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, which carry individuals in a single unit while moving, an Exchange Traded Fund is a 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 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 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 in traffic, an ETF's market price never goes up or down in a straight line without any intraday turbulence.
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. Moreover, a passenger who needs to get to Florida while the other passengers are headed to Maine certainly doesn't belong in that car!
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?
When you decide to buy shares of your selected ETF, the allocation to each company is already built-in to the fund (made by the fund's issuer). Hint: This allocation of companies can be a major decision factor when considering which ETF to buy! Once your buy order executes, you instantly own equity in multiple companies with the ease of one click.
For example:
An ETF is comprised of 10 companies.
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.
In a non-equally weighted scenario, each company may be allocated a different % weighting within the fund, so long as all 10 companies when 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% |
If one company goes down 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 when deciding which ETF to buy for your portfolio.
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!
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.
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?
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!
As with most things, with lower risk comes lower reward attached to it. Some investors may not mind the ease of investing over the uncomfortable risk in one or a few companies.
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).
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
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