatively simple, you can build a portfolio that includes dividend funds, bond funds, foreign indexes, REITs, and broad-market funds for a fairly low cost. You can also add other assets to the mix, if you have the risk tolerance. Even the most expensive ETFs rarely charge more than 2 percent for an expense ratio.
4. Look for brokers that offer commission-free ETFs: Another strategy is to consider brokers that offer commission-free ETFs. These are ETFs that the broker offers without charging you a transaction fee when you buy shares (there might be restrictions requiring you to hold the ETF for at least 30 days if you want to avoid a fee). Many brokers offer ETFs free of commission, although you still have to pay an expense ratio.
Once you have identified a few likely choices, it's time to begin investing. Use dollar-cost averaging to make the most of your investment dollar. Consistent ETF investing over a period of time can yield desirable results for your portfolio. And, because there are so many ETFs available, it's possible to completely diversify your portfolio using nothing but low-cost ETFs.
Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.