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ETFs are a popular choice for investors looking for an easy, low-cost way to diversify their portfolio. But how exactly do ETFs work, what are the different types of ETFs available, and how can you use them to make money? Keep reading to find out.
ETF stands for exchange-traded fund. An ETF is a fund that pools together investors’ money to buy a diversified range of assets, such as stocks and bonds. So when you buy a share in an ETF, you gain immediate exposure to a whole basket of securities.
ETFs are created by fund managers and ETF issuers. Just like investing in stocks, you can buy and sell shares in ETFs on stock exchanges like the New York Stock Exchange (NYSE). ETF prices fluctuate throughout the day, and you can buy and sell them at any time during stock market trading hours.
Many popular ETFs are designed to track major market index or commodity performance. For example, some funds aim to mimic the performance of the S&P 500 by investing in companies featured in the index. Investments are also weighted to accurately reflect the index — so if Amazon (AMZN) represents 3% of the S&P 500, it will also make up 3% of the ETF’s investments.
But there are also thematic ETFs that target specific market sectors or industries, such as tech stocks, renewable energy or global stocks.
Other ETF features include:
There are 3 ways to make money from ETFs:
Passive and actively managed stock ETFs are far from the only types of ETFs you have to choose from. Other ETF types include:
But there are also a couple of other stock ETFs available:
As with any other type of investment, ETFs have tax implications.
When you sell your shares in an ETF, you’ll pay tax on any capital gains. ETFs you’ve held for more than a year are taxed at the long-term capital gains tax rate, which ranges from 0% to 20% based on your income and filing status. If you’ve held the ETF for a year or less, you’ll pay short-term capital gains tax at the same rate as your income tax rate.
You’ll also need to pay tax on ETF dividend and interest payments. Ordinary dividends and interest payments are taxed at the same rate as your regular income, and you’ll need to report them on your 1099 statement.
However, the tax rules can differ for some other types of ETFs, so speak to a tax professional for advice based on your specific financial situation.
For a novice investor, it can be difficult to tell the difference between an ETF and a mutual fund. Both types of funds invest in a basket of assets, providing easy diversification, but they also have a few key differences:
Generally speaking, yes. If you’re a novice investor, there are several reasons why you might want to consider investing in ETFs.
ETFs offer a simple and convenient way to build a diversified portfolio. They’re easy to buy through online brokers, you can get started with a small amount of money and you’ll pay a lot less in brokerage fees than if you invest in individual stocks.
Of course, you’ll also need to consider management fees, and while ETFs often come with lower risk than investing in individual stocks, they don’t offer the same potential for high rewards. As for leveraged and inverse ETFs, those are better suited to more experienced investors.
Before investing in any ETF, take some time to read its prospectus. This document lays out all the essential information you need to know about a fund. Make sure you check:
ETFs are worth considering for both novice and more experienced investors, offering an easy and inexpensive way to gain exposure to a diverse portfolio of assets. However, it’s important to understand how ETFs work and compare a range of funds before deciding where to invest your money.
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