What is an ETF?

Invest in the stock market with less risk and less time by buying exchange traded funds (ETFs).

If you aren’t comfortable choosing individual companies and buying individual stocks, ETFs are the ideal way to invest. ETFs provide great diversification and require very little monitoring. There are of course trade-offs that we will get into, but first…

What is an ETF?!

If you’re trying to learn about investing, you have probably seen the letters E-T-F a few times. You’re not behind for not knowing what that means, or even what those letters stand for: tons of people who are invested in ETFs don’t even know what they are.

An exchange-traded fund (ETF) is a type of fund that can be invested in much like an individual stock. When defining an ETF, often a mutual fund is used to draw comparisons because the two are very similar: both investments bundle together assets to offer a diversified portfolio. ETFs tend to represent indexes — entire markets or market segments — as the funds own a group of assets in the same sector (i.e., stocks, commodities, bonds etc.) much like an index fund. Similarly, a fund can be made up of anywhere from 100 – 3,000 stocks.

With an ETF, you own a share of the actual fund. This is like owning a stock, where you own individual shares of a company. An ETF is actually traded on the stock market and like a stock its price changes throughout the day as its shares are bought and sold.

What’s the difference between an ETF and a Mutual Fund?

ETFs and mutual funds are very similar because both investments bundle together assets to offer a diversified portfolio. Even with these similarities, there are stark differences and the two should not be considered interchangeable.

Fund performance

Most ETFs aim to match the performance of a more established stock or bond index such as the S&P 500 or the TSX. A mutual fund will try to beat the index, which can be hard to do, especially after fees and taxes.

Cost

ETFs usually cost less. They have lower operating expenses, no investment minimums and no sales commissions, whereas traditional mutual funds often have both.

Buying and selling

Similarly to stocks, whenever the market is open you can buy and sell ETFs at their market price. Mutual funds are only traded at the end of the day (at the Net Asset Value) and shares have to be bought directly from the fund.

Consistency

Because ETFs usually aim to track an index, their holdings change relatively little over time. Mutual funds can often drift from their original investment objective as they are only as limited as the regulations.

Taxing

ETFs are usually taxed less than mutual funds. There is a tax structure that allows them to avoid or, in some cases, minimize their capital gains tax.

Benefits & Drawbacks of an ETF

Compared to investing in stocks or mutual funds, what are the pros and cons?

Benefits

  • Liquidity: it’s very easy to sell an ETF for cash.
  • Lower risk: volatility is reduced because the ETF embodies a diverse set of stocks in a specific sector rather than being tied to just one.
  • The best of both worlds: you get all the benefits of investing in a stock such as short-selling, stop-loss orders, limit-orders combined with the diverse benefits of a mutual fund.

Drawbacks

  • Limited returns: because of the spread out nature of the ETF and its goal of mimicking an index, the returns are often modest.
  • Non-credible indexes: many ETFs are tied to unknown or untested indexes which some investors see as a major negative aspect.
  • Cost: the ongoing costs are higher than trading individual stocks.
  • Control: there is an inherent lack of control and inability to deviate from the index.

Let’s see some examples

  • The most widely traded ETF tracks the S&P 500 Index and it trades under the ticker SPY (NYSEARCA). There are also ETFs that track the Nasdaq 100 (NASDAQ: QQQ) and the Dow Jones Industrial Average (NYSEARCA: DIA).
  • As mentioned, there are sector ETFs which track companies in industries such as oil (OIH), energy (XLE), finance (XLF), REITs (IYR) and biotechnology (BBH) to name a few.
  • There ETFs used to track commodity prices such as crude gold (GLD), silver (SLV), oil (USO), natural gas (UNG) etc.
  • As well, there are ETFs that track foreign stock market indices and other ETFs that track worldwide currency movements.

Conclusion

Hopefully you now have a good understanding of what an ETF is; if you are interested in creating a portfolio but don’t know exactly where to start, here’s how.

A quick recap:

ETFs generally offer a low cost, highly diverse and tax efficient way to invest across a single business sector, stock index or other basket of assets. Commissions and management fees are relatively low and ETFs can be included in many tax-deferred accounts. On the other hand, there are ETFs which limit diversification, ETFs tied to unknown or untested indexes and ETFs which trade frequently, incurring commissions and fees in the process.

If you want to invest in stocks and ETFs you can check out the Voleo app. If you are just starting you can consider investing in an investment club with some friends, family or colleagues.

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