How to Invest in ETFs: The Process, Step by Step
ETF investing is the process of choosing an exchange-traded fund, buying it through a brokerage account and holding it on a plan. The steps that decide the outcome are what the fund holds, which cost you optimize for your holding period, and how and when you place the order.
Video: Michael Whitman on YouTube, a look at ETFs to consider buying. Watch it on YouTube.
This page is the process of investing through exchange-traded funds. For the vehicle itself, what the wrapper is and how it differs from a mutual fund, see What is an ETF?. For the fund most ETF investors end up holding, see What is an index fund?.
How it works
ETF investing comes down to five steps, and the order matters. Decide what you want to own. Read what the fund actually holds. Choose between similar funds on the cost that matches how long you will hold. Place the order with a limit price, away from the open. Then hold it on a plan, without stacking funds that overlap.
Most mistakes come from doing step four first. The fund is bought because the ticker is familiar or the price is moving, and the holdings, the costs and the plan get looked at afterwards, if at all.
Step 1: decide what you want to own
The three letters describe the container. Inside can be a broad index, one country, one sector, a commodity, a bond ladder, an options-selling strategy, or a leveraged derivative position.
So the first decision is the exposure, not the fund. A broad index, a single sector and a leveraged daily multiple are three different investments that happen to share a wrapper.
Check whether the fund is physical or synthetic. Most large equity trackers are physical and hold the actual shares. A synthetic fund holds a swap contract with a bank that pays the index return instead. It can track more closely and more cheaply, and it introduces a counterparty: if the bank fails, the fund’s exposure depends on collateral arrangements rather than on owning anything.
Synthetic structures appear more often in commodities and in hard-to-access markets, where holding the underlying is impractical. The fund document says which it is in one line, and it is worth reading before a long hold — not because synthetic is bad, but because it is a different risk from the one most buyers think they are taking.
Step 2: read the holdings, not the name
Names are chosen by marketing departments. The holdings page is the document that matters, and the top ten holdings plus the fee answer most of what you need to know in about a minute.
A concentrated fund tracking a narrow theme carries single-company risk with a diversified-sounding name. The holdings page is where that shows up; the fund’s name never will.
Step 3: choose on the cost that matches your holding period
Two costs matter, and the fee only shows one of them. The expense ratio is charged every year you hold. The spread, the gap between the price you can buy at and the price you can sell at, is paid every time you deal, and it is not in the fee.
Which one matters depends on how long you hold. Over decades the annual fee dominates and the spread is irrelevant; over months it is the other way round, and the published expense ratio only tells you about the first case.
Volume decides the spread. A large, heavily traded fund is cheap to deal in; a small one tracking the same index may cost several times as much to buy and sell.
So match the cost you optimize to your holding period. A decade-long holding should be chosen on fee; a three-month one on spread. Between two funds on the same index, the heavily traded one usually wins on both.
Step 4: place the order
You buy through a brokerage account at a live price, the same way you would buy a share in a company.
A limit order is the simplest defense against the spread. It sets the worst price you will accept, which matters because the traded price can drift from the value of what the fund holds. Large institutions exchange baskets of holdings for fund shares and back again, which keeps that drift small and short-lived on a heavily traded fund, but not at every moment.
The open is the worst time to deal. Underlying holdings have not all started trading, so the fund’s price is a guess for the first minutes and a gap makes it worse.
A stop can fill at a price unrelated to value. In a disorderly open a stop becomes a market order into a wide spread, which is the specific way these funds hurt people.
Ordinary trading costs apply. Any commission the broker charges comes on top of the spread and the fee, every time the fund is bought or sold.
Step 5: hold it on a plan
Buy on a fixed schedule. A fixed amount on a fixed date removes the decision the all-day price keeps inviting you to make.
Do not stack funds that overlap. Three broad funds frequently hold the same largest companies, which is one position with three fees. A three fund portfolio built from broad trackers is the classic way to get diversification without that overlap.
Where you hold it changes the tax. In a taxable account the structure often reduces capital gains tax, because the in-kind redemption process lets the fund shed low-cost holdings without selling them. The What is an ETF? page covers why a sheltered account usually comes first.
A worked example
Take a hypothetical $10,000 in a fund charging five basis points a year, with a twenty basis point spread. A basis point is one hundredth of a percentage point.
The fee is $5 a year: $10,000 × 0.05%. The spread is $20 for one purchase and one sale: $10,000 × 0.20%. So one round trip costs four years of management fee.
Held for ten years, the fee comes to about $50 (before growth), against the same $20 of spread paid once. The fee is the bigger cost, so a decade-long holding is chosen on fee.
Held for three months, the fee comes to about $1.25, against the same $20 of spread. Now the spread is sixteen times the fee, so a short holding is chosen on spread, and on a heavily traded fund.
Buying monthly in small amounts pays a spread on every purchase. That is usually still worth it for the discipline, and it is one more reason to pick a fund that is cheap to deal in.
What ETF investing is not
It is not a strategy. The wrapper says nothing about the holdings.
It is not automatically cheap. Fees range enormously.
It is not always passive. Many are actively managed.
And it is not free of the spread. That cost is invisible in the fee.
How this connects
The creation process is run by authorized participants acting as a market maker, and it works because arbitrage between the fund price and its holdings pays whoever closes the gap.
A closed-end fund has no such mechanism, which is why it can sit at a persistent discount to the value of what it owns.
Tracking error measures how closely a fund follows its index, and it is the check that matters once the fee and spread are known.
Some wrappers change the exposure entirely. A leveraged ETF resets its multiple daily, and an inverse ETF does the same in the opposite direction, so both drift from the simple multiple over longer holds.
Income variants exist too. A bond ETF holds a changing ladder of debt, and a covered call ETF sells options against its holdings.
The largest issuers are BlackRock and Vanguard, whose scale is a large part of why broad trackers are cheap.
When it fails
In a range the spread consumes the opportunity. Small moves against a fixed dealing cost means an active approach in a thinly traded fund can lose money in a market that went nowhere.
The second failure is buying a niche fund for a broad idea. Step 1 was skipped, and a theme fund was bought to do the job of a whole market.
A third is dealing at the open. Prices are least reliable in the first minutes.
A fourth is holding several that overlap. Step 5 was skipped, and the portfolio is one position paying several fees.
And a fifth is treating the ticker as the product. Two funds tracking the same index can differ by an order of magnitude in cost.
The original data
Of the 24,971 trading and investing videos in this site’s corpus, 434 have “ETF” or “exchange-traded fund” in the title at a median of 12,309 views across 306 channels. “Index fund” returns 132 at a median of 69,951 across 87 channels, “mutual fund” returns 38 at a median of 170,093. Each video is counted once, even when several searches returned it.
The question: Two funds, same index, different fee. Which?
The contrast between those first two figures is the useful one. More than three times as many videos cover the wrapper as cover the thing most people should actually buy, and each index-fund video reaches nearly six times the audience. The supply is concentrated on the container and the demand is on the contents — and between two funds on the same index, the expense ratio is the single number that decides most of the outcome.
Related
What is an ETF? explains the vehicle this process buys. How to choose an index fund is step 1 for the most common case: picking the index, then the fund. Mutual funds is the once-a-day alternative. And sector ETF covers the concentrated versions and what they cost.
Open the holdings page before the fact sheet. Names are marketing. A fund’s top ten holdings can look nothing like what the title implies, and the fee can be well above what those holdings should cost.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.