Investing 101: ETFs

(Hey kids!  And teenagers, adults, cats who fell asleep on top of the keyboard and anyone else who might be out there reading this; guess what time it is!  That's right, it's Investing 101 Time!  This week, we'll cover the wonderful, wacky world of ETFs!)

Q: Alright, so what is an ETF?

A: Exchange Traded Funds, more commonly known as ETFs, are similar to mutual funds in that they are investments that hold stake in numerous other investments.  ETFs are created by buying a large amount of stocks (or bonds, real estate, commodities, or other investments), usually following the allocation of a particular market index, and putting them into a trust.  Shares of the trust are created, typically in lots of 50,000 (called creation units) and each share represents a stake in ownership of the trust (similar to the way that shares of stock represent ownership of a company).

Q: Why buy an ETF, then?  Why not just buy the underlying securities?

A: Because there can be hundreds, if not thousands, of securities in a particular index.  To buy all the stocks represented in the S&P 500, you're have to purchase 500 stocks, each of which will generate a commission at your brokerage.  Buying an ETF enables you diversify your holdings instantly, owning numerous securities with one fell swoop, cutting down your costs.

Q: Wait, I thought that mutual funds diversified your holdings.  Which is it, mutual funds or ETFs?

A: Both, actually.  ETFs are closely related to mutual funds, especially index funds, which follow the same allocation as popular indexes.  Both investment choices allow you to diversify your holdings with a single investment.  Most ETFs invest in the same indexes as index funds, allowing you to choose which type of investment is more appropriate for you.  The prime difference is how they are acquired (ETF shares are purchased through a brokerage, while mutual fund shares are bought from mutual fund companies) and how they are priced (ETFs are priced based on the last traded value, while mutual funds are priced based on the value of the underlying funds).

Q: Are there any particular advantages to using ETFs rather than mutual funds?

A: First, ETFs tend to have a very low expense ratio, even lower than the comparable index mutual funds.  Second, ETFs trade throughout the day, allowing you to purchase or sell them instantly (which might be a disadvantage in some people's eyes). Third, it's possible to use ETFs to invest in certain sectors of the broader economy, since you can buy an ETF that is invested in, say, financial stocks when you think they're about to increase in value, and then sell it easily when you think that sector has peaked.

Furthermore, you can do some more complex investing maneveurs with ETFs that are impossible with index funds, like shorting them (that is, borrowing shares from other investors, selling them, and then buying them back at lower prices, hopefully) or using options (specialized investment derivatives, allowing you to set particular prices at which you can sell your holdings or buy other assets). If you're an active investor, having these possibilities make ETFs a great trading vehicle.

Q: I've done enough of these to know what's next; what are the downsides to ETF investing?

A: I'm glad you asked.  One big downside is that since you purchase them through brokerages, you need to pay commissions whenever you buy or sell your ETFs shares.  This will cut into your profits, especially if you trade ETF shares regularly.  Further, there is a spread between the bid (the amount a buyer pays) and the ask (the amount a seller receives), which means even if you find a broker that offers you commission-free trades, there's a hidden cost to your purchases and sales.  For these reasons, if you buy and sell ETF shares throughout the day, you can end up losing more money than simply putting your money into a mutual fund, where the ability to trade shares is much lower (and the temptation is that much less).

Q: Which should I choose, mutual funds or ETFs?

A: It depends on your goals, investment style, and schedule.  If you are investing frequently, especially in small amounts, mutual funds are probably better for your needs.  The lower expense ratios of ETFs will make little difference if you're paying 5% of your investment money towards commisions to buy the ETF shares.

On the other hand, if your investments tend to be seldom, in large amounts, ETFs are likely to be better.  If you're investing $10,000 once a year, the expense ratio is going to take a bigger chunk of your money than a small commission fee when you buy the ETF.

Q: Is there any way to actually figure that out?

A: There is.  Just consider this equation:

Real Return = (Money Invested – Commission) * (Rate of Return – Expense Ratio)

The term in the first set of parantheses tells us the amount of money we actually have working for us in our investments.  The second term shows the real rate of return, taking into account the expenses for the fund when calculating the rate of return.  You can use this equation to figure out what will be the less expensive investment, or to work out which type of investment will lead to a greater value years from now (which I would hope is more important to you).

If you don't feel like setting up a spreadsheet, (and if you're not a geek like me, you might not want to do so), there are tools out there that allow you to figure out the better investment online.  I like Vanguard's cost comparison tool, both because I like Vanguard in general, and because it's an interesting tool.  Seeing how your investment patterns and expenses can influence the better investment choice can be informative, and sometimes surprising.

That's all the time we have for this edition of Investing 101; hopefully ETFs are now more than a random set of letters to you now, and you feel better about how to go about investing in them.

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