ETFs can be smart investments for almost any kind of investor, from professional money managers to beginners. In this article, we take a deep dive into how ETFs work and cover the different types of ETFs, and then we finish with a list of the best ETFs for beginners to start building a portfolio.
What Are ETFs?
ETFs, or exchange-traded funds, are investment funds that are traded on stock exchanges, similar to individual stocks. They are designed to provide investors with a way to buy and sell a diversified portfolio of assets, such as stocks, bonds, commodities or other financial instruments in a single security.
Why Are ETFs Good Investments for Beginners?
ETFs are often considered good investments for beginners for several reasons:
Diversification: ETFs typically hold a basket of underlying assets, such as stocks, bonds or commodities. This diversification helps spread risk across multiple investments, reducing the impact of poor performance from a single security. For beginners, diversification can be a key strategy for managing risk.
Simplicity and accessibility: ETFs are easy to understand and easy to trade. ETFs also offer access to a wide range of asset classes and investment strategies.
Professional management: ETFs are managed by professional fund managers who make investment decisions on behalf of shareholders. For beginners, this means that experts are managing the portfolio, potentially reducing the need for extensive research and stock-picking skills.
Tax efficiency: Many ETFs are structured in a way that can make them tax-efficient. For example, ETFs use in-kind creation and redemption processes that can minimize capital gains distributions.
Low cost: ETFs often have lower expense ratios compared with traditional mutual funds. Lower expenses can lead to higher returns over time, which is particularly beneficial for long-term investors.
Variety of investment strategies: ETFs offer a wide range of investment strategies, including passive index tracking, active management and factor-based investing. This variety allows beginners to choose strategies that align with their investment objectives.
Low minimum investments: ETFs typically have low minimum investment requirements, which is typically the price of one share. This allows beginners to start investing with relatively small amounts of capital.
Education and resources: Many financial institutions and brokerages offer educational materials and resources to help beginners learn about ETFs and investing. This support can help individuals make informed investment decisions.
Different Types of ETFs
ETFs come in various types, each designed to provide exposure to different asset classes, investment strategies or market segments. Here are some of the main types of ETFs that may be appropriate for beginning investors:
Equity ETFs: These ETFs invest primarily in stocks, offering exposure to various stock markets, industries, sectors, regions or styles such as growth or value. They aim to replicate the performance of specific stock market indexes.
Fixed-income ETFs: Fixed-income ETFs invest primarily in bonds, providing exposure to various types of debt securities, including government bonds, corporate bonds, municipal bonds and more. They aim to replicate the performance of bond indexes.
Commodity ETFs: Commodity ETFs invest in physical commodities like gold, silver, oil or agricultural products, or they may use futures contracts to gain exposure to commodities. They allow investors to participate in commodity price movements without having to own the physical goods. Note that commodities generally produce low returns over the long term but have low correlation to other assets, meaning that their prices can go up while others are going down, making commodities more of a diversification tool than a growth investment.
Sector ETFs: These ETFs focus on specific sectors or industries of the economy, such as technology, healthcare, financials or energy. They provide targeted exposure to specific areas of the market.
Style and factor ETFs: Style and factor ETFs emphasize specific investment styles or factors like value, growth, dividend yield or low volatility. They allow investors to tilt their portfolios toward particular investment characteristics.
Smart beta ETFs: Smart beta ETFs combine elements of both passive and active investing by using rules-based strategies to select and weight securities within an index. They aim to outperform traditional market-cap-weighted indexes.
Active ETFs: Active ETFs are actively managed, meaning a portfolio manager actively selects and trades securities within the ETF to achieve specific investment objectives. They offer flexibility and the potential for outperformance but come with higher fees.
Thematic ETFs: Thematic ETFs focus on specific themes or trends, such as clean energy, robotics, artificial intelligence or cybersecurity. They allow investors to align their portfolios with emerging trends.
Dividend ETFs: Dividend ETFs focus on companies that pay dividends to shareholders. They can provide income and may be attractive to income-oriented investors or for those who are seeking more stable long-term growth compared to the more aggressive growth stock funds.
International ETFs: These are ETFs that generally focus on stocks of companies based outside the U.S. They may also provide exposure to specific countries or regions around the world.
How to Choose the Best ETFs for Beginners
Although beginners are often long-term investors and can accept more market risk than older investors, the strategy for choosing the best ETFs is similar for all investors. These steps begin with identifying a time horizon and risk tolerance, guiding the portfolio's asset allocation and specific ETF selection.
The basic steps for choosing the best ETFs for beginners are:
Identify your time horizon: How long will you hold the ETF? Generally, the longer your time horizon, the more risk you can take with your investments.
Gauge your risk tolerance: How comfortable are you with market fluctuations? Higher risk investments, such as stock ETFs, will generally produce higher long-term returns, but they may also have more pronounced short-term declines in value compared with more stable investments, such as bond ETFs.
Determine your asset mix: Also known as asset allocation, your asset mix is a reflection of your risk tolerance and time horizon. For example, higher risk tolerance and a time horizon of more than 10 years may call for a higher allocation to stocks. Lower risk tolerance and short time horizons are more suitable for more stable investments, such as bond ETFs.
Choose the best ETFs for you: Select among the different types of ETFs and be sure that the fund(s) you choose align with your time horizon and risk tolerance from previous steps.
Choose a portfolio structure: Like any other construction, you need a design for your investment portfolio. While some may like a simple, equal allocation, such as four ETFs with 25% allocated to each fund, another good structure is called "core and satellite." As the name suggests, you begin with a core holding like an S&P 500 index fund and build around it with the satellite holdings.
With thousands of ETFs to choose from, deciding on the best ETFs for a beginning investor can seem intimidating. In general, the top criteria for choosing ETFs are high assets under management, or AUM, and low expenses. Based upon those simple criteria, here are 10 examples of the best ETFs for beginners to choose from when building a portfolio:
iShares Core S&P 500 ETF (IVV): This ETF from BlackRock checks the boxes on size, diversification, and low cost. IVV is the second-largest equity ETF, and it tracks an index of the 500 largest U.S. publicly traded companies, offering diversification and long-term growth. IVV’s AUM is $441 billion, and its expense ratio is one of the lowest on the market at 0.03%.
Vanguard Total Stock Market ETF (VTI): Vanguard is known for its low-cost ETFs and mutual funds. VTI offers broad diversification as it tracks an index that replicates the performance of the entire U.S. stock market, including large-cap, midcap and small-cap stocks. VTI’s AUM is $374 billion, and its expense ratio is 0.03%.
Invesco QQQ Trust (QQQ): For beginners who want a more aggressive growth ETF, QQQ tracks an index of the top 100 stocks in the NASDAQ index. This tilts QQQ’s portfolio heavily toward the technology sector. QQQ’s AUM is $227 billion, and its expense ratio is 0.20%. For a lower-cost version of QQQ, beginning investors can consider Invesco NASDAQ 100 ETF (QQQM), which has $22 billion in assets and an expense ratio of 0.15%.
iShares Core S&P Small Cap ETF (IJR): Since many broad market ETFs lean heavily toward large-cap stocks, a small-cap ETF like IJR can add diversity to a portfolio. IJR is the largest small-cap fund on the market with $77 billion in AUM. The expense ratio for IJR is among the lowest in its category at 0.06%.
Vanguard Total International Stock Index ETF (VXUS): VXUS tracks an index that covers 98% of the investable market capitalization outside of the U.S. This broad diversification makes VXUS a good choice for beginners wanting exposure to foreign markets. AUM for VXUS is $69 billion, and its expense ratio is 0.07%.
Vanguard Total Bond Market ETF (BND): BND enables investors to cover the entire U.S. bond market in one low-cost security. The first ETF to cross $100 billion assets, BND’s AUM is $104 billion, and its expense ratio is 0.03%.
Vanguard Dividend Appreciation ETF (VIG): The largest dividend ETF on the market, VIG focuses on stocks of companies that have a history of increasing their dividends consistently over time. VIG’s AUM is $76 billion, and its expense ratio is 0.06%.
Schwab U.S. Dividend Equity ETF (SCHD): For investors wanting higher yields, and potentially higher long-term returns than dividend funds like VIG, SCHD can be a good alternative. AUM for SCHD is $54 billion, and its expense ratio is 0.06%.
SPDR Gold Shares (GLD): Beginners seeking to add some diversification to a portfolio with commodities may want to consider a large gold fund like GLD, which tends to have low correlation with other assets like stocks and bonds. GLD’s AUM is $62 billion, and its expense ratio is 0.40%. Investors wanting more diversification may consider a broad-basket commodity fund like Invesco DB Commodity Tracking Index (DBC).
VanEck Semiconductors ETF (SMH): For investors who want to invest in technology that can benefit from artificial intelligence, and don’t mind taking on more risk in exchange for the potential for higher long-term returns, SMH is the best performing ETF in the past 10 years and can be a good addition to a growth-oriented portfolio. SMH's assets are $18 billion, and its expense ratio is 0.35%.
Tip: When researching ETFs, an excellent tool to use is etf.com’s ETF Screener. If you want to compare ETFs, use etf.com’s ETF Comparison Tool.
Data as of May 1, 2024. This list is for educational purposes only. Past performance is no guarantee future results.
How to Get Started Investing in ETFs
To invest in ETFs, you will need an investment account, which may be an individual brokerage account, a joint brokerage account, or any variety of individual retirement account. Once you have the investment account open, you will need to fund it with cash, and you’ll be ready to invest in ETFs.
The basic steps to invest in ETFs are:
Open an investment account: Most brokerages will offer ETFs, but the largest investment companies that offer ETFs include Vanguard, Charles Schwab and Fidelity.
Fund the investment account with cash: Investors typically link a bank account to their brokerage account to transfer cash and make deposits. You can also set up a systematic investment plan and invest a fixed dollar amount over a specified frequency, such as once per month.
Select the ETF(s) to purchase: When your brokerage account or IRA is funded, and you’ve researched ETFs suitable for your goals and risk tolerance, you’re ready to buy shares.
Execute the trade(s) to buy shares: Most beginners will place what’s called a market order, which is an order to buy or sell a stock at the market's current best available price.
Is It OK to Start Investing With Just One ETF?
When getting started building a portfolio, it's not only acceptable to start with one exchange-traded fund, but it may also be necessary. Investors who aren't able to buy multiple ETFs in the beginning, can start with a core holding, such as an S&P 500 index fund or a total stock market index fund. From there, an investor can build around the core with other ETFs that add diversity to the mix, such as fixed-income funds and sector funds.
Bottom Line on the Best ETFs for Beginners
While ETFs offer many advantages for beginners, it's important to do some research, understand the specific ETFs you're interested in, and develop an investment strategy that aligns with your financial goals and risk tolerance. Additionally, seeking guidance from a financial advisor or using educational resources on ETFs can be valuable when starting your investment journey.
