How to Make Money With ETFs: Fundamental Approaches

An Exchange Traded Fund (ETF) is a collection of investments (e.g., stocks or bonds), bundled into a single fund that trades on major stock exchanges. This article explains how investors can generate returns by investing in these funds. ETFs offer a diversified approach, combining mutual fund diversification benefits with stock trading flexibility.

Understanding ETF Returns

ETFs offer investors two ways to generate returns: capital appreciation and income distributions. Capital appreciation occurs when an ETF’s value increases. Selling shares for more than their purchase price results in capital gain.

ETFs also provide returns through income distributions. Equity ETFs provide dividends from underlying stocks. Bond ETFs distribute interest from underlying bonds. These pass through to the investor as a regular income stream. Both contribute to an ETF’s overall profitability.

Choosing ETFs for Your Goals

Selecting an ETF involves aligning it with investment objectives. ETF categories serve distinct financial goals. Equity ETFs aim for capital growth and dividend income for long-term growth. Bond ETFs provide steady income and portfolio stability, appealing to conservative or income-focused investors.

For diversification or inflation hedging, commodity ETFs expose investors to raw materials like gold or oil. Sector or industry ETFs focus on specific economic segments, to target areas for outperformance. International or global ETFs offer geographic diversification by investing in non-domestic companies.

When evaluating ETFs, several factors warrant consideration. Expense ratios, annual management and operational fees, impact returns; lower ratios retain more earnings. Liquidity, the ease of buying or selling an ETF without significant price impact, is important for efficient trading. Tracking error measures how closely an ETF’s performance mirrors its underlying index; lower error indicates better replication.

Implementing Investment Approaches with ETFs

ETFs can be used in common investment approaches for financial goals. Long-term holding is a straightforward strategy, where investors hold ETFs for sustained capital appreciation. This emphasizes patience, allowing investments to grow without frequent trading.

Dividend reinvestment is an approach for income-generating ETFs. By automatically reinvesting dividends from an ETF into more shares, investors compound returns. Many brokerage firms offer Dividend Reinvestment Plans (DRIPs) that facilitate this without additional fees.

Dollar-cost averaging involves investing a fixed amount at regular intervals (e.g., monthly or quarterly), regardless of the ETF’s price. This reduces market volatility’s impact by acquiring more shares when prices are low and fewer when high, lowering the average cost per share. It promotes consistent investing and removes the need for market timing.

Asset allocation with ETFs involves combining different ETF types (e.g., equity and bond funds) to construct a diversified portfolio. This balances risk and return by distributing investments across asset classes based on an investor’s risk tolerance and goals. For example, growth-oriented investors might allocate more to equity ETFs, while conservative investors might favor bond ETFs for stability and income.

Executing ETF Transactions

Purchasing and selling ETFs requires a brokerage account, an intermediary for transactions. Online brokerage firms are common due to accessibility and lower costs. Investors can choose individual, joint, or tax-advantaged retirement accounts (e.g., Traditional or Roth IRAs), depending on their objectives.

Once a brokerage account is established, it must be funded before transactions. This involves transferring money from a bank account via electronic funds transfers (ACH), wire transfers, or checks. Funding can take a few business days, depending on the transfer method.

Buying an ETF is similar to buying individual stocks. Investors can choose between a market order, executing immediately at the best current price, or a limit order, allowing a specified maximum price. A limit order executes only if the ETF’s price reaches or falls below the specified limit. Selling ETF shares follows a similar process, allowing investors to sell at market price or set a minimum price with a limit order. Online trading platforms provide the interface for transactions.

Monitoring and Adjusting ETF Holdings

Managing an ETF portfolio involves periodic review to ensure alignment with financial goals. Reviewing performance against objectives helps assess if ETFs meet expectations. This should occur at regular intervals (e.g., quarterly or annually), rather than reacting to daily market fluctuations.

Rebalancing is a key aspect of portfolio management. It involves adjusting the portfolio’s asset allocation back to target percentages. For instance, if equity ETFs outperform bond ETFs, causing the equity portion to exceed its target, rebalancing involves selling some equity ETFs and purchasing more bond ETFs. This maintains the desired risk profile and portfolio diversification.

Adjustments to ETF holdings should be driven by changes in personal financial circumstances, such as risk tolerance shifts or new financial goals. Long-term market outlooks can also prompt adjustments. Decisions should avoid short-term market movements or emotional responses, focusing instead on disciplined portfolio maintenance.