An exchange traded fund, or ETF is an investment fund that trades like a stock. ETFs, like other types of funds, pull together money from investors into a basket of different investments, including stocks, bonds, and other securities. By spreading the funds’ money into different securities.
What Are ETFs
What is an ETF? If an index fund and a stock got married and started a family, their children would be ETFs, exchange-traded funds. ETFs have inherited traits from each parent, just like index funds. Most ETFs are passively managed, diversified, and low-cost. And just like stocks, ETFs are bought through a brokerage account and traded on an exchange at any time during the day.
This mashup of desirable traits has made ETFs increasingly popular investment tools. There are over 6,000 ETFs on 60 exchanges around the world with about $3 trillion in assets.
ETFs can generally provide investors with diversification, which can help balance risk. And because ETF shares are traded on the stock exchange, They’re bought and sold like stocks and usually incur commissions and other related fees. Just like there are a variety of mutual funds, there are a variety of different ETFs, each with different objectives. Some ETFs invest in a variety of stocks and bonds.
Some replicate the performance of a stock index like the Dow Jones Industrial Average or S&P 500 and others track the performance for particular market sectors like technology or pharmaceuticals. However, different ETFs offer different amounts of diversification. For example, ETFs that focus more on specific sectors typically offer less diversification than those that are designed to replicate an index.
Let’s look at an example of investing in an ETF. Suppose an investor wants to make a diversified investment that is designed to mirror the performance of a major stock index, like the S&P 500.After researching different ETFs and funding the one he wants, based on his objective. He purchases shares of it through his broker just like he would in individual stock. Now that he owns shares, the investor has a stake in each of the fund’s basket of investments, while only having to purchase one ETF.
How Do ETFs Work?
Here’s how they work. Imagine ETFs are baskets, and this is the important part. Each basket holds actual securities. So for example, a bonds basket could be packed with a collection of government or corporate bonds. A solar stocks basket holds real shares in companies that make solar panels. There’s even a gold basket backed by gold bars sitting in a vault. Now, let’s say you had a thousand dollars and you wanted to buy gold. The problem is a thousand dollars isn’t gonna buy a whole lot of gold, only about an ounce, and it’s really difficult, not to mention risky, to store your own gold.
What would be a lot easier and safer is to invest your thousand dollars in a gold ETF. When you do that, you’re not buying the gold itself. You’re buying shares of a big basket of gold shares that trade just like stocks. And those are the two big attractions of ETFs. You don’t need to be wealthy to invest in them, and they’re simple to buy, sell, and own.
Another draw is that ETFs almost never incur yearly capital gains taxes like mutual funds can. You’ll only pay taxes when you sell your shares in the ETF for a profit. It’s no wonder that ETFs have exploded. In the US alone, ETFs trade about 20 trillion worth of shares a year, which is more than the US GDP. It seems clear that ETFs are going to be part of the investing universe for many years to come.
Participating in the wide market with only a single purchase instead of multiple purchases can save an investor research and analysis time. So how can an investor potentially achieve a positive return from the ETF?
Similar to a stock, he can earn a return in two ways. A rising ETF market price and dividends. Typically, if the value of the ETF’s investments increases, so does its price. If our investor purchased a hypothetical ETF at $40 and a year later it was selling for $50, our investor could profit $10 per share by selling his position.
Of course, if the ETF’s price dropped, our investor would have lost money if the position was sold at a lower price. Because many ETFs are traded on a stock exchange, they can be bought and sold throughout the day. However, not all ETFs are widely traded, which can cause difficulty when trying to fill orders.
Now, compare this to a mutual fund. Most mutual funds are only priced and traded at the end of the day. Separate from changes in price, our investor could potentially gain income if the ETF pays its investors a dividend, which is a payout of part of the fund’s earnings and capital gains.
Not all ETFs pay dividends. Many instead reinvest earnings into the fund’s holdings. One of the ways to tell whether a fund pays dividends is to look at what’s called its dividend yield. This yield is the amount that the fund pays out compared to the current market price of a share. ETFs have other attractive qualities. While most mutual funds require a minimum investment, which can be substantial, an ETF investor can just buy a single share, plus any commissions and fees.
Also, because most ETFs aren’t actively managed, they typically have lower management fees than mutual funds. There is a wide variety of ETFs that attempt to track assets like corporate bonds, stocks, remote countries, commodities, and even currencies among many other investments. While these assets carry unique risks, the ETFs that track them offer investors a practical way to analyze and potentially find opportunities in a number of markets.
