What is an ETF?
basically, An etf is a bundle of investments with something in common
An ETF (exchange traded fund) provides affordable access to practically every type of investment in every market in the world. When you buy an ETF, you effectively buy stock in every security or company (sometimes thousands, but at least 16 securities) within it. Because they own these securities or companies’ stocks, ETFs enable investors to gain exposure to an industry or area of the market at a much lower price (but at a cost: fees).
At a very basic level, ETFs work like this:
- The ETF buys 16 or more securities, for example stocks or bonds
- Many investors want to buy the ETF
- Because so many want to buy it, the ETF can sell this collection of securities at a much lower price than it would cost you to buy every security individually
- (For example the iShares Russell 2000 Exchange Traded Fund costs about $166 as of today. To buy each of the ~2,000 stocks in the ETF would cost you much, much more)
- The ETF provides buyer exposure to an industry or an area of the market that is as diversified as buying each of the securities it holds (the “holdings”), but at a significantly lower price
Through ETFs, you can invest in:
- Indexes: Many ETFs aim to replicate an index of securities. Indexes (indices) are otherwise un-investable.
- REITs: Real estate investment trusts
- Currencies, like the USD
- Sovereign bonds, like 2 year or 10 year, or a mix of different-maturity U.S. Treasuries
- Stocks, like Amazon or Apple
- Leveraged securities, and even leveraged ETFs (i.e. the S&P 500 triple-leveraged 3x ETF)
- Commodities, like gold or lithium
- Leveraged loans
- Convertible bonds
- Mortgage-backed securities, and more
ETFs Versus mutual funds
ETF fees are often cheaper compared to mutual funds, but not always. The average fee is about 0.31%, but each is different. They can range anywhere, usually from 0.02% to 1.00%. Mutual funds usually charge at least 0.50%, with some exceptions. Fidelity, for example, recently launched two index mutual funds (FZROX and FZILX) with a zero expense ratio (if you purchase them on the Fidelity platform).
Mutual funds are otherwise quite similar to ETFs, except they are mostly actively managed (more on that below), and they can invest in any number of securities (there is no minimum of 16, as with ETFs).
Types of ETFs – Actively Managed or Passive ETFs
There are two ways ETFs “choose” their holdings. In an actively managed ETF, a portfolio manager chooses the ETF’s investments based on research, market experience and knowledge. The manager rebalances (changes) the holdings of the ETF at his discretion (because of reasons that he or she decide).
In a passive ETF, the holdings are based on an index, which is also a large collection of securities in an industry or particular area of the market. There are two main differences between an ETF and an Index. First, an index is not investable; you can’t buy it. Second, an Index holds a larger quantity of securities. The ETF invests in most of the securities in the Index, but ETFs have certain rules that exclude some index holdings. For example, the S&P 500 High Dividend ETF holds only those stocks in the S&P 500 Index with a 20-year or longer history of paying dividends. Many bond ETFs do not hold securities with less than one year to maturity.
Examples of ETFs
- SPY: The S&P 500 ETF (equity or stock)
- EEM: This ETF invests in large- and mid-cap emerging market equities (equity)
- USO: The United States Oil Fund (technically, this is an ETP, an “exchange traded product”). It holds near-month NYMEX futures contracts on WTI crude oil (futures)
- MAGA: Invests in companies whose employees and political action committees are highly supportive of Republican candidates (equity)
- GLD: Invests in gold, the SPDR Gold Trust (commodity)
- FXI: Invests in Chinese equities (equity)
- CQQQ: A China ETF that focuses on tech companies
- SHY: Invests in U.S. Treasuries with less than 3 years to maturity
- SHE: Invests in large cap companies with at least one woman in a leadership position
- MJ: Invests in companies involved in the legal cultivation, production, marketing or distribution of cannabis, cannabinoids or tobacco products (bond)
A Fixed Income ETF
ETF Fees & cost
The total of all the ETF fees you will pay is called the “expense ratio.” The expense ratio is the sum of the management fee plus a few other small fees (0.01% to 0.03% usually) for things like administration. The expense ratio is how much you will be charged. You will always pay a percentage of your investment, not a flat amount, like $1. The average ETF expense ratio charges 0.31% without counting Vanguard ETF Funds, which charge on average 0.08%. The most expensive ETFs are typically actively managed ETFs or ETFs of assets that are less liquid or harder to procure.
The cost of the ETF includes another factor: the price. ETFs have two prices most of the time: the price you pay, and the price of that the ETF is “worth,” which is the value of the holdings in the ETF. This brings us to ETF premiums and discounts.
ETF Premiums & Discounts
Because ETFs are subject to their own buying and selling trends, the market price (which you pay) of the ETF on an exchange can be higher or lower, or the same, as the value of all of its holdings (its NAV or net asset value). To check if you’re buying or selling at a premium (more) or a discount to what the ETF is worth, compare the market price of the ETF to its NAV. When buying, you’re paying a premium if the market price is higher than the ETF NAV, which means you’re paying more than the ETF is worth at that moment. If it’s lower, you’re buying at a discount, paying less. When selling, you’re receiving a premium if the market price is higher than the NAV, meaning you’re receiving more than the ETF is worth. Likewise, when selling, if the market price is lower than the NAV, you’re selling at a discount, less than the ETF is worth.
Premiums and discounts are usually not too large. Market makers are contractually obligated to keep the market price in close range of the NAV. In most markets, they are able to with ease. However, one of the benefits of ETFs is liquidity, and it could also be a drawback.
ETFs are said to provide better liquidity than their underlying assets because, for example, it is much easier to sell a bond ETF or gold ETF than it is to sell a bond or physical gold. This feature is extremely helpful most of the time.
However during periods of low liquidity, premiums and discounts can widen and linger for longer periods of time.
Want to invest in an ETF?
ETFs have surged in popularity because they are relatively low cost, liquid, and provide broad exposure. However this does not mean that they are the best investment option. While they may be relatively low cost, there may be cheaper options. And while they may provide liquidity most of the time, their liquidity feature may also cost you in times of market stress, as explained above, because of premiums and discounts.
As for broad exposure, Investing in 500 companies (like in the S&P 500) is generally considered safer than investing in just one company or a handful of companies, simply because of the number of companies you are investing in. Recall that in 2008, the S&P 500 dropped more than -16% in the month of October in 2009. Of course, this is a weighted-average return, meaning that many companies in the S&P 500 posted better returns, and many posted worse returns than -16%.
The thing to remember is that investing always comes with potential gains, and potential risks. To reduce the potential risks, diversifying across multiple companies and securities (such as with ETFs) is important, but equally if not more important is diversifying across multiple asset classes, such as gold, U.S. Treasury bonds, and riskier investments like the S&P 500.
Read more about ETFs here:
- More on the definition from Investopedia.
- USA Today has a ranking of the top performers.
- Here is an ETF database of all exchange traded funds.
Just starting to learn about investment management? Read here to learn about investment management and how to do it.