Exchange Traded Funds (ETFs): The Basics

July 2, 2015

Lately, financial advertising has been packed with stories about the newest exchange traded fund (ETFs) and its many benefits. The first ETF began trading in January of 1993, but their popularity has really exploded over the past 5-7 years. Even though they’re in many people’s investment accounts, few people actually understand these investment vehicles.

So, what is an ETF?

Well, it’s similar to a mutual fund, but with stock-like features.

Like a mutual fund, an ETF pools the money of many investors and buys an underlying basket of assets (shares of stock, bonds, etc.). It then divides ownership of those assets into shares. And although the shareholders only indirectly own these assets, they’re still entitled to a proportion of the profits, such as earned interest or dividends paid.

However, they’re like a stock, for several reasons. First, they trade on an exchange (think the New York Stock Exchange or the Nasdaq). Second, an investor can purchase them directly from their brokerage account. Third, they trade throughout the day, so they can be purchased at any time. Lastly, investors can use stock-like strategies when trading them, such as market or limit orders, selling short, or sometimes buying on margin.

What kinds of ETFs are available?

The original ETFs tracked major U.S. indices like the S&P 500 index. Like an index mutual fund, the owner of the ETF bought shares of a portfolio that tracked the return and yield of that index. Today ETFs still primarily track indices and offer exposure to every asset class from U.S. stocks, to bonds, to emerging markets. ETF’s are available on individual countries and individual currencies. ETF’s can be the core of a small growing diversified stock portfolio, or they can add some unique satellite exposure to a large established portfolio.

What are some additional advantages of ETFs?

By owning an ETF, investors get the diversification of an index fund as well as the ability to purchase as little as one share (there are no minimum deposit requirements). Another advantage is that the expense ratios (administrative costs of the funds) for most ETFs are lower than those of the average mutual fund. There also exists a potential for favorable taxation on cash flows generated by the ETF, since capital gains from sales inside the fund are not passed through to shareholders as they commonly are with mutual funds. The investor pays a capital gain tax only when they choose to sell the ETF.

What are some things to be cautious about with ETFs?

Because you’re investing in the stock market, there is always market risk. If you invest in an S&P 500 ETF, and the market goes down 50%, your ETF will go down similarly. Second, when buying and selling ETFs, you will have to pay the same commission to your broker that you’d pay on any regular order. However, some brokerage accounts have marketing deals to let investors trade some ETFs commission-free. Third, like mutual funds and stocks, some ETFs are traded more often than others. If an ETF you’re interested in purchasing is not traded a lot, you may not be able to purchase or sell shares for their net asset value (what they’re actually worth). And fourth, because the market seemingly creates new ETFs every day, it’s important that investors do their research and understand what the ETF is actually investing in. If the marketing makes the ETF sound too good to be true, it probably is.

ETFs are an investment vehicle that may have already found a home in your investment portfolio. Now that you better understand the basics, make sure they are right for you.

-Pearce Wegener