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What are ETFs and how do they work?

 

Exchange Traded Funds for beginners:

 

If you understand that a stock is part of a company, and the value is linked to the stock price, then understanding an Exchange Traded Funds (ETFs) should be easy. An ETF is like a stock, only instead of being a piece of a company, an ETF is a part of a pool of other securities. This is very similar to a mutual fund.

 

How ETFs work:

There is a collection of securities or stocks. This collection typically mirrors the performance of whatever the fund is tied to; usually a market, some sector, a group of securities. For example, a fund could be setup to track the performance of the NASDAQ, bonds, oil, etc. Each share "holds" an amount of the underlying securities, the shares are set up to enter or exit the market in a way that each share always owns about same number of underlying securities.

 

Risks:

These Exchange Traded Funds (ETFs) are a way to minimize risk by distributing your ownership over multiple securities. The result of this is a fund with great liquidity (easy to buy and sell), with more stable performance than purchasing a single stock.

 

Costs:

ETFs do have some fees associated with them, typically in the .01% to .25% range. The fees are taken from the fund returns, not something you pay (you just get reduced performance).

 

It is important to compare fees when comparing funds. The fees, typically, relate to the difficulty of managing a fund, markets that move change quickly, or have a large number of rapidly changing stocks will typically have higher fees.

 

In addition, some companies have traditionally lower fees than others. Traditionally Vanguard has been a leader in low fee ETFs. If you have a feeling about the market in general, or a specific type of securities, an ETF can be a great way to easily buy into the market.

 

Performance:

 

Stocks are difficult to pick, difficult to the extent that stock performance may as well be random.

 

A great resource, strongly recommended for investors who want to know more, comparing mutual funds to all types of managed funds is A Random Walk Down Wall Street by Burton G. Malkiel -

The basic premise of this book is stock performance may as well be random. This inability to predict stock movements is evidenced by the performance of experienced/professional stock pickers. The professionals results are almost always worse than the returns from buying a market ETF, over the long run.

According to this book, and the numerical analysis by Burton G. Malkiel, buying total market ETFs is preferable to buying individual stocks.­

Article by: Jacob K Lloyd

Jacob@startingwithstocks.com

Published: 4 July 2015

Last updated: 13 Sep 2015

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