Investing Basics: What is an ETF?

October 12, 2015

I’ve recently had a number of conversations about ETFs – how they work, what the benefits are, etc. Despite the fact that they make up a significant portion of the stock market, they remain largely misunderstood by the average investor. To help clarify, we thought we’d take a moment to provide a quick crash course on ETFs.

 

The term ETF stands for Exchange Traded Funds. ETFs are a relatively new financial instrument (the first conceptual ETF was launched in 1989, but actual ETFs didn’t begin trading until 1993) and were born in response to investors wanting a way to invest in a particular type of asset with more flexibility than is provided by traditional mutual funds. Since then, the ETF universe has grown to more than 1400 funds and will likely continue to grow as demand increases.

 

One question that we get a lot is how are ETFs different than mutual funds. The main difference is that ETFs price throughout that day, while mutual funds price at the end of the day. ETFs are, in essence, an easy way to own a lot of things without having to put up a lot of money. Let’s say that you wanted to own all of the stocks in the S&P 500, but you didn’t have enough money to buy 1 of each stock (there are 500 after all). You could, however, get together with a bunch of people, combine resources, purchase all of the stocks in the S&P 500 and then let everyone have “shares” in that bulk purchase. This is, in essence, how ETFs work: a large financial institution (such as Charles Schwab, BlackRock, or Fidelity) will assemble a basket of underlying stocks depending on what the mandate of the fund is. If the ETF is an emerging market ETF then the institution will buy a basket of emerging market securities. If the ETF is a large-cap growth ETF, then the institution will buy a basket of large-cap growth stocks. Then, the institution will sell shares in that basket allowing you, the investor, to have exposure to all of those stocks without having to buy each one individually. The price of the ETF then changes throughout the day to reflect the various changes of price of all the underlying stocks (this occurs due to what is known in the financial world as arbitrage, which basically means prices will converge between the underlying stocks and the ETF to prevent individuals from profiting from discrepancies).
 

Another question we get is what the pros and cons of ETFs are compared to those of mutual funds. One of the major benefits of ETFs is that they’re often cheaper than mutual funds because they require a lot less work on behalf of the fund managers because they’re indexes. The manager isn’t actively trading in the ETF, he’s just putting it together at the beginning, which makes it a very inexpensive option. Another benefit of ETFs is that you can trade them based on price fluctuations during the day instead of having to wait to find out what the closing price is like you would for a mutual fund. That being said, because ETFs are relatively new, they don’t enjoy the prime position that most mutual funds hold in major retirement and pension plans – in fact, some plans don’t allow you to hold ETFs. If you are a believer in active management, mutual funds also offer an active advantage over index-based ETFs.

 

If you’d like to learn more about the differences between different types of securities or asset prices, never hesitate to reach out. We’re happy to share what we know to help you make more informed decisions.

 

“Exchange-Traded Fund.” Investopedia. 2015. http://www.investopedia.com/terms/e/etf.asp

“Frequently Asked Questions About the U.S. ETF Market.” Investment Company Institute. February 2015. https://www.ici.org/etf_resources/background/faqs_etfs_market

 

Simpson, Stephen D. “A Brief History of Exchange Traded Funds.” Investopedia. Dec. 14, 2011. http://www.investopedia.com/articles/exchangetradedfunds/12/brief-history-exchange-traded-funds.asp

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