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FinEdFriday: What are ETFs? Thumbnail

FinEdFriday: What are ETFs?

In this series, we are going to address some common financial questions from the ground up, using the simplest terminology, so that everyone can share an understanding of the basics. Whether you are just learning for the first time, or using these posts as a refresher, we hope we can set the record straight on some of the most commonly used terms in the finance industry.

In our last post “What are Mutual Funds?” we discussed the idea of an investment vehicle that had built-in diversification. This means that without having to spend extra time and money building an a-la-carte portfolio, you could easily invest money into a mutual fund, or bucket of stocks, bonds, etc. to achieve a certain level of diversification. 

However, mutual funds are not the only way to achieve this objective in one purchase. 

ETF stands for Exchange-Traded Fund.

The easiest way to think of an ETF is as a mutual fund that, instead of being bought and sold directly with the fund company, is bought and sold on a major exchange (New York Stock Exchange, etc.) similar to a singular stock.

But that is not all that separates Mutual Funds from ETFs.

ETFs are usually less pricey than Mutual Funds.  Why, you may ask?

Exchange-Traded Funds are constructed to “track” a specific slice of the overall market.

These slices could be:

An index (think S&P 500 or Dow Jones Industrial Average)

A sector (like Healthcare or Real Estate)

A commodity (like Lumber or Copper)

But since they are built to passively track one of these, there is less research and maintenance that needs to go into its initial creation and ongoing accountability. 

There are also active ETFs that cost a bit more, since their managers are trying to arrange the underlying investments in a way that may provide better returns than a passive index. 

Unique Types of ETFs

Industry Specific ETFs

You can gain exposure to things like real estate, biotechnology, even space development without having to actually own the assets. 

Commodity ETFs

You can gain exposure to things like lumber, gold, lean hogs (ha!), or cattle without destroying your home.

Currency ETF’s

You can invest in foreign currencies, and possibly soon, even cryptocurrencies without having to own the actual assets.

Social Sentiment ETF’s

Yes, you can even purchase an ETF that tracks stocks that are most highly regarded on blogs, social media platforms, etc. 

How do you make money with an Exchange-Traded Fund?

Similar to mutual funds, you purchase shares of the fund but do not own the actual underlying assets. This means you can make money by being passed a capital gain from inside the actual fund (where managers are buying and selling the assets).

You can also make money by selling an ETF at a higher price than what you paid for it. Keep in mind that with certain securities (stock, mutual funds, or ETF’s), if you hold for at least a year before selling, you will pay “long-term” capital gains tax on the gain. This is usually at a lower rate than if you were to hold the security for less than a year and then sell, triggering a “short-term” capital gains rate (most likely at your higher ordinary income rate).

All this to say, ETFs are a great way to begin learning about risk and reward while mitigating concentration risk. Their fees are often times lower than that of a mutual fund, and they provide exposure to a whole universe of underlying assets without taking on the complication that comes with owning that particular asset (I have no idea how a hog becomes lean…).

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors. 

Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Because of their narrow focus, investments concentrated in certain sectors or industries will be subject to greater volatility and specific risks compared with investing more broadly across many sectors, industries, and companies.