How to Buy ETFs

I got an email from a reader other day about buying exchange-traded funds (ETFs). The question is really about what ETFs to invest in, but how. How to buy ETFs to be exact.

I am no stranger to ETFs. Actually, I have became a fan of ETFs over the years. Having bought my share of ETF, PowerShares Golden Dragon Halter USX China (PGJ) nearly six years ago, I now own a few of them in my portfolio, including PGJ, PHO, PID, VBR and EEM. But when I first heard of ETFs, I had no idea what they are and how to trade them either. After learning the basics of ETFs, the how to invest part became quite clear.

What Is ETF

Before talking about how to buy ETFs, let me first explain what ETF is and the difference between ETF and the traditional mutual fund.  Investopedia.com has the definition of ETF as

A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.

So basically ETF, or exchange-traded fund, is, as the name suggests, a fund that can be traded on exchanges like a stock. From the above definition, you can that an ETF can be created either like an index mutual fund which consists lots of individual stocks (an actively managed ETF however may not track an index). Before the introduction of active ETFs in 2008, all ETFs track some kind of index. An example of such an ETF is SPDR S&P 500 (SPY), which corresponds to the yield performance and price of the S&P 500 Index.  Or an ETF can be created to simply track a commodity such as gold or sliver, such as the SPDR Gold Trust ETF (GLD), which is backed by physical gold. If you don’t really want to know all the details, you can just consider an ETF as a stock, and both can traded  in the same way.

The biggest difference between an ETF and a mutual fund is that the latter is priced only once a day, at the close of the market, which means that you can buy or sell a fund on a specific day, but not at a specific price. For trading of a mutual fund, the transaction will be executed on the day after the price is calculated based on the price of its underlying stock. For an ETF, on the other hand, it’s priced continuously throughout the trading day, therefore, you can buy or sell shares of an ETF at any time in a trading day, at the price you specify (if it’s a limited order), just like what you would do when trading a stock.

Since ETFs can be bought and sold like stocks, there are extra fees, namely commissions, involved in the transactions. That’s on top of the expense ratio (ER, which represents the cost for the fund company to operate the fund) charged by the fund. This is also different from mutual funds, which all charge a certain amount of operating costs, but there’s usually no additional fee if, for example, a fund is purchased from the fund company directly. For ETFs, which can only be traded through brokers, commissions can’t be avoided, unless under some special conditions, which I will talk about later.

How to Buy ETFs

Once you know what an ETF is, the answer to the question of where and how to buy ETFs then becomes straightforward. To buy and sell ETFs, you first need a brokerage account. There’s simply no other way around it.

I bought my first ETF from Scottrade with a commission of $7, when it was my only stock broker. Now there are many discount brokers for you to choose from and many of them charge much less to buy and sell ETFs than I paid in 2004. In my discount broker comparison post, I listed dozens of online discount brokers and their respective commissions to trade stocks and ETFs. It should give you some ideas on how much you can expect to pay when trading ETFs with them. The list also contains information about the initial deposit required to open an brokerage account. That’s the amount of money you have to put into the account when it is opened.

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Buy ETFs for Free

With most of the brokers in the list, you will need to pay a commission when trading ETFs and it could be anything from $2.95 to $9.95 per trade, depending on which broker you decide to use. There is, however, a few ways to avoid the trading fee as I mentioned above, once you meet certain conditions. Let me share with you how to get free ETF trades from my experience.

  • Zecco Trading: Zecco now charges $4.50 per trade for stocks and ETFs. But you can still have 10 zero-commission trades if 1) you have more than $25,000 in your account, or 2) trade more than 25 times in the previous month. The requirements are pretty high, especially for small investors, but it’s doable.
  • Scottrade: Even though Scottrade doesn’t officially offer any free trade to its customers, there is one way to earn a few free trades from Scottrade and that’s how I do it. Scottrade has a referral program which will rewards you 3 commission free trades for every new customer you refer to them (they will get 3 free trades too). Of course, the number of free trades you can earn depends on the number of people you refer to Scottrade.
  • Merrill Edge and others: If you have more than $25,000 in your account, Zecco Trading isn’t the only choice to get free trades. There are a couple of alternatives to Zecco as I discussed before.

With the above mentioned discount brokers, you can pretty much buy any ETF you want to own, with or without commission. There is a growing trend recently, thanks to competition, that among large brokerage firms to allow their customers to buy some ETFs for free. You know, for example, when you buy a Vanguard mutual fund from Vanguard directly, you don’t need to pay any extra fees. That’s also happening to ETFs. Since last year, Charles Schwab, Fidelity, Vanguard, and most recently TD Ameritrade all started to offer some commission free ETFs to their customers. You can find more of these free offerings in my previous discussions.

Now that you know what ETFs are and how to buy them, maybe it’s time to consider building a simple, yet diversified, all ETF portflio :)

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One Response to “How to Buy ETFs”

  1. Success |  Nov 23, 2010 at 12:23 pm

    I have found purchasing ETFs to as easy as purchasing individual stocks, however, with reduced risk as it is essentially a basket of stocks of a particular group or interest. Almost comparable to a mutual fund, except you can buy/sell intraday.