What is an ETF?

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Someone asked me the other day what exactly an ETF is. It’s one of those investment terms that probably everyone has heard by now and it made me aware that I have referred to Exchange Traded Funds in several posts already, assuming that people know what they are. So for the sake of clarity I thought it might be useful to provide a simple overview.

Probably the first point of reference here is to look at mutual funds. A mutual fund is a pooled investment run by a professional manager for a fee. The manager decides what assets to buy and sell in the fund and is usually benchmarked to an index in order to gauge performance. The idea is that investors are paying the manger to keep up with or beat that benchmark. Each investor owns a share of the fund, and at the end of each day the fund adds up the value of all the assets it owns and divides it by the number of shares so everyone knows the value of their share.

In 1976 Vanguard Group launched the first index fund. An index fund is still structured as a mutual fund. The difference lies in the investment strategy. Instead of trying to beat the market, an index fund simply tracks the market. Because tracking an index such as the S&P 500 does not require the skills of an active manager, the costs are lower. That first index fund, known as the Vanguard 500 (VFINX) is still around today.

An ETF is also a pooled investment. Like a mutual fund it can invest in cash, bonds, equities, commodities, or a blend of assets, and these assets are divided up into shares. The main difference from a mutual fund is that it is exchange traded – this means that it is traded just like a stock. You don’t have to wait until the end of the day to get the price of an ETF, it updates in real time. Therefore you can buy and sell it whenever the market is open. You can also utilise stock-like strategies such as stop losses, limit orders, or buying on margin. The structure makes it very low cost and easy to access through a brokerage account.

In January 1993 the American Stock Exchange released the S&P 500 Depository Receipt, the first ETF. Early ETFs were typically index trackers, but they have become more and more sophisticated and these days you can even find ETFs that short the market (in the expectation that it will go down) and use leverage to magnify returns.  There are currently almost 7,000 ETF strategies available, so there is plenty of choice.

So just how widely used are ETFs these days? Well in May this year the global total assets under management in ETFs went past $4 trillion. And if you’re wondering now how much a trillion is, take this on board:

1 million seconds ago was 12 days ago.

1 billion seconds ago was 32 years ago.

1 trillion seconds ago was 32,000 years ago!

 

Disclaimer: This should go without saying, but the information contained in this blog is not investment advice, or an incentive to invest, and should not be considered as such. This is for information only.

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