Introduction to ETFs

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What Is an ETF?

The acronym ETF stands for "Exchange Traded Fund." Think about that phrase carefully for a minute and, very intuitively, you are well on your way to understanding the basic character of an ETF.

When you think about things that are traded on an exchange, likely stocks and bonds come very quickly to mind. Now, think about the word "fund." Perhaps that immediately makes you think of mutual funds; entities that hold a wide variety, often referred to as a basket, of stocks and bonds.

And there you have it. Basically, an ETF is a security that trades on an exchange, just like an individual stock or bond, but in reality represents a basket of assets.

Characteristics Of an ETF

This could become an extremely complicated discussion in and of itelf, and perhaps I will devote future articles to greater detail on such topics. For this article, however, here are 5 basic characteristics:

1. Traded On An Exchange -- Simply put, this means that ETFs trade just like stocks, at any time while the markets are open. They are different from mutual funds in that, while you can only buy and sell shares in a mutual fund at the closing price of the day, ETFs are traded immediately at whatever the current bid and ask price is at the time you submit your order. Particularly on days with wide price swings, this can sometimes mean a substantial difference in the price at which you can buy or sell.

2. Subject to Trading Commissions -- Typically, you will have to pay commissions to trade an ETF, although some brokerages are now featuring commission-free trading on certain ETFs. While there is no minimum investment required to purchase an ETF, the potential exists for trading commissions to eat up a large portion of your returns if you buy and sell in very small dollar amounts. However, unlike mutual funds, you are never charged a separate load or redemption fee to buy or sell shares in an ETF.

3. Management and Operating Expenses -- As you might imagine, since someone has to create and administer the ETF, there are fees associated with management and operation of the fund. As we will discuss later, however, often these can prove to be very low when compared with what it would cost you to trade stocks individually yourself.

4. Transparency of Underlying Securities -- Since issuers of ETFs are required to disclose the holdings in their fund at the end of every trading day, you are able to determine what assets comprise your fund at any given time.

5. Risk Can Vary Greatly -- A large percentage of ETFs are what are commonly called index funds. Basically, this means that they seek to track, or mirror, the performance of a large and diversified index of assets, such as the S&P 500 index. However, over time, ETFs have been developed to track all sorts of things. If an ETF tracks a very small number of assets, or they have something in common (such as stocks that are all in one country, or industry), the risk of the ETF can rise dramatically. Additionally, some ETFs use leverage in an attempt to magnify their returns, or perhaps are designed to perform exactly opposite of the market. These ETFs, in general, are not designed for buy-and-hold investors, but rather for more sophisticated traders who are aggressively seeking to pursue some short-term strategy that they believe in.

Why Invest in ETFs?

In large part, the answer to this question can be boiled down to one word; diversification.

Risk in the financial markets can basically be broken down into two components:

1. Market risk
2. Single-entity risk (governmental entity or corporation)

Market risk refers to the potential for negative events with respect to the overall economic environment. If the economy enters a recession (a period of time where economic activity is shrinking rather than growing), the entire stock market may decline for a period of time. All investors in stocks will be affected by this, to some extent.

Single-entity risk, in contrast, refers to the potential for negative events that specifically affect that entity, separate from the industry of which it is a part, or the overall economy.

A recent example is what happened to British Petroleum (BP) in 2010. British Petroleum is one of the foremost, and most diversified, oil companies in the world. However, on April 10, 2010, a terrible accident occurred on one of its oil rigs in the Gulf of Mexico, resulting in a giant oil spill that took months to contain. Below is a chart, from Yahoo Finance, that covers the period from February-August, 2010. As you can see, concern over cleanup costs, lawsuits, and similar fears caused the stock to lose over half of its value; from over $60 just prior to the accident to a closing price of $27.05 on June 28, 2010. As this article is written, some five years after that event, BP stock is hovering in the $42-43 range, or approximately 30% below the pre-spill price of early-2010. The S&P 500 index, in contrast, is up approximately 75% during that span (approximately 1,200 as of April, 2010 and 2,100 as of May, 2015).

(Click to Enlarge)

These circumstances were unique to BP. They were not a result of a downturn in either the oil industry or the larger economy. The key lesson is that single-entity risk is not limited to newer, smaller, or more speculative companies. Unforeseen events can affect even seemingly the most stable of companies.  

To minimize single-entity risk, investors generally try to build a portfolio; purchasing shares in several quality companies across a variety of industries. This, however, poses a couple of challenges:

1. The investor is challenged with spending much time researching and evaluating which stocks should be purchased. Some investors may have neither the time nor the skill to do so. 
2. The trading costs associated with building a portfolio can be daunting, particularly for an investor of modest means. Imagine an investor with $10,000 to invest who wanted to diversify by purchasing shares in all 30 stocks in the Dow Jones Industrial Index (The "Dow"). To do so, he would likely have to pay $240-300 in commissions ($8-10 per stock), using most online brokerages. In other words, he would "lose" about 2.4% to 3% of his initial investment in commissions. 

This is where ETFs come into the picture. If owning shares in the "Dow" was his goal, the investor discussed above could purchase an ETF with the trading symbol DIA. With one trade, he would effectively own the basket of shares making up this index. 

The good news is that one can purchase ETFs that encompass even larger baskets of stocks, such as the S&P 500 index. This allows an investor of even modest means to acquire a diversified portfolio at extremely low cost, compared to trading individual stocks. More sophisticated investors, or those with a much larger base of assets to invest, can choose ETFs that target specific industries, or even countries, as just a couple of examples.

Further Reading

March, 2015 white paper from Vanguard Funds on The Case For Index-Fund Investing.