What are ETFs or exchange-traded funds? In Clo Bare’s Investing 101 series, she works on demystifying the stock market so folks like yourself can understand, invest, and get some of that sweet, sweet, passive income. In this post, Clo Bare breaks down exchange-traded funds (ETFs) by explaining what they are, the different types of ETFs, how they make you money, the benefits, and the drawbacks.
Welcome back to the Investing 101 series where I aim to break down investing a tiny bite-sized chunk at a time. If you’re new here, welcome. My name’s Chloe, but you can call me Clo Bare, and today we’re going to break down exchange-traded funds, also known as ETFs.
What is an ETF: First Understanding Funds
Now, before we get to what an ETF is, we first need to talk about what a fund is in the world of investing.
Let’s say you and a group of friends decide to pile your money together so you can start investing. You all throw in different amounts of money, but there is a minimum amount each person has to contribute to be a part of your little experiment.
With the money you collect from each person, you put it into a big bucket of cash.
You then decide that one person from the group gets to decide which investments to purchase, we’ll call him Brad. With the cash inside of the bucket, Brad then purchases stocks, bonds, and other financial assets with the money on behalf of the group of friends.
Brad gets to decide what to do with the money, and he also makes all the decisions for the bucket of money. And everyone else pays Brad a small sum of money to manage the bucket of money.
Now, the assets that Brad purchases create a portfolio of all kinds of things– stocks, bonds, etc. And since these assets were purchased with shared money, each of your friends who put money into the bucket owns a small share of ALL the assets purchased with that money.
Watch this Post on YouTube: What are ETFs?
The bucket of money and all the assets? That’s your fund.
I also like to think of funds like boxes of chocolates versus chocolate bars.
A fund is like a box of chocolates– it contains a little bit of everything, stocks, bonds, and other assets, and you have to buy the box as a whole.
You can’t pick out all the caramel creams, and only pay for those– you’ve gotta get the pecan clusters and chocolate-covered raisins too.
Stocks, bonds, and other non-fund financial assets are more like chocolate bars.
When you purchase a chocolate bar, like when purchasing a single stock, you only get that one chocolate bar– there’s nothing else inside it. To translate this to buying stocks– if you bought share of Apple, you ONLY bought a share of Apple.
Stocks and bonds are like chocolate bars. Funds are like the whole box of chocolates.
What is an ETF: Exchange-Traded Fund
ETFs are exactly what they sound like– Funds that can be traded on an exchange, just like stocks.
Unlike mutual funds and index funds, you can buy and sell ETFs all day long. They’re highly liquid, meaning you can cash out your shares for cash at any time during the day. This differs from index funds and mutual funds, which you can only cash out at the end of the day.
ETFs and Risk
ETFs can be considered relatively low-risk investments because most are diversified. Diversification in the world of investing is a good thing because you’re not putting all your eggs in the same basket. If one company within the fund fails– you’re covered because you’ve got tons of other stocks cushioning the blow. Buying single stocks in comparison can be a whole lot more risky because it’s hard to replicate the diversification of a fund that contains THOUSANDS of stocks inside it… when you’re picking individual stocks.
What Makes ETFs Unique
ETFs are also unique in that they can mirror an index, sector, commodity, or another asset– and they can even be created to mimic the performance of different countries.
Basically– if there’s a group of stocks, a sector, or even a niche market that you’re interested in– there’s probably an ETF for it.
Indexes, sectors and commodities– sounds like a lot of jargon, right? So let’s identify those terms and what it means for an ETF to mirror each kind.
What is an Index?
An index is a way to measure the performance of an investment. But honestly? The simplest way to think about an index is to remember that it’s essentially a grouping of stocks.
- S&P 500: Tracks the performance of stocks of 500 of the largest companies in the US.
- Dow Jones Industrial Averages: Tracks the performance of 30 companies representing the largest publicly traded companies in the US.
- Nasdaq 100: Tracks the 100 largest, most actively traded US companies in the Nasdaq stock exchange.
ETFs Created to Mirror an Index
ETFs that are created to mirror an index will contain all the stocks, bonds, and other assets in that index.
For example, if you purchase an S&P 500 ETF, that ETF will contain all the stocks that comprise the S&P 500, like Google, Allstate, Accenture, Amazon, Tesla, etc. When you purchase one S&P 500 ETF, you’ll then own small portions of each of those stocks in the S&P 500.
Remember the box of chocolates we talked about earlier? These ETFs are boxes of chocolates– they have a little bit of everything in ETFs mirrored to track an index.
What is a Sector?
A sector describes a large segment of the economy. Within different sectors, businesses create similar products or services. The economy has four, main sectors that include:
- Primary sector: agriculture, mining, forestry
- Secondary sector: processing, manufacturing, construction
- Tertiary sector: retailers, entertainment, services, financial
- Quaternary sector: intellectual pursuits, educational businesses
Think of it like the way investors divide the economy. That’s pretty much all that sectors are used for– to help identify different parts of the economy.
What it means when an ETF mirrors a sector?
So when we say that ETFs can mirror a sector, we mean they hold funds from companies within different sectors.
For example, financial sector ETFs will hold the stocks of financial companies like JP Morgan, Wells Fargo, Citigroup, Charles Schwab, etc.
What is a Commodity?
A commodity is pretty much anything that is traded based on a price, so like a product, good, or service. It isn’t traded based on its qualities and features– there’s a set price.
For example, have you ever wondered why gas prices are relatively the same across the country, give or take a bit depending on where you live?
It’s because gas is a commodity and its produced on a massive scale, by many different companies, but the value, quality, and price from each producer are about the same. Some examples of commodities are precious metals, electricity, oil, beef, wheat, natural gas, milk, etc.
What does it mean to purchase a Commodity ETF?
There are commodity ETFs that allow investors to purchase shares of different commodities, like gold, oil, precious metals, etc. For example, you can purchase the Aberdeen Standard Physical Gold Shares ETF that just contains gold as the asset in the ETF. Or you can purchase the United States Oil Fund that holds oil as an asset.
Different Types of ETFs
Now that we’ve got the definition of indexes, commodities, and sectors out of the way, let’s talk about the six different types of ETFs.
- Equity ETFs: These are the ETFs that track indexes or sectors. Some of the index ETFs represent entire indexes, and sometimes they use just a sampling of stocks from the Index.
- Fixed-Income Funds/Bond Funds: These are basically bond ETFs. They’re way more secure, and they provide a fixed interest payment to the investor in addition to the amount you invested. Bonds are basically loans you give to a company, and they pay you back interest on the money you invested as a thank you for loaning them the money. You don’t own any part of the company.
- Commodity Funds: These funds track the price changes of particular commodities, like gold, oil, natural gas, etc.
- Currency Funds: These funds invest in foreign currencies like the Euro or Canadian dollar. Investors do this to protect their money from when/if the value of the US dollar goes down.
- Real Estate Funds: These funds contain real estate investment trusts (REIT). REITs are basically companies that hold income-producing properties.
- Inverse or Leveraged Funds: There are inverse funds that provide a profit when an index does poorly, and leveraged funds. Leveraged funds are extremely risky, but they can double or triple returns of indexes by using leverages. Not for beginners, fam.
How to Buy and Sell ETFs
Buying and selling ETFs is pretty simple.
You can also purchase ETFs in your IRA or other retirement accounts.
Like any kind of investment, I recommend you look into different funds and do some research before opening a brokerage account and purchasing ETFs. Each brokerage has different options, and you want to make sure that whatever brokerage you create an account with has the funds you want to buy.
Another thing to note, there are fees every time you buy and sell. There are some brokerages that offer free trades but do your research beforehand to make sure you know whether or not you’ll have to pay fees to buy and sell ETFs. E*trade, TD Ameritrade, Charles Schwab, Fidelity, and Vanguard all offer some commission free ETFs. But again, do your research on the fund before you buy to find out if it’s free to trade or not.
Another thing to note, is that while some brokerages will offer funds from other brokerages– for example you may be able to buy Vanguard from Charles Schwab, but usually there are extra fees so you might be better off buying directly from the brokerage that made the fund.
How do ETFs Make Money?
ETFs make money the same way mutual funds and index funds make money– through dividends and capital gains when buying and selling.
Capital Gains: Investors can also sell fund shares when they go up in price, making a gain in the difference between when they bought the fund and when they sold it. This is called a capital gain.
Dividends on stocks held in the funds portfolio: A dividend is like a thank you from a company to investors for holding their stocks. Not all investments have them, but when buying a stock or fund, this information should be readily available. These dividends get paid out to investors once a year (sometimes quarterly or more) and investors usually get the choice to get a check from the mutual fund or reinvest the earnings in the mutual fund.
Examples of ETFs
There are thousands of ETFs that you can buy on the market today. Some of the most popular ones are:
- SPDR S&P 500 (SPY): This is the oldest ETF that tracks the S&P 500.
- Invesco QQQ (QQQ): This tracks the Nasdaq 100, which contains technology stocks.
- Vanguard Growth ETF (VUG): Tracks the performance of US large cap growth index.
- Vanguard Information Technology ETF (VGT): This fund holds 340 technology companies in big tech.
Pros of Investing in ETFs
1) Low Cost
ETFs are usually passively managed just like mutual fund Index Funds which means you have lower costs! Woo! For example, an actively managed mutual fund fee is usually about 1-3% of your portfolio plus fees when you buy and sell; Index funds can be as low as 0% to .5%, and ETFs can be as low as 0.03%.
2) Immediate Diversification
Like the other funds mentioned above, these are baskets of securities that will prevent you from putting all your eggs in one basket. Unless of course you buy a commodity ETF or sector ETF, but we’ll talk about that more below.
3) Liquid/Trades Like a Stock
Just like stocks, ETFs can be bought and sold throughout the trading day. That’s a benefit and a drawback– benefit because if you want to actively manage your ETF trading, then you might be able to make some quick cash. Drawback? Your ego might convince you that you can beat the market long-term AND it encourages that betting/gambling behavior that doesn’t work out so well in the long-run.
4) More Tax-Efficient
Usually, ETFs don’t make as many gains for investors as actively managed funds, which if you’re trying to not pay taxes a lot of taxes on your gains– is great.
When an ETF buys or sells shares, that’s considered an in-kind redemption which means that you’re not going to get any additional tax charge.
This differs from mutual funds because if a manager buys and sells within the fund, any capital gains will be distributed to investors if the manager sells for a profit. What does that mean? It means that if your manager makes money for you, you have to pay taxes on that isht. You won’t have that issue with ETFs.
Investing in ETF Drawbacks
1) Encourages Gambling Behavior
Now, this doesn’t apply to everyone but when you can trade stocks and ETFs all day just hoping for that quick fix of cash? That usually leads to an inflated ego and increased gambling behavior which in the long-run, doesn’t do so great. Remember that bit about Index Funds outperforming 90%+ of the market? That’s from buying and holding, not buying and selling every day.
2) Actively-Managed ETFs have higher fees
You can purchase actively-managed ETFs, which means there is a professional trading within the fund to try and give the investor the most bang for their buck. This, of course, comes with more fees.
3) All ETFs are Not Created Equally– Some Extremely Risky
Like I mentioned earlier, there are some extremely risky ETFs like commodity ETFs and leveraged ETFs. Just because it says “fund” doesn’t necessarily mean it’s a true fund, or that it’s diverse, but if you purchase Index ETFs, generally they are diversified, but you have to do your research on ETFs to make sure they’re the right fit for your investment strategy and risk preference.
My Opinion on ETFs
I invest in ETFs just as much as I invest in my index mutual funds. Most of my ETFs are passively managed and the only reason I would pick an ETF over a mutual fund is if I didn’t have the $3k minimum investment for a new mutual fund I wanted to buy.
That doesn’t apply everywhere though. Vanguard is one of the few brokerages out there that STILL doesn’t allow fractional share investing and has high minimums for their mutual funds, index or active.
Because of that? In my Vanguard IRA, I have a lot of ETFs. Because sometimes I don’t have $3k to invest in a new mutual fund, and I’d rather throw $500 in an ETF than WAIT until I have $3k to invest in a new index fund.
If you look at the bulk of my portfolio though, you will notice MOST of my investments are in index mutual funds. The reason for that is because I like automation (you can’t automate ETFs), and because a large portion of my net worth is in my old 401k which only offered mutual funds.
Now, this may change once I finally get my 401k rolled over into an IRA, but for now? That’s where I’m at.
TLDR: What are ETFs?
The long short of it– ETFs are a great low-cost way to invest in a variety of different types of fun. You can buy and sell to your heart’s desire, save some money on taxes, and keep your money diversified. They can be risky, and sometimes it might encourage some gambling like behavior due to the ability to buy and sell all the time– but generally speaking, some ETFs can be a solid choice as long as you do your research, and know what you’re getting yourself into.
Your Turn: Thoughts on ETFs?
Do you invest in ETFs? If so, what are your thoughts? Share in the comments below!
Disclaimer: As always, this is not investing advice, this is just for entertainment and educational purposes. Do your own research to decide if ETF investing is right for you.