What is an ETF?

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ETF stands for Exchange Traded Fund and it is an investment fund that is traded on a stock exchange. An ETF is a pooled basket of investments, similar to a Mutual Fund. We will discuss the core differences between an ETF and a Mutual Fund later.

Trading ETFs, Mutual Funds & Stocks

An ETF is traded similar to how a stock is, meaning you have the ability to purchase or sell that ETF during the trading day and it will be at whatever the price is at that given moment. The reason I mention this is because a Mutual Fund, which is also a pooled basked of investments, trades differently. Buying a Mutual Fund is incurring a transaction with the fund company that manages the fund and is bought at the Net Asset Value. The Net Asset Value is calculated at the close of every trading day, so this is where an ETF is different. An ETF will fluctuate in price, depending on market conditions, up or down throughout the trading day, not at market close.

ETFs and Indexes

Majority of ETFs are also mirroring a particular index. Meaning they will track an index and will try to match the returns of that index. For example, there is the SPDR S&P 500 ETF, which is very popular. This ETF will allocate towards a percentage of the S&P 500 companies, hoping it can match the returns of the S&P 500 index itself. So, this would be similar to buying an entire portfolio. If you don’t like buying individual companies or have the time to do all the necessary research, this can be your best option. There are also many different options, you don’t only have the choice to invest in stock ETFs. There are also Bond ETFs and Commodity ETFs, like gold, silver and oil. Most ETFs will invest in only one asset class, such as shares or commodities.

ETFs have become increasingly popular in recent years. According to ETF.com writer Todd Rosebluth, as of mid-December 2018, there have been inflows of approximately $280 billion into ETFs. This would be the 3rd straight year of greater than $250 billion net inflows into ETFs, as investors are finding ETFs to be more attractive than mutual funds.

The reasons this could be happening are first and foremost, that ETFs have much lower fees than traditional portfolios and mutual funds. If you look at Vanguard ETFs (not promoting, just stating the numbers), Vanguard’s average ETF expense ratio is 74% less than the industry average. The reason ETF fees are much lower is because they aren’t as active as a traditional portfolio or even a mutual fund. They are there to mostly track an index. Meaning there isn’t much research going on as often as portfolio managers would be conducting for a mutual fund. They also aren’t incurring as high of transaction fees for trading like a mutual fund or any aggressive stock portfolio. ETFs do not need to hire expensive fund managers or stock pickers, help keeping management fees low.

ETFs are one of the fast-growing investing products globally. You will see many investment companies are opening their doors and offering just ETF products. Making them an ETF shop, as one would put it in the industry. Globally, more than $3 trillion US dollars are held in ETFs.

Advantages of ETFs

Another advantage to an ETF is there is a much much less upfront cost to purchasing an ETF. Looking back at our example of the SPDR S&P 500 ETF, you can do one transaction and begin tracking the S&P 500. If you were to buy X amount of individual stocks of the S&P 500, you would be paying a fortune if you would want to get close to the same exposure the SPDR would give you.

The last advantage of an ETF is the liquidity it provides. This brings us back to how an ETF is traded, compared to a mutual fund. An ETF is traded like a stock, so it is easy to buy and sell. You also are always getting the most up to date pricing of it. When you purchase a mutual fund you will be purchasing the Net Asset Value that was calculated from the prior day closing. You won’t know what the NAV will be or how it has changed, until that trading day closes, and the NAV is calculated.

Also, diversification is a key benefit to buying ETFs. Getting the exposure of a full index in a single trade, minimizing transaction costs and diversifying into a whole portfolio seamlessly.