What Even IS an ETF?!

So you've heard of an ETF but you're left wondering what it does, or even what it stands for!

ETF stands for "Exchange Traded Fund", and it does exactly that. Simply stated, it is a fund that can be traded on an exchange. Let's dive into what that actually means in the simplest way possible!

Think of an ETF Like a Vehicle.

Similar to cars (and other means of transportation), which carry one or multiple individuals in a single unit while moving, an Exchange Traded Fund is a financial vehicle that contains one or multiple companies under its roof for a single price in the stock market.

An ETF is identified by a single ticker symbol (i.e. ABCD) on the stock exchanges, just like individual company stocks are too. Think of the car's license plate as the ticker symbol for the ETF, while the passengers already have their own identification independent of the car. The car is ultimately responsible for the passengers riding within it, just like the ETF's issuer is in charge of its components.

The passengers in the car decide where the car should head towards, just like the selection of companies within the ETF mainly determine which direction the price of the ETF will go (up or down)!

No matter how quickly those passengers want to get to their desired destination, there may be unintended obstacles along the drive, such as heavy traffic, nasty weather conditions, or construction on a major highway. As these obstacles are mainly out of the car's control, regardless of how well the driver, these setbacks make for a longer drive for all cars on the road. Think of this as overall market risk, with uncontrollable items (such as unfavorable economic events) setting back the majority of companies in the S&P 500.

While we can't always predict what may go wrong on the road trip, there are elements that are controllable based on the decisions made by the individuals in the car. For example, the route they choose to drive, their speed, and/or reckless driving activity can heavily influence what happens along the way, even in perfect driving conditions.

Just like the car complying with traffic lights, an ETF's market price never goes up or down in a straight line without any intraday turbulence. The ebbs & flows of the fund are what makes up the market! There are buyers and sellers in the market, and it is completely normal to have a healthy drop in price from sellers taking profits, in order for the buyers to step in and buy that dip afterwards.

Of course, price fluctuation of an ETF can also be influenced based on the sector of the market it follows, the business decisions of the individual companies it contains, and risk rating it holds.

ETFs typically track an index, which contains a predefined set of listed companies that it follows. Think about it, you wouldn't want just anyone riding in your car who could ultimately cause an accident to occur!

The passengers are carefully selected based on their reputation and intentions for being in the car. A history of DUIs or DWIs on a driver's license can pose a serious risk to the vehicle AND the safety of the other passengers in the car. Needless to say, the companies held in an ETF hold different risks based on their financial picture, fundamentals, reputation of their CEO, and much more.

Let's look at the building blocks that structure an ETF.

When selecting from the thousands of ETFs available to invest in, it's important to understand the weighting or allocation that each company has within the fund. Issuers create ETFs with a strategy in mind and by tracking an underlying index of companies. An ETF can contain anywhere from a single stock up to a total market of stocks (hundreds to thousands of stocks). The greater the number of companies within the ETF, the less exposure there will be to each one overall. The lower the number of companies in the fund, the more exposure each one will have, and therefore will have a greater impact on the price of the ETF. The quantity of stocks can be beneficial or suboptimal to the price depending on each company's performance within the fund. More on the diversification of ETFs will be covered in a bit.

Sometimes, you'll see the allocation of stocks determined based on the company's market capitalization where the larger cap companies have the highest weighting within the ETF. You may also see the weighting based on the price per share of each company, where the highest priced stock holds the greatest allocation. There are also equally weighted ETFs and other strategies that determine the allocation to each company.

*Note: Market capitalization (market cap) and price per share of a company are not the same! Market capitalization is a company's share price multiplied by its total number of outstanding shares. Think millions, billions, and trillions when it comes to market cap!

For example: 

Let's take the hypothetical ETF symbol 'ATOJ' containing 10 companies to display each company's allocation within the fund.

In an equally weighted situation, each company in the ETF represents 10% or 1/10th of the fund. The pie is sliced into 10 equal slices, and each slice resembles each company's allocation in the ETF. See table below:

ETF Symbol 'ATOJ'	Allocation %^
Company A	10%
Company B	10%
Company C	10%
Company D	10%
Company E	10%
Company F	10%
Company G	10%
Company H	10%
Company I	10%
Company J	10%
Total (10 Companies)	100%

Here, the performance of each individual company will impact the ETF to the same extent as all the others. Equal weighted ETFs come in handy to prevent too much (or too little) exposure to any one company within the fund and give a fair chance to all.

In a non-equally weighted scenario, each company may be allocated a different % weighting within the fund, so long as all 10 companies added together equal 100%. See table below:

ETF Symbol 'ATOJ'	Allocation % ^
Company A	25%
Company B	20%
Company C	15%
Company D	15%
Company E	10%
Company F	5%
Company G	4%
Company H	3%
Company I	2%
Company J	1%
Total (10 Companies)	100%

As you can see, Company A holds the highest allocation (25%) within the hypothetical ETF ATOJ. If Company A performs well during a certain period of time, you can expect a solid rise in the price of 'ATOJ' since 1/4 of the fund is allocated to Company A. However, in the event that the other 9 companies in the fund are performing poorly during that same time period, that will put a damper on the price increase, as they balance the remaining 75% of the ETF.

On the other hand, Company J holds the lowest allocation (1%) within the ETF, so it's performance will most likely get washed out by the other 9 companies at all times, but that small stake in ownership is still there.

What are some of the benefits to owning an ETF?

Diversification

Owning shares of an ETF (containing multiple companies) allows for more diversification in an investor's portfolio rather than owning just one of those companies alone. Single stock risk is real, so why take the risk of owning just one company in a particular market sector when you can own the whole group?

Once your buy order for an ETF symbol executes, you instantly own equity in multiple companies with the ease of one click. This can be used as a safety net to broaden the exposure of names in your portfolio and reduce volatility associated with any one stock.

If one company plummets based on poor business decisions or bankruptcy, the presence of other companies in the fund allows for a balance to help reduce the risk of an overall price drop in your portfolio.

It's important to know the weighting or allocation that each company holds in an ETF so that you can make your decision wisely based on your tolerance to risk and knowledge of those companies.

Lower Expenses

Instead of buying each company's stock individually, you can own a portion of all of them without paying the lofty price for each stock! For example, an ETF that costs $500/share containing 500 companies is similar to paying $1 per share for each company when in reality those companies can cost hundreds of dollars per share individually.

Just like mutual funds, there is an expense for owning a basket of funds in your portfolio. However, ETFs carry lower expense ratios, meaning it costs less to buy & hold these funds overtime.

ETFs also tend to be more tax efficient than other vehicles (such as mutual funds) in your portfolio overall. Ask your tax advisor for more specifics on taxes.

Ease of Use

Everyday (retail) investors are now able to buy & sell ETFs on the secondary market without needing a financial advisor to choose mutual funds which essentially do the same thing.

Some investors would rather take less risk and have exposure to many companies in an ETF over the uncomfortable risk single stocks.

Now, unlike ever before, we have the ability to pick & choose from a variety of curated ETFs that can be bought & sold in an individual brokerage account. Transitioning to a digital world comes with accessibility to products so that we can build a DIY portfolio!

What are some of the downsides to owning an ETF?

Dilution

As with most things, with lower risk comes lower reward attached to it.

Just like in the diversification example, if one company is outperforming their peers in the ETF, unfortunately the upside potential is only limited to its proportionate weighting (% allocation) in the fund! In this case, the investor will probably wish they'd bought the individual stock instead of the ETF to reap the full benefit of its gain. The addition of too many companies in the ETF basket can dilute the portfolio performance overall, so company gains are not felt by the investor as much.

Gimmick Ticker Symbols & Low Volume Funds

There are (of course) some things to watch out for, like lack of liquidity in a fund, or catchy ticker symbols (i.e. YOLO, WEED). Sometimes when ETFs are new to the market, the low volume of trades on the symbol can make

Everyday investors have access to thousands of ETFs that they can buy in their individual brokerage accounts (& retirement accounts) just like fund managers and financial advisors.

ETFs range in price, by their expense ratios, their issuers, their market cap, their sectors, etc.

With a plethora of ETFs to choose from, ETF.com makes it fun & easy to find the right one with screener tools & filtered search options! This website is what I personally used to gauge an interest in the stock market myself. Being able to search for an ETF simply by entering your favorite stock in (to find similar funds in that particular sector) is incredible, and I would recommend it to anyone wanting more information about exchange traded funds. *not sponsored*

The beauty of being able to trade ETFs in the stock market is that the price is constantly changing during market hours, giving the trader more prices to target throughout the day for a greater intraday return. It's important to be cautious of "overtrading" (churning) where the trade fees may cost more than the return it would give if buying and holding overtime. There is definitely more temptation on the secondary stock market!

ETFs are no secret anymore, word on the street is that they're the cool new mutual fund that you can buy & sell in the stock market!

XO Hope