Education

What is an ETF?

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Jared Elson

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July 14, 2021

What is an ETF?

An ETF is a security that contains multiple investments and is characteristically similar to a mutual fund while having some of the functionality of a stock. An ETF can be considered a hybridization of the two. I think it’s more helpful to think about what ETFs do and can do, rather than trying to succinctly define ETF. It’s a way for you to invest in indexes, stocks, bonds, and commodities, while owning only one thing versus having to pick a bunch of different things yourself. 

What does ETF stand for?

ETF stands for exchange-traded funds. A more succinct ETF definition could be: a product that is traded on the stock exchange, containing a number of individual investments, but that are bought and sold throughout the day. It is an investment with the diversity of a mutual fund, but the trading agility of a stock.

How are ETFs made?

ETFs are made by combining different investments, whether it be stock or cryptocurrency, and packaging them together to create an investment that simultaneously both singular and diverse. Historically, ETFs were created to be passive investments but we have seen a shift to an active understanding of them. Today, we see a lot of fund companies that would have normally created a mutual fund instead creating ETFs and performing active management inside an ETF. From that sense, it is very much like a mutual fund, where you have a fund manager behind the scenes saying, "buy this, sell that". ETFs are typically made to be centered around a theme, maybe innovative companies or technology companies or green energy or any number of interests and industries. When you examine them you'll notice that they are actively managed. There’s a chief investment officer and they’re actually buying and selling and moving companies in and out of the ETF as they manage. I like to look at flows, where is money flowing in and out of the market. Over the last few years there’s been a lot of flows out of mutual funds and into ETFs because of the several advantages that they have stemming from the lower costs, lower commissions, and even actually have some tax advantages as well because of how they’re managed. There’s some things that ETFs just do better than mutual funds. 

ETFs vs. Mutual Funds

What’s the difference between an ETF and a mutual fund? Do ETFs diversify your investments in the same way?

In a way, yes! Mutual funds have been around much longer but ETFs generally follow the same principle of a mutual fund. You’d go to a mutual fund and you could get something that has an active manager, somebody behind the scenes buying and selling and picking which stocks or companies to own inside that mutual fund. This allows you to have a diverse investment while only having to purchase shares of the mutual fund. You could also get a mutual fund that tracked an index, like the S&P 500, or the DOW Jones, or the NASDAQ. In the 1990’s and the early 2000’s, ETFs began to become much more popular. The ETF was brought about as a tool to kind of fill the gap between buying individual stocks and mutual funds. When we think about an ETF vs index fund, or an ETF vs mutual fund, or even an ETF vs stock, we have to consider its purpose as a financial vehicle. They exist in that kind of in-between space between stocks and funds. When they first came out, the attitude from preparers was,  “we’re really going to be passive, in our ETFs”, meaning they’re mostly going to track an index. What the ETF owns is defined by an index that it tracks. For example the S&P 500, you can get an index that tracks the S&P 500. It’s going to own all the stocks of the S&P 500 while you just have to buy that one ETF.

They came out to solve a couple of issues that the mutual funds have. One is fees, ETFs have much lower embedded fees than a mutual fund does. Even an index mutual fund, typically an ETF which tracks the same index as a mutual fund is going to have fees that are less than half of a similar mutual fund. The other issue that it tries to solve is how you trade it. Buying ETFs can be done multiple times throughout the day. A mutual fund limits you to buying or selling basically once a day. So if you want to sell your mutual fund, you put in your order, and the whole trading day goes by and at the end of the day your shares are redeemed. The fund manager looks at all the change in price of securities and creates a price, and that’s what you get. An ETF, it trades like a stock. Which may be why you’ve likely heard it referred to as an ETF stock. You can sell it, or buy it, you get a price right now. The price of an ETF fluctuates throughout the day, just like the stocks that it tracks. You can buy and sell, and do so at will, so it’s a fair bit more liquid than a mutual fund might be. 

Why would you invest in ETFs over mutual funds with a retirement fund? 

For us, for what we do for our clients, we employ ETFs as one of our investment strategies. We are mixing and matching, we’ll say we’re not going to just buy one ETF, we’ll have a whole basket of ETFs that we invest in. There isn’t one best ETF. Those ETFs are going to represent different areas of the market, different sectors, different types of assets. Some may be bonds, some may be stocks, some may be international, some may be commodities, whatever they may be;  we’ll combine them together. Typically what we’re looking for when we’re looking for an ETF for our clients is very low costs, don’t want to pay too much for it, we’re looking for a certain amount of volume. So we want to make sure that it is frequently traded, so if we ever want to sell it, we’re confident that there’s going to be a market for it so we can get in and out. And we’re looking at performance, especially if we’re looking at an active ETF, that’s where you get into the fund manager and their philosophy and how they’ve performed. If it’s just tracking an index, it’s how closely does it track that index? You want to make sure there’s not a lot of error in what it does. Additionally, ETFs allow us to tailor a client's investment around their values, so if they're passionate about the environment we'll prepare strategies to invest in Green Energy and avoid investment in major polluters.

ETF Frequently Asked Questions

So who prepares ETFs? Who are the entities or persons behind them?

You’re typically going to find yourself buying ETFs from major investment companies. Fidelity, Vanguard, Blackrock, there are several other fund-companies that create ETFs. Even if you go to a broker like Charles Schwab, they have their own branded ETFs if you want to use those. Typically, they’re passive. They just create an ETF, they pick an index or a commodity, or a sector of a market that they track. A sector might be technology, or healthcare, or green energy, or recently, 5G. So if you say, “I want to invest in companies that are involved with 5G”. There are a few companies that have 5G ETFs, and you go and pick one and go on from there investing in ETFs for industries that seem attractive to you. 

Are ETFs just for stocks?

No, they are not just for stocks, you can have different kinds. For cryptocurrency, the ETFs that exist today, the company that prepares the ETF is actually buying crypto and storing it and you’re getting shares of their store of cryptocurrency in that ETF. It comes with some expenses as they are relatively expensive and have some high fees associated. As we see more players and competition enter the space, or more companies create cryptocurrency ETFs, fees are going to come down commensurately with that competition allowing them to be more widely traded and eventually one will make it onto a major exchange, get approval by the SEC to be traded on the NYSE and leave the OTC world behind. Are ETFs a good investment? Generally speaking, yes, but depending on the sector this is a situation you may find yourself having to navigate to invest at the more ideal opportunities. 

Are ETFs good for beginners?

I think they’re excellent for beginners. The reason being, as a beginner, unless you’re comfortable with a lot of risk, you don’t necessarily want to be trying to choose individual companies. What’s been shown and researched and reported over and over and over, is that your investment returns come primarily from the sectors or the asset classes that you invest in. If you had good returns in a portfolio, most of that return was because you were in the tech sector and tech had a good year. Not necessarily because you picked some individual tech companies. So for beginners it’s great to say, “you know what, I want to have technology in my portfolio”. Go get a tech ETF, and get exposure to all the tech companies and know you’re going to get most of the return without trying to pick an individual company that’s going to try and hit a home run. It lowers your risk using an etf. So if you say, “i don’t even want to try to pick” or make my mix between large cap and mid cap and just say “I want somebody to do it for me”, you can find actively managed ETFs out there that will get you in a broad diversity of asset classes. They’re called multi-asset ETFs, where a professional manager behind the scenes buys and sells different stocks or blends different ETFs within that ETF. It’s kind of like bartending for finance nerds, something like that. 

ETF Opportunities

Could there even be ETFs for sectors like cannabis?

Actually, there already is! The interesting thing about ETFs is, typically you’re going to see an ETF that is created for an emerging investment area or a new investment area before you see a mutual fund or something else. First comes individual stocks, so to create a cannabis ETF, you have to have individual companies that are publicly traded. So those come, and then an ETF will get created that bundles up those companies together. Sometimes, when they first come out, they’re not going to be traded on a major exchange like the NASDAQ or the NYSTE, ETF trading occurs “OTC”, or over the counter. It’s a market that may not be as liquid, there may not be as much buy-and-sell demand, which means things that are traded there can be more volatile. In the cannabis ETF world, when those first came out, and some of them still are, they were traded OTC. So you can buy and sell them, but it comes with more risk than if it were an ETF traded with one of the major exchanges. This is why not all ETF investing is equal and you should be especially thorough with OTC purchasing. 

How would Cryptocurrency ETFs work?

In just the same way as the rest! There are some companies with Bitcoin, ethereum, and other cryptocurrencies that are packaged together and traded as an ETF. These allow you to get exposure to cryptocurrencies without obsessing over the minutiae of the market as a whole. This is another sector that you’ll find traded over the counter, not generally on the major exchanges. 


ETF vs. Index Fund

What is the difference between an ETF and an index fund?

An index fund and an ETF can very much be the same thing, you can get an index ETF, you can get an index mutual fund. But as I said earlier, index mutual funds are typically going to have higher costs than index ETFs. Especially in today’s world, if you go to one of the low-cost fund providers, like Vanguard, it is famous for having very low-cost funds. Their index mutual funds are just slightly more expensive than index ETFs, but it’s not astronomically different. Beyond that there, they are largely the same, but if you asked me, “hey I want to track indexes, should i do it with index mutual funds or ETFs?”, we would probably recommend ETFs because their cost is a little better and they’re more liquid and there’s a good marketplace for it. 


Closing Thoughts


I hope this gave you some confidence in approaching ETFs now! What is an ETF? is a rather broad question and it can be hard to get a straight answer at times. Investing in ETFs has become a core strategy of ours and I am excited to see how they develop going forward. If you want to take the next step in your financial planning, schedule a time to speak with me directly and we can get you on your way to your money goals.

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