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What Are Exchange-Traded Funds (ETFs)?

Investing your money can help you build wealth, but it’s a misconception to think that you need a lot of money to get started. Whether you’ve got $50,000 or $500 to play with, you can make a dent in your savings goals (like retirement) if you know where to put your money. While you could go with stocks or bonds, exchange-traded funds (ETFs) can offer a lot of bang for your buck.

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What Is an Exchange-Traded Fund?

Exchange-traded funds combine features of both stocks and index funds. They track market indices but unlike a mutual fund, they can be traded like stocks. Exchange-traded funds track widely known indices like the S&P 500 or the Dow Jones Industrial Average, but they can also track smaller indices associated with a particular market segment such as biotechnology.

How ETFs Compare to Other Investments

What Are Exchange-Traded Funds (ETFs)?

Exchange-traded funds offer a lot of advantages over individual stocks or actively managed funds, especially for newbies who haven’t quite mastered the ins and outs of the market. For one thing, having ETFs in your portfolio means you get more diversity than you would by purchasing individual stocks. While they’re still subject to market volatility (price changes), you might be able to minimize your losses by choosing an ETF that tracks a broader index.

Similar to stocks, ETFs can be bought and sold throughout the day and their price fluctuates accordingly. With a mutual fund, the price is set once per day when the market closes. If you’re savvy about making trades, you may be able to leverage your investment in an exchange-traded fund to get a bigger return.

Related Article: How to Start Investing on a Shoestring

Why They’re a Good Pick for Beginners

Exchange-traded funds can be a good choice if you don’t have a lot of money to get started with because they don’t require a huge initial investment like many mutual fund offerings. Many mutual fund companies, for example, requires you to bring at least $3,000 to the table to invest in many of their funds. With an ETF, it’s up to you to decide how much or how little you want to invest.

Another upside is that unlike many mutual fund offerings, ETFs tend to carry fewer fees, which means you’ll be able to keep more of your investment income in your pocket. If you know nothing else about investment fees, you need to understand the expense ratio. This is the percentage of the fund’s assets that are used to cover expenses.

Some mutual funds can carry expense ratios as high as 2%, which doesn’t seem like much, but it can take a serious bite out of your earnings over the long haul. Some ETFs, on the other hand, can have expense ratios as low as 0.09%.

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Pay Attention to Trading Fees

What Are Exchange-Traded Funds (ETFs)?

Because brokers sell ETFs, you might pay a commission fee every time you buy one, just as you would if you were purchasing stocks. These fees vary widely from one brokerage account to the next, so it’s important to be clear on how much it’s going to cost.

To put things in perspective, if you’re investing $100 a month in an ETF and paying a $10 commission to the broker, you’d need to see a 10% return just to recover the cost. You also pay commission fees any time you sell an ETF, so if you’re making a lot of trades that can eat into your returns even further.

The Bottom Line

Exchange-traded funds have a lot of appeal for new investors based on their affordability and the potential for high earnings. Like with any investment, you’ll want to read over the fund prospectus carefully to make sure an ETF is a good fit for you and your financial needs and goals.

Photo credit: ©iStock.com/gong hangxu, ©iStock.com/Ximagination, ©iStock.com/MichaelDeLeon

Rebecca Lake Rebecca Lake has been writing about the nuts and bolts of personal finance for nearly a decade. She is an expert in investing, retirement and home buying topics. Her work has been featured on The Huffington Post, Business Insider, CBS News, U.S. News & World Report and Investopedia. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.
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