ETFs Explained

For investors in the U.S., it's been more than 27 years since the first exchange traded fund (ETF) burst onto the scene. That ETF is the SPDR S&P 500 ETF (SPY).

Much like the disruptions caused by passenger air travel to tourism, cell phones to technology, and other famous product evolutions, ETFs have disrupted the financial services industry. From its humble beginnings nearly 30 years ago with a single ETF product, the ETF has come a long way. Consider that at the end of July 2020, there were nearly 2,400 exchange traded products listed in the U.S. with combined assets under management of $4.61 trillion.

To put that $4.61 trillion figure into context, it's more than the GDP of Germany. It's also more than two Apple's (AAPL). They're kind of a big deal.

Even with that whopping number, plenty of investors aren't exactly sure what an ETF is while others are just starting their investing journeys and want to see what all the buzz is about. Here are some foundational points to consider.

What is an ETF?

In the late 1990s and even earlier this century, a satisfactory explanation of an ETF would be it's “a mutual fund that trades like a stock.” While that remains true today, there's more to the story. ETFs are baskets of securities, meaning that the key to any particular ETF is what's included in its underlying basket. An ETF is a collection of stocks that follow a certain theme. SPY, mentioned above, tracks the S&P 500 index, for example.

To put this concept into plain English, imagine a hypothetical ETF that holds just two stocks, Apple and Amazon (AMZN). If both stocks rise on the same day, that ETF will do the same. If both stocks fall, so will the ETF.

Adding to conversation about how ETFs are structured, though there are growing number of actively managed products, the bread and butter of the industry is index-based funds, such as the aforementioned SPY or the Invesco QQQ (QQQ), which tracks the Nasdaq-100 Index.

Broadly speaking, index providers are typically transparent when it comes to costs and methodology. Take the case of QQQ, which tracks the Nasdaq-100 Index. That index is a collection of the 100 largest non-financial stocks trading on the Nasdaq and its components are weighted by market capitalization (essentially how valuable the company is), meaning the largest weight is assigned to Apple, next largest to Amazon and so on.

Second, linking a fund to an index, particularly one that's widely followed and has highly liquid components, such as the Nasdaq-100, creates cost efficiencies. Because there's no "active" management (e.g. someone picking out stocks for that ETF), it helps drive down the cost of owning that ETF. Say you've got $10,000 to invest in one fund and your choices are an ETF with an annual fee of 0.10%, or $10 per year on that investment, or an active fund that charges 0.57% annually. Over 20 years, you'd save more than $2,800 with the low-cost ETF.

How do ETFs Work?

As mentioned above, there was a time when it was frequently said that ETFs are mutual funds that trade like stocks. That's true to an extent because ETFs can be bought and sold on trading days, and are listed on exchanges, just like stocks. This is different from mutual funds, which trade at just one price regardless of the time of day and are bought and sold over-the-counter.

However, there's some “plumbing” involved with how ETFs are bought and sold and for new investors, it's worth gaining a basic knowledge of these mechanics. When an investor wants to sell shares of a mutual fund, the fund manager must sell stocks or bonds, creating a possible taxable event. Unfortunately, it's the investor that holds the capital gains bag and is liable for the taxes, not the fund company. This isn't an issue with ETFs, meaning ETFs are far more tax efficient than traditional actively managed mutual funds.

This makes ETFs more attractive from a cost perspective.

Thematic Investing with ETFs

One major component of using ETFs is being able to invest in a trend, concept, or theme, and this is known as "thematic investing." Let's say you're interested in cloud computing; rather than researching and buying individual companies, you could instead invest in CLOU, an ETF that tracks that industry. Interested in robotics? Check out BOTZ. Cybersecurity? CIBR. Clean energy? ICLN. This whole working-from-home trend? There's an ETF with the ticker symbol -- you guessed it -- WFH. But beyond concepts like the environment, social justice, healthcare, fintech, etc, there are other types of thematic ETFs that appeal to more sophisticated investors.

There are volatility-hedged ETFs that can double or triple-down on the direction of the markets. The ProShares UltraPro Short S&P 500 (SPXU) offers 3 times daily short leverage to the S&P 500 Index, for example. Basically, if the S&P 500 goes down on any given day, SPXU will go up 3 times that amount. Obviously, the reverse is also true -- if the S&P 500 has a good day, then anyone owning SPXU will have a pretty bad day. The fund's leverage resets each day, and typically investors use it for short-term trades. Products like these tend to be more sophisticated, so if you are a new investor, I would recommend staying away from them and focus instead on broader ETFs, like SPY or QQQ.

Sometimes you'll find ETFs that chase the same theme, and it can be tricky to tell them apart. For example, CLOU is not the only ETF that follows cloud computing. There's also WCLD and SKYY, for example; so how do you tell them apart? Which one is the best one to buy?

This really depends on what you're looking for. One ETF might have a higher annual fee than the others. Another might be actively managed rather than passively managed. Stocks held within that particular ETF might be equally weighted (which is what it sounds like -- it weighs all stocks within the fund equally), or market weight (where one stock might have a larger presence within the fund than all the others).

Final Word

The real strength and advantage to ETFs is that owning an ETF offers instant diversification. Rather than worrying about whether or not you have a balanced portfolio of stocks, you can simply buy an ETF that follow an index, like SPY or QQQ. And that is no small thing. After all, Warren Buffett famously bet that buying an index fund would outperform hedge funds over the course of 10 years (and hedge funds are filled with expert stock pickers). The final result wasn't particularly close -- the index fund returned 7.1% annually while hedge funds returned an average of 2.2%.

He said, "In my view, for most people, the best thing to do is to own the S&P 500 index fund."

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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