As of 2013 the total assets that are being traded by ETFs amounts to almost $900 million. In this series, we will be going through some of the fundamental concepts of ETFs, exactly what is an ETF, how ETFs are different from other funds, as well as an overview of ETFs to help you decide if investing in ETFs is the right move.
Exchange-Traded Funds, or ETFs, in a nutshell, are a kind of mutual fund. ETFs have direct connections to the indexes, stocks, commodities or baskets of assets that they are bound to. The results and returns of ETFs are designed to replicate the specific index such as a stock or commodity index. This also means that the movement of the fund mirrors very closely the trend of an index. Since ETFs are funds, money is pooled together, just like how a mutual fund works to make purchases. There are also professional fund managers that insure that the fund meets goals and objectives.
An index can include a list of stocks such as the S&P 500, Russell 2000 or DJ Wilshire 5000. It is essentially a representative sample of the stock market that is distilled down to a numerical value for easier reference. For example, if the S&P 500 drops by 100 points today, it would mean that the overall average performance of the 500 stocks that are represented by the index is in the red.
The mechanics and principles behind ETFs are relatively easier to understand than most other managed funds, which is the reason why they are quite popular with new investors. It is also relatively “hands-off” kind of investing because since its only objective is to mirror the indexes, there is really no need to repeatedly buy and sell stocks if your goal lies in the long term. However, if you are looking to trade ETFs in larger volume, this might incur a high commission cost. We will go into this in depth in a later chapter.
So if the ETF is designed to model an index, what then is the difference between an ETF and an Index Fund?
Firstly, ETFs can be purchased in smaller sizes than Index Funds. This means that investors will have more agility to buy in smaller amounts, sometimes even one share.
Secondly, ETFs usually distribute dividends generated from the underlying stocks invested back to the investors. An Index Fund would reinvest that dividend back into the fund.
By owning an ETF, investors effectively gain access to the diversification of an index, more diversified than mutual funds, and also the ability to short sell, buying on leverage and purchasing as little as one share. Another key attraction of ETFs is that the commission of trading ETFs are much lower than that for mutual funds.
At the end of the day, choosing the right fund, which will be covered in a later chapter boils down the personal investment preference and capabilities.