10 Things Every Investor Needs to Know about ETFs

by on August 6, 2012 | Updated May 27, 2014

Exchange-traded funds have found their way into countless portfolios as investors of all walks and styles have embraced the cost-efficient nature of these vehicles. With innovation however comes complexity, and while ETFs are incredibly versatile and easy to use, investors still need to do their homework and take a good look under the hood before jumping into a position. ETF education is most certainly an ongoing process, and as such, below we cover ten questions about the industry and the products that many are hesitant to ask [see also 101 ETF Lessons Every Financial Advisor Should Learn].

1. How do you buy an ETF?

ETFs are bought and sold like any regular stock. You will need a stockbroker to handle the trade, and the broker may charge you a commission. Many brokerages have started offering commission-free trading for selected lists of ETFs. Unlike mutual funds, ETFs cannot be bought or sold directly from the sponsor by regular investors [see also 3 ETF Trading Tips You Are Missing].

2. Are ETFs only for stocks?

Although ETFs trade like stocks and on the major stock exchanges, ETFs are not limited to owning stocks. ETFs can own stocks, bonds, currencies, commodities, futures contracts, and almost any other financial asset [see How To Pick The Right ETF Every Time].

3. Why would I want to own an ETF?

ETFs give investors many advantages. Owning an ETF can give an investor a position in a diversified portfolio of stocks or bonds that would be too difficult or expensive to build for themselves. ETFs also allow investors own assets like gold or foreign-listed stocks that may be difficult or expensive for a regular investor to buy, hold, and sell. ETFs can also offer investors lower expenses and more efficient tax management than mutual funds.

4. Are ETFs the same as REITs?

ETFs are very different than REITs. A REIT (or real estate investment trust) is an actual operating company – one with offices, employees, and day-to-day business operations. REITs are required by law to focus on buying, developing, or managing real estate properties (or earning dividends or interest related in some way to real property) and are required by law to pay out a very large percentage of their earnings as dividends [see also Five Important ETF Lessons In Pictures].

An ETF is not an operating company – it is a fund established by a fund sponsor (often a bank or asset manager) designed to hold specifics assets (like stocks or bonds).

5. Is my money safe?

With stories of brokerage executives dipping into client money still in the news and the memory of Bernie Madoff still fresh, this is a good question. Luckily for investors, all listed ETFs have to have a trustee – a financial institution (often, but not always, a bank) that actually holds the assets of the fund. While the presence of a trustee does NOT guarantee that the value of the fund’s assets won’t go down, it does provide security that investors’ funds will not be plundered by the fund’s managers or sponsors [see How To Deal With ETF Closures].

6. Are ETFs and ETNs the same thing?

No, they are not the same thing. While an ETF is in many respects similar to a mutual fund or a closed-end fund, an ETN (exchange-traded note) is actually an unsecured synthetic debt instrument. In creating an ETN, a bank promises to pay the returns (minus fees and expenses) earned by whatever index to which the ETN is benchmarked. Unlike an ETF, there are no specific assets backing the ETN other than the assets and credit of the underwriting bank(s).

7. Is buying a leveraged ETF like buying stocks on margin?

No, leveraged ETFs are very different than buying stocks on margin. Leveraged ETFs do not charge fundholders interest. What’s more, these funds are designed to match the leveraged returns of their benchmark index on a day to day basis, and that requires daily rebalancing – this creates a phenomenon called “volatility drag” and means that a leveraged ETF held for a period of weeks or months is very likely to underperform the leveraged return on the benchmark [see also The Ultimate Guide To Leveraged ETFs].

8. Are ETFs cheaper to own?

It depends. While ETFs with large amounts of assets under management are often cheaper than similar mutual funds, this is not necessarily the case for smaller funds. There are certain fixed costs that are all but unavoidable for an ETF sponsor or manager. These can significantly inflate the annual fees and expenses as a percentage of fund assets for small funds [see also Cheapskate ETFdb Portfolio].

9. Does the ETF sponsor matter?

From the starting point of just one sponsor, there are now over a dozen ETF sponsors offering ETFs and ETNs to the market. Often times an index manager will give an exclusive license for a particular index and there will be only one ETF sponsor offering a product to match that particular index. Furthermore, ETF sponsors have different policies on fees and expense structures, as well as different levels of marketing support and willingness to keep funds open below a certain level of assets.

10. Can I have my ETF dividends automatically reinvested?

Generally speaking, the answer to this question depends upon your broker. While most brokers now offer automatic dividend reinvestment for eligible/qualified securities, some charge commissions or fees to do so. Unlike with mutual funds, though, it is the broker and not the mutual fund that is handling the reinvestment process [see Monthly Dividend ETFdb Portfolio].

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Disclosure: No positions at time of writing.