For those without a lot of cash—or just starting out—exchange-traded funds offer a simple, low-cost way to invest and gain instant diversification.
ETFs look like mutual funds, yet behave in some ways like stocks. Similar to index mutual funds, most basic ETFs are passive investments that don't require a manager and therefore don't charge high fees (in many cases, ETF expenses are lower than those of index funds). Investors can also buy as little as one share of an ETF, whereas mutual funds often require minimum investments of $1,000 and up. Like index funds, ETFs mirror an index, but they can be traded all day on an exchange like stocks. Another plus: Since they track a particular index, investors can easily find out what stocks (or bonds) they hold.
Small investors could theoretically create a diversified portfolio with just two or three ETFs. For example, Vanguard Total Stock Market Index ETF (symbol VTI) invests virtually in the entire U.S. stock market (more than 3,000 individual stocks of varying sizes and across different sectors of the economy). Other broad-based ETFs include the iShares Barclays Aggregate Bond Fund (AGG), which covers the spectrum of U.S. investment grade bonds. The Vanguard fund charges just 0.09 percent in annual fees, and the iShares fund charges 0.24 percent.
[Also see 5 Steps to Set Up an ETF Portfolio.]
Although ETFs are cheap to own, the cost of buying and selling them is a big drawback for small investors. To trade ETFs, investors must set up a brokerage account (TradeKing, TD Ameritrade, and Scottrade are a few that offer online trading services). Keep in mind that buying an ETF is like buying a share of a stock, so don't plan on investing a flat $500 in an ETF. Instead, decide how many shares to buy based on the current trading price. Trading is usually not free. Fees to buy and sell can range from a few bucks to more than $10. That may not sound like much, but the fees add up, say, if you're investing $100 per month in several ETFs.
Free trades aren't unheard of, but they're not common. Online brokerage Zecco once offered 10 free trades per month for investors who maintain a balance of at least $2,500. The company hasn't completely abandoned the offer, but it now requires investors to maintain a balance of $25,000 or trade 25 times a month. Brokerage Charles Schwab is now offering a better option for small investors: commission-free trades of its new ETFs with no minimum balance. Last week, Schwab introduced four ETFs: U.S. Broad Stock Market (SCHB), U.S. Large-Cap (SCHX), U.S. Small-Cap (SCHA), and International Equity (SCHF). The funds' annual fees are low, to boot: Schwab U.S. Broad Stock Market ETF and U.S. Large-Cap ETF carry expense ratios of 0.08 percent. The brokerage plans to introduce four more ETFs in December, including an emerging markets ETF.