What are ETFs? Exchange Traded Funds explained in 7 Minutes
Learn what are Exchange Traded Funds and why they are a great tool to invest in the stock market
When you start your journey on the investment world and you do your research, you should stumble upon the concept of Exchange Traded Funds pretty quickly. Although they are extremely famous, they may come out as a confusing financial instrument, particularly if you’ve just started to understand how the stock market works. Adding to that, there are more than 8.000 ETFs available, making it even harder to choose one when you finally decide that you would like to own a piece of some ETF out there.
In a nutshell, ETFs are one of the most famous ways to invest in the stock market, today. They are (partially) similar to mutual funds in their core, helping you diversify across multiple investments and making sure that you’re protected in terms of risk. But, these types of instruments are not tied to stocks alone — there are ETFs for commodities, bonds and even crypto currencies.
In this post, we’ll understand what exactly are ETFs and why are they extremely useful on your journey to financial independence. We’ll see the difference between investing in individual stocks and ETFs and how the latter compare with mutual funds.
Let’s start!
Individual Stocks vs. ETFs
When you purchase a stock of a company, you are becoming a shareholders of that company, entitling you to dividends and share price appreciation.
In the stock market, unless you purchase huge chunk of a company’s available shares (something that is not for everyone’s wallet!), you will own a tiny, tiny percentage of the company you are investing in. For instance, let’s imagine that your portfolio only consists of a single share of Apple — and imagining that you bought that share at a price of 157 $ (values of September 2022). As of today, that will mean that you will own exactly 0.00000000006% of Apple.
While this will not make you influence Apple’s strategy at all, you will be completely exposed to the company’s ability to execute. If something strange would happen and Apple would have to file for bankruptcy, you would be completely unprotected and your portfolio would (potentially) be worth 0$.
If you build a portfolio on your own, you probably buy pieces of several companies — some people buy 10, 20 or 30 companies to protect themselves from risk. While that is reasonable, there should be a better way for you to diversify across several companies without so much work, right?
Exchange Traded Funds and Mutual Funds are the way to do it! For instance, if you buy an ETF, you will have access to a tiny portion of several companies at the same time — for instance, let’s check the top companies represented in the iShares Core S&P 500:
These are the top 10 holdings that the ETF tracks— in the Weight column, you can see the percentage that that particular stock weights on the total fund portfolio. When you buy this ETF, you don’t directly own the companies it tracks — the fund does that for you!
And what are the advantages of owning companies through an ETF? Let’s see:
- It diversifies by design;
- If something weird happens to one of the companies in the index (bankruptcy, cash flow issues, etc.) that stock will be replaced by other stock that will enter the index —basically, the value you would lose can be (theoretically) replaced in the long run.
- It is, normally, an low cost approach to investing, when compared with manually rebalancing your portfolio.
- It protects you from acquisitions and spinoffs (something that may make you pay capital gains before your investment timeline) or other external events that may happen with the stock.
How does the fund knows which companies to track? That depends on the fund strategy! On iShares Core S&P 500, the ETF buys pieces of companies that are part of the Standard & Poor’s 500. This fund passively invests and diversifies according to whichever companies are being tracked in the index at a specific time.
Different stock ETFs have different strategies. Let’s check some examples:
- The iShares Euro Dividend ETF tracks european companies with high dividend yield.
- The iShares Emerging Markets tracks emerging markets companies.
- The VanEck eSports and Gaming tracks companies related with videogames and the eSports industry.
Normally, in the webpage of the ETF, you can see the strategy near the top. The strategy is, probably, the most important factor to consider when choosing one ETF to invest in — for instance, on the top of the iShares Emerging Markets, you can see the following:
There are other aspects to consider when investing in an ETF but we will discuss them near the end of the post.
Bottom line — ETFs let you invest in the Stock Market without too much stress and help you maintain a strategy that is consistent — something that is probably harder and more expensive to do when you perform stock picking.
Most of the things I’ve detailed above are also relevant for Mutual Funds! Let’s see the difference between Mutual Funds and ETFs, next.
ETFs vs. Mutual Funds
If you’ve already read about Mutual Funds, you may notice that ETFs are, in their core, a similar concept.
While that’s true, the major difference is that ETFs are more liquid — meaning you can sell a piece of an ETF like any stock on the market you’ve bought it, as long as the market is operating. With mutual funds, you normally place an order and the transaction is done at the end of the day or at the start of the day after.
Another relevant difference is that mutual funds are typically managed in an active way, with higher fees. This has been changing in the last decades as a lot of mutual funds are modifying their approach to a passive one to try to tackle the huge market share that ETFs have been gaining lately.
Passive vs. Actively Managed
What do passive vs. active management mean? Basically, when an ETF or mutual fund is actively managed, there’s a fund manager responsible to adjust the weight of companies and (theoretically) achieve higher returns than the underlying index that the ETF tracks. The downside? There’s no guarantee that the fund manager can achieve higher returns and the fund’s expense ratio will typically be higher.
Passive funds only follow a specific index with automated (or minimal) adjustments. The fund manager has little or zero influence on where the fund invests and what stocks it adds to the portfolio. For instance, ETFs that follow indexes such as S&P 500 or the NASDAQ are typically passively managed, just tracking the underlying indexes.
Some examples: the ARK Innovation ETF, one of the most famous technology ETFs that is managed by Cathie Wood has an expense ratio of around 0.75% — meaning that every year, from the total assets of the fund, 0.75% will be taken out as a fee for Ark.
Compare this with an ETF that follows NASDAQ’s technological companies — for instance the NASDAQ 100 ETF. This ETF has an expense ratio of 0.36%, minus 50 percentage points! Does the extra return in active managed funds compensate the higher expense ratio? History mostly states that no as actively managed funds underperform passive ones.
More than Stocks
So.. are stocks the only asset class we can invest in with ETFs? Of course not!
You can use ETFs to track multiple types of asset classes such as bonds, commodities or even gold. For instance, the iShares 7–10 year Treasury Bond ETF tracks the value of U.S. treasury bonds with remaining maturities between seven and ten years. Another example, the Invesco DB Commodity Index ETF tracks a basket of commodity prices and helps you have exposure to this “exotic” asset class.
The advantage of these ETFs is they make it much easier to buy baskets of commodities or bonds than buying them all individually — the expertise needed to trade and invest in these assets individually is probably a big blocker for many people. Luckily, these ETFs democratize the access to these asset classes, enabling everyday investors to diversify away from stocks.
What to Choose in an ETF
In this blog post, we’ve discussed several aspects of ETFs. If you want to start right away, what should you look into? Here’s a shortlist:
- First, you need to search for ETFs of the asset class you want to be exposed to. Stocks, bonds, commodities, gold, silver or other.
- Next, you need to understand what is the strategy of the ETF. Does it follow a specific index or a specific subset of companies? In case of bonds, what maturities does it invest in? Questions about strategy are super important to make sure that the ETF fits your investment profile.
- The expense ratio of the ETF is another important variable that will impact your lifetime return. Make sure that, when comparing similar ETFs, you always choose the one with the lowest expense ratio.
- Remember to check if the fund is actively or passively managed. Active managed funds are typically more expensive.
- Lastly, check if the dividend distributes or accumulate dividends. If the ETF accumulates, your dividends will be compounded without exposing you to a (potential) capital gains tax.
Do you have other things you search for when you invest in ETFs? Let me know in the comments below!
