In All About ETFs (Exchange Traded Funds), you learned that ETFs are essentially mutual funds that trade like stocks. To buy or sell an ETF, you do so through a stock broker and they charge a commission, just as if you were purchasing or liquidating shares of IBM or Microsoft.
Still, there seems to be some confusion as to how investors actually make money from ETFs. This overview was designed to help clarify the answer so you can make more informed choices about your portfolio.
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 upon 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.
What does this mean for you, as an investor? Basically, how you make money from an ETF will depend upon the underlying investments of that ETF.
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 Making Money from Mutual Fund Investing, you learned there are three keys that might help you increase your returns over time. Those three things hold true when you are attempting to make money with ETFs.
- Keep your ETF expenses low. The number one consideration when it comes to making money from ETFs is keeping your costs at rock-bottom levels. Saving 1% over an investing lifetime can lead to much more lucrative results. Consider this: If an 18 year old saved $5,000 per year, the difference between a 7% return and an 8% return over 50 years is $836,206 in extra money. That is real cash by anyone's standards!
- Keep your money invested for as long as prudently possible, consistent with your financial needs, objective, goals and situation. The longer money remains invested in profitable assets, the larger your fortune can grow due to the nature of compound interest.
- Don't invest in any ETF 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 exactly what each of your ETF owns and why you have an investment in it.
More Information About Making Money
To learn more, read the New Investor's Guide to Making Money.