When you buy an ETF where does the money go?
The money you use to buy an ETF goes to the person who used to hold it. If you buy enough of an ETF, your money will start to go instead to people who create new ETF shares, and from them to people who held the underlying assets.
An exchange-traded fund, or ETF, allows investors to buy many stocks or bonds at once. Investors buy shares of ETFs, and the money is used to invest according to a certain objective. For example, if you buy an S&P 500 ETF, your money will be invested in the 500 companies in that index.
ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
ETFs can contain all types of investments, including stocks, commodities, or bonds; some offer U.S.-only holdings, while others are international. ETFs offer low expense ratios and fewer broker commissions than buying the stocks individually.
Most ETF income is generated by the fund's underlying holdings. Typically, that means dividends from stocks or interest (coupons) from bonds. Dividends: These are a portion of the company's earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock.
In order to withdraw from an exchange traded fund, you need to give your online broker or ETF platform an instruction to sell. ETFs offer guaranteed liquidity – you don't have to wait for a buyer or a seller.
ETF issuers collect any dividends paid by the companies whose stocks are held in the fund, and they then pay those dividends to their shareholders. They may pay the money directly to the shareholders, or reinvest it in the fund.
The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance. For example, young investors might be 100% invested in equity ETFs when they are in their 20s.
Key differences between stocks and ETFs
Since ETFs are more diversified, they tend to have a lower risk level than stocks. Similar to stocks, ETFs can be bought and traded at any time and they are also taxed at short-term or long-term capital gains rates.
ETFs can be a great investment for long-term investors and those with shorter-term time horizons. They can be especially valuable to beginning investors. That's because they won't require the time, effort, and experience needed to research individual stocks.
How do ETFs work for dummies?
ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their price can change from second to second. Mutual fund orders can be made during the day, but the actual trade doesn't occur until after the markets close.
Commissions and Expenses
Every time you buy or sell a stock, you might pay a commission. This is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment's performance.
Buy a money market mutual fund
Going with an ETF is one way to use funds to make your brokerage account look like a bank account. Another way is buying a money market mutual fund backed by bonds of the federal government. Both accomplish similar goals with similar (very limited) risks.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF. Receiving an ETF payout can be a taxable event.
If the stocks owned by the fund pay dividends, the money is passed along to the investor. Most ETFs pay these dividends quarterly on a pro-rata basis, where payments are based on the number of shares the investor owns.
Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.
For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.
Liquidity refers to how quickly and easily an investment can be converted into cash without significant price impact. Some funds, such as money market funds or certain exchange-traded funds (ETFs), are highly liquid and allow for same-day or next-day withdrawals.
| Mutual Funds | ETFs | |
|---|---|---|
| Trades executed: | Once per day, after market close | Throughout the trading day and during extended hours trading |
| Settlement period: | From 1 to 2 business days | 2 business days (trade date + 2) |
| Short sales allowed? | No | Yes |
| Limit and stop orders allowed? | No | Yes |
How much money should I put in ETFs?
You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.
Thankfully, there are some stock ETFs that do pay dividends on a monthly basis. They're definitely in the minority, but there are enough where you can actually build a pretty diversified portfolio using just monthly pay stock ETFs.
Holding period:
If you hold ETF shares for one year or less, then gain is short-term capital gain. If you hold ETF shares for more than one year, then gain is long-term capital gain.
| ETF | Assets Under Management | Expense Ratio |
|---|---|---|
| Vanguard Information Technology ETF (VGT) | $70 billion | 0.10% |
| VanEck Semiconductor ETF (SMH) | $16.3 billion | 0.35% |
| Invesco S&P MidCap Momentum ETF (XMMO) | $1.6 billion | 0.34% |
| SPDR S&P Homebuilders ETF (XHB) | $1.8 billion | 0.35% |
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
