How Investors Earn Income from Investing in ETFs
Why Some Investors are Drawn to Exchange-Traded Funds
With their fairly recent rise in popularity, I think it is important to take a moment to speak with you a bit about exchange-traded funds, or ETFs as they are more commonly called, in order to help you understand what they are and how they work. In the chance you aren't already aware of them, or if you don't own them in your own investment portfolio, ETFs are essentially mutual funds that trade similarly to stocks under their own ticker symbol.
To buy or sell an ETF, you do so through a stockbroker and, unless the ETF is part of some special deal the broker has worked out with the sponsor of the ETF, they charge a commission, just as if you were purchasing or liquidating shares of, say, IBM or Microsoft.
Still, there seems to be some confusion as to how investors actually make money from ETFs. Contrary to the impression you might get speaking to those who have an incentive to sell you these financial products, ETFs are not lottery tickets nor are they magic.
Like all things, they have pros and cons that must be carefully weighed, especially in light of your personal circumstances, preferences, resources, and other relevant factors. While this general overview can't do that for you, it can provide you with a fundamental understanding of how profits are generated for ETF investors in the hope that it will give you a chance to make more informed choices about your portfolio or, at the very least, the right questions to ask your financial advisor.
How Investors Make Money from ETFs
Making money from ETFs is essentially the same as making money by investing in mutual funds because they operate almost identically. Just like mutual funds, the way your ETF makes money depends on the type of investments it holds.
The ETF itself is sort of like a trust fund - it may invest in stocks, bonds, commodities such as gold or silver, preferred stock, or a famous index such as The Dow Jones Industrial Average or the S&P 500.
What does this mean for you, as an investor? Basically, it all comes down to this: How you make money from an ETF will depend on the underlying investments of that ETF over time.
That is, if you own a stock ETF that focuses on high-dividend stocks, you are hoping to make money from a combination of capital gains (an increase in the price of the stocks your ETF owns) and dividends paid out by those same stocks.
Likewise, if you own a bond fund ETF, you hope to make money from interest income. If you own a real estate ETF, you hope to make money from the underlying rents, capital gains on property sales, and service income generated by the apartments, hotels, office buildings, or other real estate owned by the REITs in which the ETF has made an investment.
The Same Keys for Making Money in Mutual Funds Hold True for ETF Investing
In the article Making Money from Mutual Fund Investing, you learned that all else equal and from a broad, academic point of view, there are three keys that might help you increase your returns over time. These three things hold true when you are attempting to make money with ETFs:
- Don't Invest in ETFs You Don't Understand: There are some crazy ETFs in the world - some that utilize super leverage and short stocks, some that invest only in countries that are barely above third-world, and others that concentrate heavily in specific sectors or industries. As Warren Buffett is fond of saying, the first rule of making money is to never lose money. The second rule is to see rule #1. You should know the exact underlying holdings of each ETF you own why you have an investment in it.
- Keep Your ETF Expenses Reasonable: Generally, this isn't a major problem because ETFs tend to have expenses that are more than affordable. This is one of the reasons they frequently are preferred for investors who can't afford individually managed accounts. That is, a financial planner, financial advisor, or do-it-yourself investor can cobble together a portfolio of reasonably diversified holdings, even picking up things like ETFs that focus on individual sectors or industries for an expense ratio of like 0.50% per annum.
- Focus on the Long-Term: Ultimately and all else equal, short of some sort of structural problem or other lower probability event, ETFs should perform roughly in-line with their underlying holdings. This means if you hold an equity exchange-traded fund, you might be subjected to fairly horrific swings in market value in any given year. You'll see periods like 2007-2009 when your ETF holdings are down 20%, 30%, 50% or more on paper. If you can't handle this, you have no business investing in these securities. Though there is no guarantee the future will look like the past, historically, time has ironed out most of that volatility and investors have been well-rewarded.
The thing to remember is that ETFs are like any other investment in that they won't solve all of your problems. They are a tool. Nothing more, nothing less.
Please note that The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.