Introduction to Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) are a type of financial instrument whose unique advantages over mutual funds have caught the eye of many an investor. If you find the tasks of analyzing and picking stocks a little daunting, ETFs may be right for you.
What Is an ETF?
Think of an exchange-traded fund as a mutual fund that trades like a stock. Just like a mutual fund, an ETF represents a basket of securities (such as stocks) that reflect an index such as the S&P 500 or the Barclays Capital U.S. Aggregate Bond Index.
An ETF, however, isn’t a mutual fund; it trades just like any other company on a stock exchange. Unlike a mutual fund that has its net asset value (NAV) calculated at the end of each trading day, an ETF’s price changes throughout the day, fluctuating with supply and demand. It is important to remember that while ETFs attempt to replicate the return on indexes, there is no guarantee that they will do so exactly. It is not uncommon to see a small difference between the actual index’s year-end return and that of an ETF.
By owning an ETF, you get the diversification of a mutual fund plus the flexibility of a stock. Because ETFs trade like stocks, you can short sell them, buy them on margin. Another advantage is that the expense ratios of most ETFs are lower than that of the average mutual fund. For example, the SPDR S&P 500 ETF (SPY) has a low expense ratio of 0.0945% as of 2022. When buying and selling ETFs, you pay your broker the same commission that you’d pay on any regular trade.
The first ETF was the S&P 500 index fund (nicknamed “spiders” because of their SPDR ticker symbol), which began trading on the American Stock Exchange (AMEX) in 1993. Today—tracking a wide variety of sector-specific, asset-type-specific, country-specific, and broad-market indexes—there are thousands of ETFs trading on the open market.
You can pretty much find an ETF for just about any kind of sector of the market. For example, if you were interested in getting exposure to some European stocks through the Austrian market, you might take a look at the iShares MSCI Austrian Index fund (EWO).
Some of the more popular ETFs have nicknames like cubes (QQQ) and diamonds (DIAs). Many ETFs are passively managed, meaning investors save big on management fees.
This ETF tracks the Nasdaq-100 Index (QQQ), which consists of the 100 largest and most actively traded non-financial domestic and international companies on the Nasdaq. QQQ, or “cubes”, offers investors broad exposure to the tech sector. Because it curbs the risk that comes with investing in individual stocks, the QQQ is a great way to invest in the long-term prospects of the technology industry. The diversification it offers can be a big advantage when there’s volatility in the markets. If one tech company falls short of projected earnings, it will likely be hit hard, but owning a piece of a hundred other companies can cushion that blow.
Usually referred to as “spiders“, these investment instruments bundle the benchmark S&P 500 and give you ownership in the index. Imagine the trouble and expenses involved in trying to buy all 500 stocks in the S&P 500. SPDRs allow individual investors to own the index’s stocks in a cost-effective manner.
Another nice feature of SPDRs is that they divide various sectors of the S&P 500 stocks and sell them as separate ETFs – there are literally dozens of these types of ETFs. The technology select sector index, for example, contains around 70 different holdings covering products developed by companies such as defense manufacturers, telecommunications equipment, hardware, software, and semiconductors. This ETF trades under the symbol XLK on the NYSE ARCA.
iShares and Vanguard
iShares is BlackRock’s brand of ETFs. In 2020, there were over 800 iShares ETFs globally with more than 2 trillion dollars under management. BlackRock has put out a number of iShares that follow many of the major indexes around the world including the Nasdaq, NYSE, Dow Jones, and Standard & Poor’s. All of these particular ETFs trade on the major exchanges in the U.S. just like normal stocks.
Just like iShares are BlackRock’s brand of ETFs, Vanguard ETFs are Vanguard’s brand of the financial instrument. Vanguard also offers hundreds of ETFs for many different areas of the market including the financial, healthcare, and utility sectors.
Funds can also provide a way to invest in natural resources such as the United States Natural Gas Fund (UNG). These investments give a replication of natural gas prices, after expenses and try to follow the prices of natural gas by buying futures contracts on natural gas in the coming months. As with all the funds, you need to keep an eye on the total expense ratio before investing.
Emerging Market Focus
This investment attempts to mimic the returns seen in the BlackRock Institutional Trust’s, iShares MSCI Emerging Markets Index (EEM). This ETF was created as an equity benchmark for international security performance. If you would like to gain some international exposure, specifically to emerging markets, this ETF might be for you.
Not all ETFs are designed to move in the same direction or even in the same amount as the index they are tracking. Inverse ETFs have prices that go up when the markets go down and vice-versa. For example, the Direxion Daily Financial Bear 3x Shares (FAZ) is a triple bear fund. It attempts to perform 300% in the opposite direction of the Russell 1000 Financial Services Index using derivatives and other types of leverage to boost performance returns of the underlying index. This fund became popular in 2008 and 2009 when the financial crisis placed downward pressure on financial stocks.
These ETF shares, SPDR® Dow Jones® Industrial Average ETF, tracks the Dow Jones Industrial Average. The fund is structured as a unit investment trust. The ticker symbol of the Dow ETF is DIA, for Dow Industrial Average, which is where it gets its moniker, “diamonds.” It trades on the NYSE ARCA.
The Bottom Line
A great reason to consider ETFs is that they simplify index and sector investing in a way that is easy to understand. If you feel a turnaround is around the corner, go long. If, however, you think ominous clouds will be over the market for some time, you have the option of going short.
The combination of the instant diversification, low cost, and the flexibility that ETFs offer, makes these instruments one of the most useful innovations and attractive pieces of financial engineering to date. There are a number of brokers who provide ETF investments.