What Is An ETF Fund?

by: Joseph L. Shaefer
Summary

"Exchange-Traded Funds" -- ETFs -- have taken the investing world by storm.

Their popularity has begun to eclipse the popularity of many traditional mutual funds.

But just what is an ETF? In what ways are these investments different and how does one acquire them?

The term “mutual fund” refers to traditional open-ended funds, closed-end funds and the gaining-in-popularity-every-day Exchange-Traded Funds, or ETFs. All mutual funds are nothing more than companies which are organized in such a way that their "business" is to accept capital from you and thousands of other investors. Then, by pooling those funds, they create greater buying power for all of you who have decided to invest together.

What Makes an ETF Different Than a Traditional Mutual Fund?

An ETF also pools funds to achieve diversification, but with one important distinction: you can trade shares in an ETF just like you can any exchange-traded stock.

Exchange-Traded Funds are listed on the major stock exchanges and easily bought through any broker or online brokerage firm of your choice. Unlike traditional mutual funds, you can buy the ETF at 10 a.m. or 1 p.m. or any other time the exchange it is listed on is open for business. (In the USA this is usually 9:30 a.m. to 4 p.m. every weekday.) You can then sell this Exchange-Traded Fund any time you like. In addition, ETFs are offered by such giants in the financial services arena as BlackRock, Vanguard, State Street, Invesco, and many, many more.

These Exchange-Traded Funds created quite a stir when they were first created in Canada back in 1990, followed by the US in 1993. Since then, ETFs have proven so popular with investors that their growth has been nothing short of spectacular:

Source: The Vanguard Group, Inc.

For a more in-depth timeline of the history of this “new” type of mutual fund and its phenomenal growth in popularity (investors now own nearly $4 trillion worth of ETFs) the chart above from Vanguard is interactive at Vanguard's What is the history of ETFs?

Why Would You Want to Own an ETF?

What advantages and disadvantages accrue to you when you spend your money on an Exchange-Traded Fund to invest on your behalf? There are three potential advantages:

  1. professional management,
  2. diversification and, in most cases,
  3. lower costs than you would pay with a traditional mutual fund – and certainly less than you would pay if you tried to buy all the individual stocks of all the individual companies that comprise the ETF’s portfolio!

Professional Management

Please note that professional management doesn't necessarily mean better management; it does, however, mean full-time management. Often it means the managers have degrees in finance or MBAs in business. However, “professionals” can be gifted or they can be also-rans. In this case, the term simply means that this is what they do all day long. Theoretically, if you do something all day long you're likely better at it than someone who does it only occasionally as an incidental adjunct to the way they make their living.

Diversification

As for diversification, however, there is no question that this is an advantage. And unlike traditional mutual funds, which always have some kind of minimum amount to begin investing with them, you can start buying ETFs with any amount you choose. You cannot achieve this kind of diversification by buying your own basket of common stocks. You don't want to buy one share of a $42 stock one month, 2 shares of a $25 stock the next, and so on. Even buying direct from the company, as with a Dividend Reinvestment Plan, or DRIP, the record-keeping alone might prove so onerous it will take all the fun out of investing.

Exchange-Traded Funds, ETFs, do all this for you. By pooling your funds with thousands of other investors' monies, the fund might receive $50 from each of 1000 people, $1000 from a thousand more, $10,000 from a few hundred more, and so on. What you end up with is a diversified portfolio of scores of different stocks.

If one company held in the mutual fund's portfolio goes bankrupt, it doesn't wipe you out, since it's just a small part of the total portfolio. Of course, if one stock skyrockets and the rest just coast along, it doesn't do much for you on the upside, either; such are the object lessons of the risk/ reward ratio: reduced risk sometimes means reduced reward.

Lower Costs

An Exchange-Traded Fund can get a much better deal when buying and selling individual stocks within its portfolio – you and I might trade common stocks for only a few dollars per transaction. However, because ETFs (and all mutual funds) can place “block” trades of 10,000 shares, 100,000 shares, or more, they are going to pay less per share than you or I will. As a result the “management fees” on the biggest ETFs tracking the most common benchmarks are quite low. In fact, some are now being offered with 0% management fees! In addition, many others are offered with $0 commission to buy or sell (subject to a minimum holding period.)

While other factors are more important to me, like long-term performance and a management team that stays true to its charter, low fees are certainly a benefit.

Exactly How Does an ETF Work?

When you invest in an ETF, you give someone else, the ETF’s management team, the responsibility of deciding how your funds are invested in keeping with the selected investing in the benchmark or sector or industry its charter dictates.

This is usually easily discerned from the name of the Exchange-Traded Fund and definitely ascertained by simply viewing the “strategy description” of the ETF that is available on many websites, including Seeking Alpha. Here, for instance, is the description listed by Seeking Alpha for the SPDR S&P 500 Trust ETF (SPY), one of the most popular available ETFs.

By the way, Seeking Alpha’s “Strategy” description in the link above is just one of many drop-down headings that are readily available, without having to leave that one page, for your perusal. From that single page, you can see the latest price and chart, view the historic returns, peruse the ETFs largest holdings, and so much more. Taken together, that will pretty much tell you everything you might want to know about a particular ETF!

Most individual investors consider giving the day-to-day management of a portfolio of companies to be a real positive. You buy the ETF and the managers of the ETF make the daily decision of what and how much to buy and sell. With an index fund that invests exclusively in a benchmark index, those decisions are few and predicated only on the index changing one of its components. In a more active ETF like, say, a biotech health care ETF, those decisions might come fast and furious.

Either way, when you turn on your nightly news and you hear that there was heavy selling (or buying) by "institutional investors" on Wall Street today, at least by proxy, that is you they’re talking about. It is your money that is doing the institutional buying and selling.

How Much Flexibility Do I Have in Choosing an ETF That is Right for Me?

Your investment choices are virtually endless: there are ETFs comprised of a basket of stocks from a single country, from certain countries that have something in common, from certain regions of the world, from certain sectors, from certain industries, and so on. Anything the mind of man can conceive to lump together, there’s probably an ETF that covers that area.

The Exchange-Traded Funds that have attracted the biggest following and share of investors’ monies are the so-called “index” ETFs. These ETFs invest in one of the primary benchmarks like the Dow Jones Industrial Average, the Standard & Poors 500, or the Nasdaq 100. (This index includes 100 of the largest US and international non-financial companies listed on the Nasdaq Stock Market.)

You may have heard of some of these better-known ETFs, like the NASDAQ 100s, called the Qubes (QQQ) (see its strategy here), the above-mentioned SPDR S&P 500 Trust (SPY), or Diamonds (DIA), an ETF that tracks the Dow Jones Industrials (here's the strategy) All of these are passively managed, which is to say they aren’t really “managed” at all. When a stock is de-listed from their underlying index, they sell it. When one is added, they buy it.

But don’t stop there. You can select an ETF as broad or as granular as you like. After all, there are more than 6,000 ETFs globally – with almost half of those based in the US.

For Further Information

In short, ETFs offer low fees, excellent liquidity, superb diversification and are usually excellent proxies for the benchmarks, sectors or industries they represent. I maintain that as much as on-half of all market success is determined by being long the market when it’s moving up and as much as an additional quarter to three-eighths is assured by being in the right sectors. If you agree, you will want to do more due diligence and research on these funds. There are many resources available on the Internet and also directly from the sponsoring ETF companies. I think Seeking Alpha’s ETF Investing Guide is one good place to begin your analysis.

Good investing!

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.