ETFs Explained: A Simple Guide to Building Wealth with Exchange Traded Funds

Approx 7-10 min

Summary:

• ETFs are like a buffet of investments (stocks, bonds, commodities, etc.) bundled into a single fund. They offer a low-cost, diversified way to invest, especially for busy professionals.
• ETFs provide liquidity, tax efficiency, and the potential for long-term growth.
• Consider your financial goals and risk tolerance carefully before choosing this popular investment vehicle.

Are you a high earner aiming to grow your wealth but feeling overwhelmed by the investment world?

Exchange Traded Funds, or ETFs, could be the game-changer you’ve been waiting for.

An ETF is an investment vehicle that pools together a collection of assets — think stocks, bonds, or commodities — into a single fund that’s traded on the stock exchange.

Each share of an ETF gives you access to a diversified portfolio of assets. This might include stocks from different industries, bonds, or even commodities like gold or crude oil.

ETFs are a flexible, low-cost way to invest across multiple sectors (or even the entire market) without buying individual stocks. For busy professionals with demanding schedules, ETFs provide a smart, reliable path to wealth-building without the need to analyze each underlying asset that makes up the fund.

How ETFs Work

Think of ETFs as a well-stocked buffet. At this buffet, you have a wide selection of dishes, representing different types of investments like stocks, bonds, commodities, and currencies.

When you decide to enjoy the buffet, you’re not just picking one dish. Instead, you’re filling your plate with a variety of items, allowing you to sample many flavors all at once. Each dish contributes to a balanced meal, just as each investment within an ETF contributes to a diversified portfolio.

By choosing an ETF, you’re essentially purchasing a plate filled with a mix of these investment “dishes.” This means you’re not relying on the success of just one investment. Instead, you’re spreading your risk across multiple options.

So, if one dish (stock) turns out to not be as tasty (or profitable) as expected, the others can still provide a satisfying experience.

This is what makes ETFs a suitable option for affluent but busy professionals who may not have the time, desire, or experience to select individual stocks, conduct the necessary research, and navigate all the associated risks.

Structure and Functions

ETFs can be structured to track specific indices, commodity prices, or a diverse array of securities, such as stocks and bonds.

For instance, some ETFs might track the performance of major stock indices like the S&P 500 or the Dow Jones Industrial Average, while others might focus on specific sectors like technology or healthcare. You can also find commodity ETFs that track the price of gold, oil, or agricultural products.

The first ETF was the SPDR S&P 500 ETF (SPY), designed to track the S&P 500 Index. ETFs are traded on exchanges similar to stocks, enabling you to buy and sell them at any point during the trading day. This makes them different from mutual funds, which only trade once a day after the market closes, while ETF prices fluctuate throughout the day.

Most ETFs in the United States are regulated under the Investment Company Act of 1940. Structured as open-ended funds, they don’t typically restrict the number of participating investors.

Advantages of ETFs

All ETFs must be registered with the Securities and Exchange Commission (SEC). One of their main perks is their low expense ratios and reduced broker commissions when compared to purchasing individual stocks or mutual funds.

When you invest in an ETF, you’re purchasing a piece of the fund, not directly owning the underlying securities. This means that you indirectly own a fraction of all the individual stocks or bonds included in that ETF, helping spread out the risk.

For example, if an ETF tracks the S&P 500, it holds shares of all 500 companies in that index. If one company performs poorly, the overall impact on your investment is cushioned by the performance of the other companies in the ETF. This built-in diversification can help reduce the volatility you’d experience when investing in individual stocks.

Types of ETFs: What’s Available?

Here’s an overview of the different types of ETFs, each designed to support specific investment goals for high-earners like you who’re focused on building their wealth.

• Stock (Equity) ETFs: These hold a variety of stocks, providing broad market exposure or targeting specific categories like large-cap or small-cap companies.
• Bond ETFs: Offering exposure to bonds, these ETFs focus on government, corporate, or municipal bonds, providing a relatively steady income stream and lower risk than equity ETFs.
• Sector ETFs: These concentrate on specific sectors – like technology, healthcare, or consumer staples – offering a way to capitalize on industry trends. However, these ETFs can be more volatile due to the heightened exposure to sector-specific risks like regulatory changes or shifts in consumer demand.
• Commodity ETFs: Designed to track commodities like gold, oil, or natural gas, commodity ETFs provide portfolio diversification and can be used as a hedge against inflation. A gold ETF, for instance, will hold physical gold or futures contracts to match gold’s market value.
• Currency ETFs: These provide exposure to foreign currencies by tracking their exchange rates. The ones that hold pairs like the euro and the U.S. dollar can offer an opportunity to capitalize on fluctuations in the forex market.
• Dividend ETFs: Tailored for income-seeking investors, dividend ETFs focus on companies with a history of paying dividends, so as to provide you with a steady income stream. They may also invest in “dividend aristocrats,” or companies with long histories of increasing dividends.
• Growth ETFs: These focus on companies with high growth potential, often in innovative sectors like AI, biotechnology, or renewable energy. They aim to provide capital appreciation, but can be riskier in volatile market conditions.
• Crypto ETFs: They provide exposure to digital assets like Bitcoin and Ethereum by either directly holding cryptocurrencies or tracking their price through futures contracts, offering investors a regulated and accessible way to participate in the crypto market.

Each of these ETFs can be a strong addition to your portfolio, depending on your financial goals, timeframe, and risk tolerance.

ETF Performance and their Role in Cash Savings

If wealth-building feels impossible due to inflation and increasing lifestyle costs, ETFs can offer a simple and efficient way to grow your money that combines liquidity, low fees, and portfolio diversification.

Here’s why ETFs might be a good fit for you:

• Liquidity
  ETFs are as accessible as stocks but give you the diversity of a mutual fund. Their high liquidity means you can buy or sell anytime during the trading day – ideal if you need quick access to funds. For high earners juggling lifestyle costs, this flexibility makes ETFs a smart choice for balancing immediate needs with long-term wealth growth.
• Low Fees
  ETFs typically come with low expense ratios, often between 0.03% and 0.25%, so you’re only paying a fraction of what actively managed funds charge. This is because most ETFs passively track an index, which minimizes management costs. With fewer management fees, a larger portion of your returns stays in your pocket.
  For high earners with substantial lifestyle costs, this efficiency can be a game-changer. It lets you grow your wealth without needing to cut back on expenses due to high fees eating into your returns.
• Diversity
  Investing in ETFs gives you exposure to a broad market or sector, allowing you to spread out your risk, according to Investopedia. If you’re a high earner wanting to safeguard your cash savings from inflation without the complexities of stock-picking, ETFs can provide a solid mix of safety and growth.

ETFs vs. Traditional Savings Accounts

Traditional savings accounts are considered to be one of the safest investment options, but they only offer an average annual percentage yield (APY) of around 0.57%, according to Bankrate’s survey (Oct 28, 2024). In contrast, ETFs have historically returned more over 10 years or longer.

To evaluate an ETF’s performance, examine its historical annualized returns over 3, 5, and 10 years for consistency.

Next, look for low expense ratios, ideally under 0.25%, to maximize net returns.

The Role of Financial Management Apps

Apps like Marygold & Co. are designed to help you track these metrics easily, monitor your ETF portfolios, and access performance data at a glance. Their primary purpose is to make it easy for new investors to step into the world of ETFs and other investment vehicles for saving and building wealth.

With Marygold you can buy small shares of stocks or ETFs, set up automated bank deposits, and create unlimited Money Pools – dedicated ETF portfolios tailored to various savings goals.

These features help you stay organized, remain on track, and make informed investment decisions. Financial management apps like Marygold will also walk you through the entire investing process when you start out, so they’re suitable for beginners.

How to Buy and Invest in ETFs

To invest in Exchange Traded Funds, start by choosing a brokerage account that allows ETF trading. You can open such an account through financial management apps like Marygold & Co.

On the app, you can avail investment features like customizable ‘money pools’ as well as an investment calculator for goal-oriented financial planning. These are designed to make it easier for beginners to navigate ETF investments.

Once the account is set up, you’ll want to research ETFs by focusing on three key factors: expense ratios (aim for under 0.25% for cost efficiency), holdings (look at the underlying assets to ensure alignment with your goals), and long-term performance (review at least 5-10 years of returns, if available). When you’ve made your choice, you can buy ETFs just like stocks on the exchange.

Are ETFs Tax-Efficient?^*

As a high-earning professional looking to build wealth with ETFs, you need to understand the tax implications. ETFs generally offer greater tax efficiency compared to similar investments like mutual funds, which can make a noticeable difference in your after-tax returns over time.

Unlike mutual funds, which trigger taxable events when the fund manager buys and sells assets, ETFs use something called “in-kind transactions.” This process allows ETF managers to exchange securities within the ETF without generating a tax event for you, the investor.

This is possible due to a specific section in U.S. tax law – Section 852(b)(6) of the Internal Revenue Code of 1986 – which allows capital gains to be passed to market makers instead of investors like you, so taxes aren’t triggered until you sell your shares.

This is not tax advice, and all tax advice should always come from a qualified professional.

Long-Term vs. Short-Term Gains

In the U.S., holding an ETF for over a year qualifies it for long-term capital gains treatment, which results in a lower tax rate. Short-term gains apply if you hold the ETF for a year or less, usually at a higher tax rate.

ETF dividends are taxed as either qualified or non-qualified dividends. Qualified dividends, if held for more than 60 days, are taxed at the long-term capital gains rate, which is lower, while non-qualified dividends are taxed as ordinary income.

A study by the University of Pennsylvania suggests that ETFs hold an average after-tax advantage of around 0.92% per year over mutual funds. While that may sound small, it can add up significantly through compounding, especially for high-income investors in higher tax brackets. Lastly, high earners must account for the 3.8% net investment income tax applied to profits from ETF sales.

Why ETFs Should Be Part of Your Financial Strategy

In conclusion, ETFs can be a smart addition to your wealth-building toolkit, offering you growth, low fees, and plenty of liquidity. For high earners juggling career demands and lifestyle costs, ETFs provide an easy, diversified way to invest without the expertise required to select individual stocks.

ETFs work well alongside other investment vehicles like bonds, savings accounts, and mutual funds, helping you create a more resilient, well-rounded investment strategy. Explore how the best performing ETFs can complement your existing portfolio by adding another layer of stability and growth.

Ready to make ETFs work for you? Start today with a trusted financial management app that simplifies ETF investing; and explore options that fit your portfolio and goals.