What is an ETF? The Complete Beginner’s Guide to ETFs

What is an ETF?

What is an ETF? Find out in Our Complete Guide

When investing, picking stocks can be a hard task, especially if you are just starting out in the investment world. You may have read somewhere about some great stock with a lot of potential; but how much do you really know? How much does anyone know?

Like anything in life, picking good stocks involves as much skill and effort as it does luck. The truth of the matter is that nobody can predict the future. At the end of the day, for a lack of a better expression, shit happens.

It doesn’t matter that you spent hours researching and going through balance sheets. Any company can be subject to unexpected downfalls. New technologies can render certain goods or services redundant, or competition con simply squeeze them out of the market.

We are dealing therefore with two problems. Firstly, the risk of picking a bad stock, despite our best efforts, and secondly, dealing with unexpected and unpredictable bad fortune. However, there are different ways of mitigating these risks.

One of these, which will be the subject of this article, is investing in ETF’s.

What is an ETF?

An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds or a basket of assets like an index fund.

Put more simply, an exchange traded fund follows the performance of its underlying asset. If the value of these assets goes up, so does the ETF.

Basically, it’s as if you and your friends pooled some money together and bought a variety of goods and shared their ownership. The only difference being, these goods are performing assets that give a return. Sharing ownership means that you would add up the performance of each asset and then give out the returns proportionally to each participant.

Participants may even get residual value if the fund is liquidated.

An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds or a basket of assets like an index fund.

How ETFs Work

Like anything else, from goods to common shares, the price of an ETF is determined by supply and demand. An increase in supply, means a lower price; a reduction of supply, means a higher price.

An easy way to imagine this is with a graph (look below). The vertical axis is price, and the horizontal axis is quantity. The higher the price the higher the quantity in the supply, since more people will be willing to produce or sell. So we have a diagonal line going from the bottom right corner. (Logically, 0 price means 0 supply).

We then have demand beginning from the top right corner and going down since a very high price means no demand, and the lower the price the higher the demand.

This is more easily understood visually.

Image result for supply demand curve

The supply of ETF shares is regulated through a mechanism known as creation and redemption. The process of creation/redemption involves a few large specialized investors, known as authorized participants (APs). APs are large financial institutions with a high degree of buying power, such as market makers that may be banks or investment companies.

Only APs can create or redeem units of an ETF. When creation takes place, an AP assembles the required portfolio of underlying assets and turns that basket over to the fund in exchange for newly created ETF shares. Similarly, for redemptions, APs return ETF shares to the fund and receive the basket consisting of the underlying portfolio. Each day, the fund’s underlying holdings are disclosed to the public.

Basically, to ensure the ETF, which is much like a stock, has the same value as the asset it represents, say, silver, for example, investors will make the supply curve shift by creating or redeeming the ETF. Creating the ETF means increasing supply, shifting the curve to the right and decreasing the price. Redeeming the ETF means reducing the supply, shifting the curve to the left and increasing price.

Advantages of ETF’s

There are many advantages to ETF’S. The biggest one being that it allows you to easily diversify your portfolio.

Diversifying means that you have a variety of different stocks and assets. Because of this, you mitigate the risks we mentioned above, such as bad choices and bad luck.

Because you are investing in a wide range of things, it will affect your returns less if one of your investments goes south. Also, because you are invested in many different companies or commodities, luck will play a smaller role in your investments. It’s possible for one company to go under, but for 100 of them to do so is highly unlikely.

And here in lies the beauty of ETF’s and Index funds, with very little money, you can invest in hundreds, even thousands of companies. As an individual, it would require vast amounts of money to buy a share in each one of 100 companies, but ETF’s make this possible by pooling people’s money together and then dividing them accordingly.

In practice, you may end up owning 1/100th of a single share in many companies. But that 100th part is just as good as a regular share. If I own 1/100th of an Apple share and Apple shares increase by 5%, so does my 100th of a share.

The most common ETF’s of this nature are those that follow indexes, or a basket of stocks in a certain sector or country.

For those that don’t know, Indexes are a measure of the performance of a certain stock market. The FTSE 100 index, measures the overall performance of 100 stocks in the UK. The S&P 500 does the same for 500 major companies in the US.

FTSE 100 Index

Read: What is the FTSE 100 Index? Complete Beginner’s Guide

Index funds, which are similar to ETF’s basically allow you to invest in an index, which means you are investing in the performance of all the companies in said index. Much like an ETF, the index fund purchases stocks from all these companies and then divides the ownership amongst its participants.

Much like ETF’s, index funds allow you to easily diversify your portfolio by exposing you to a wide array of stocks.

At this point, some of you may be wondering why you wouldn’t just invest in an index fund, rather than an ETF. This is a valid point. There is no particular reason not to invest in an index fund, but again, ETFs offer some advantages over simple index funds both for beginners and more advanced investors.

Most importantly, ETFs allow you to invest in an index with less capital, since you can buy as little as one share. Furthermore, ETFs tend to have less expenses than other mutual funds. And finally, there exists 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.

For the more experienced investors and traders, ETFs allow you to use leverage and sell short. Many things are possible with ETFs. One simple example are inverse ETFs which track the opposite change in a stock or index.

If you have an inverse ETF on Unilever shares, this means that when those shares go up 1%, your ETF will increase 1%. Effectively you are betting against the underlying asset.

Disadvantages of ETFs

Don’t be fooled though, not all is sunshine and smiles in the world of ETFs, there are indeed some disadvantages worth noting.

Firstly, ETFs can be limited in some countries. Some ETFs only include large-cap products, leaving a lack of mid and small sized funds.

Furthermore, with certain ETFs, low trading volumes can affect your investment, since the bid-ask spread is too large.

Also, because of the way ETFs work, holding one for longterm investment might not be optimal.

ETFs offer arbitrage opportunities. Like we explained before, the price of an ETF is controlled through a supply/demand mechanism knows as creation/redemption. The way the ETF reaches a fair price is through arbitrage. When the price of the ETF is too high or too low there is money to be made, either by selling the ETF and buying the underlying basket of assets, or by doing the opposite.

Finally, though this was listed as an advantage before, tax laws are different in every country and for every product, so it’s important that you check before you buy anything.

Commodity ETFs

But not all ETFs work as I explained above. Some ETFs simply follow the price of a single asset, normally commodities. The advantage? You can expose yourself to the changes in price in that commodity, hopefully an appreciation, without actually having to own the asset.

GLD for example does this with gold. Basically, this ETF is managed in such a way that the price is the same as gold, effectively giving you the same return.

There are of course some arguments against owning ETFs of this nature, as mentioned here. Namely, you don’t actually own the asset, and in some cases this may end up being a problem. Personally, I would go for owning and storing physical gold. But with things like crude oil, this might be harder, so for the moment, consider buying USO, an ETF that tracks the price of oil, instead.

Investing in Gold

Read: Investing in Gold: A Complete Guide for Beginners

Examples of Widely Traded ETFs

To help you get started, here is a list of some of the most widely traded and popular ETFs on the market as of today.

  • One of the best known and traded ETFs tracks the S&P 500 Index and is called the Spider (SPDR), and trades under the ticker SPY.
  • The IWM tracks the Russell 2000 Index.
  • The QQQ tracks the Nasdaq 100, and the DIA tracks the Dow Jones Industrial Average.
  • Sector ETFs exist that track individual industries such as oil companies (OIH), energy companies (XLE), financial companies (XLF), REITs (IYR), the biotech sector (BBH), and so on.
  • Commodity ETFs exist to track commodity prices including crude oil (USO), gold (GLD), silver (SLV), and natural gas (UNG) among others.
  • ETFs that track foreign stock market indices exist for most developed and many emerging markets, as well as other ETFs that track currency movements worldwide.

Conclusion

To sum up, ETFs are a great way to get started with investing. They are fairly simple to buy and understand, they will help you diversify your portfolio and they do not require much capital.

However, there can be some disadvantages such as low-trading volumes and limitations in terms of offer.

As you become a more knowledgeable and savvy investor you can begin to utilize some of the more advanced features of ETFs such as margin calls.

In addition, ETFs are a great way to expose yourself to a certain industry or market which you think may do well.

If you think tech companies are going to thrive, you can buy an ETF which represents a basket of stocks in that industry. The same can be said for any other type of industry. There are as many ETFs as there are ways to categorize and group stocks.

Lastly, remember that investing, at least the way I see it, is a longterm game. So be patient and keep saving.

James Foord

Based in Barcelona - Spain, James is an Economics Graduate and Financial Advisor offering advice on Pension Plans, Insurance & Mortgages. He has been writing about economics and investments for 7 years.


james@moneycheck.com
https://www.linkedin.com/in/james-foord-7272608a/

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