When I first started investing, I knew that I was not going to buy individual stocks because it is too risky. For long term investors, purchasing funds which hold baskets of diversified stocks is a much better approach and is supported by academic research and leading investors and authors. If you don’t believe me, check out the research compiled by Cambria Investments and its Chief Investment Officer Meb Faber or the research compiled by Vanguard, a pioneer in market indexing. The two types of funds that you should buy are mutual funds and exchange traded funds (ETFs). When you have the option you should always buy exchange traded funds in taxable accounts. In tax free accounts (like a Traditional IRA or a 401(k), mutual funds can still be good options.
Why You Should Always Buy ETFs In Taxable Accounts
In taxable accounts, Mutual funds are tax inefficient while ETFs almost never pass along taxes to the fund holders. The tax inefficiency has to do with how mutual fund shares vs ETF shares are created and destroyed. This starts to become complicated, but Mutual fund shares are always created and destroyed with a taxable event while ETF shares are created and destroyed without causing a taxable event.
For example, in 2017 the Charles Schwab Total US Stock Market mutual fund (SWTSX) distributed capital gains of $0.106/share (0.22%) while the equivalent Schwab ETF (SCHB) has never distributed capital gains. Ever. Some mutual funds that are actively traded will cause huge taxes. For example, the Lord Abbett Developing Growth Fund recently distributed $6.25 in capital gains per $18.98 share. This is basically 33% of the entire holding that will be taxed. To make matters even worse, the Lord Abbett fund did not even perform well while causing these taxes.
ETFs Are Bought Like Stocks Through a Broker
ETFs are bought and sold on stock market exchanges just like stocks. To purchase stocks or ETFs you will need a brokerage account. Some brokerages will charge fees per trade, called commissions. You want to avoid any brokerage which charges commission.
Luckily, there are several extremely good options for trading ETFs without paying a commission. Here is a rundown on the big players for free ETF trades:
Schwab charges for stock trades but all of the class-competitive Schwab ETFs can be traded commission free, as well various ETFs from other companies. Schwab also does not sell your order flow, meaning that Schwab is not making money off your trades at your expense. Schwab also offers retirement accounts and banking services.
As the creator of low cost investing, Vanguard now allows you to purchase any non-leveraged and non-inverse ETF commission free. This means that you can purchase around 1800 different ETFs. Like Schwab, Vanguard does not sell your trades to make money. Vanguard has been known to face certain technical difficulties, and is best suited for long term investors. Vanguard also offers retirement accounts.
Fidelity is the powerhouse in the mutual fund world but they also offer Blackrock iShare ETFs commission free (as well as some very niche Fidelity ETFs). Fidelity cannot compete with Schwab or Vanguard in the ETF game because Blackrock is not committed to low fees and has been known to make new products with lower fees rather than reducing fees on old products. In other words, if you hold Blackrock iShares ETFs, expect to pay a lot more down the road than you would for a comparable Schwab or Vanguard ETFs. Fidelity also offers retirement accounts and banking services.
Robinhood charges no commissions on any ETF or stock trades, although they do sell your trades in order to make additional money at your expense. This trade off may be worth it to you because you can literally buy anything that trades on the stock market, including leveraged and inverse ETFs (which you probably shouldn’t buy anyways). Robinhood does not currently offer banking services or retirement accounts. Transfers from your bank to Robinhood are immediately available under a margin feature that Robinhood offers to all users.
Chase You Invest
Chase You Invest: Chase is new to the game of low cost investing but they are taking a page out of Robinhood’s playbook. They will offer 100 free trades of any stock or ETF each year as long as you hold at least $15,000 in assets at Chase or JPMorgan. Chase offers retirement accounts and the best banking services of all brokerages. Also, transfers from Chase accounts to You Invest is instantaneous.
Other Discount Brokerages
Enter TD Ameritrade and eTrade. I do not reccomend either of these brokerages. The fact that neither of them offers their own products means that what is available can change on a moment’s notice. For example, in 2017, TD Ameritrade dropped all Vanguard ETFs from their commission free lineup. It is simply not worth the risk to hold ETFs with any of these discount brokerages because it may not be free in the future.
Recent development note: you can actually buy shares of ETFs through programs like M1 Finance and Betterment. ETFs are held through a custodian which allows for purchases of partial shares making ETFs behave more like mutual funds (traded in specific windows only during the trading day).
How To Make The Purchase
With ETFs, you have to buy whole numbers of shares. For example, if you want to buy an ETF that costs $25 per share, you would not be able to buy it if you only have $20. Here, I will walk you through how to make your first purchase using Charles Schwab. For this example, we will be buying the Schwab US Large-Cap ETF and that we have $200 to spend.
Step 1: Figure Out How Many Shares to Purchase
The first step is to figure out how many shares to purchase. To do this, look up how much the current share price is. You can do this buy going to google finance or your brokerage account and searching for the ETF ticker. A ticker is the 1-4 letters that are assigned to the ETF or stock. In this case, the ticker for Schwab US Large-Cap ETF is SCHX, so we will search SCHX in my Schwab account.
Once you click “Research,” the summary page will load:
On this summary page, you will see that the last price was $62.95/share. OF course, this will continually fluctuate when the New York Stock Exchange is open as this ETF trades on the New York exchange. By dividing our amount of money ($200) by the price per share ($62.95), we get the number of shares we can afford (3.177 shares). However, you cannot buy partial shares so we will round down to the nearest whole number (3 shares). Now we are ready to place an order for 3 shares. We do this by clicking on the “Trade” button. Clicking this trade button will then send us to the following page:
As you can see from my example, you put the ETF ticker SCHX in the first box. We are buying, so we select “Buy.” We also want to use a “limit” order so that we do not accidentally overpay (which can happen if you select market order). I then place my price at the current market price ($62.95) and place the order.
Because we are using limit orders, it may take a couple minutes for the order to clear as your order will not be submitted unless it can be made at or below the limit price we selected at $62.95. If it does not clear by the end of the day, you can resubmit the order the next day. Of course, you can try to get fancy with your limit order amounts. As a long term investor, however, I am satisfied paying market price for my trades and I am not waiting for a daily small dip in price before I make a purchase.
You Have Successfully Purchased an ETF!
Once you have made several trades, you will appreciate the control the limit orders and ETFs bring, even if you plan to hold the ETFs long term. Don’t make the mistake of avoiding ETFs because trading seems scary or more difficult than purchasing a mutual fund. If you want to learn more about Bond funds, I recently wrote an article explaining how Bond funds work.
Author: Kelton Johnson
Disclosure: I have accounts with Charles Schwab, Vanguard, and Robinhood, although I have received no compensation for writing this article. I also am long SCHX.