What is an ETF?

My last post led to some interesting comments. Canadianmdinvestor argued that Apple’s price is more influenced by “ETF computers” than “average investors.” Which prompted another commentator to ask “What is an ETF?” 

An ETF is an “Exchange-Traded Fund.” There are several different companies that offer a wide variety to choose from. The most popular brands of ETFs are SPDRS and iShares. Each ETF has its own ticker and it trades, like a stock, on an exchange. When you buy a share of an ETF you are purchasing an asset that mirrors a pre-determined basket of securities. Usually the basket is an index (e.g. the S&P 500 or the Russell 2000) or a sector (e.g. financials, energy, etc) or a region (e.g. emerging markets or Japan). An ETF may contain stocks, bonds or currency or all of the above. They are a low cost alternative to mutual funds.

Why are they cheaper than mutual funds?

The way an ETF is managed is different than the way a mutual fund is managed. At the inception point of an ETF it generally announces the basket of securities it is going to track. From that point forward the folks running it simply need to make sure that the assets in the ETF match the basket of securities they are modeling. It is not complicated. This type of management is called “passive” management. The cost of administering a fund passively is quite low. A mutual fund might state that it will focus on a particular type of security or sector of the economy, but the people managing it have discretion over how to invest the money. Funds with investment discretion are said to be “actively” managed. Since the mutual fund managers will be researching and making decisions to buy and sell they are paid more money…..and there is an expectation that they will deliver results that beat the market.

Can you be more specific about different types of ETFs?

There are so many ETFs out there that it is almost silly to narrow down the possibilities. Commentator Marc shared one company, Wisdom Tree, that has a large variety of ETFs tracking currencies, equities, and bonds. They have developed a unique system to maximize the return (at least that is what their website says). Here are some examples of other funds out there: you could buy coal producers (ticker KOL) or wind energy (ticker FAN) or companies in Brazil, Russia, India, China (aka BRIC ticker BKF) or pharmaceutical companies (ticker PPH) or literally anything you can imagine. As the scope of the ETF gets more technical the expense of managing it goes up. Further, the more obscure it is, the less liquid it will be.

Why would I invest in an ETF instead of a mutual fund?

Well the cost of investing in an ETF is lower than a mutual fund. Sometimes the difference can amount to as much as 2% a year. Over time that annual 2% difference will really add up. As I stated before, mutual fund managers will tell you that they can outperform the market. This may be true in the short run. But in the long run most everybody reverts to market. So if I am going to invest for a long period of time I’m going with the lower cost alternative that will likely return an equivalent amount anyway. And to show I’m not kidding around, you can see on my disclosure page I own several different ETFs: SPY, RSP, XLF and XLK.