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What is An ETF? Exchange-Traded Funds 101

What is An ETF? Exchange-Traded Funds 101

December 14, 2020
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Keeping up with investment terminology can be very daunting, even as an advisor. Standard deviation, stocks, beta, Jensen's Alpha: it's all a bit overwhelming. Most people may feel that they have a basic understanding of terms such as stocks, bonds and mutual funds. And then in recent years, the term ETF started popping up over and over again. But what is an ETF and how does it work? What makes an ETF different from a stock or a mutual fund? I thought we'd break down some of the basic components of these investment types, ending with an explainer on ETFs and how they could fit into a portfolio.

What Is A Stock?

One way companies raise money is by offering a percentage of their ownership to investors in the form of stock. Yes, that means that when you're buying stock you are actually becoming a partial owner of the company in which you've invested. This ownership comes with certain rights: voting power, ownership (via stock), the right to transfer ownership, the right to dividends, to inspect corporate documents and the right to sue for wrongful acts. Each unit of stock is referred to as a share. There are shares called common shares and shares called preferred shares.

Shares of common stock are traded between investors on a platform called an exchange, and the value of each stock is determined by supply and demand. If investors have a high demand for a particular stock, its price will rise to meet the demand, and its price falls if demand decreases.

There are two main ways that investors make money with stocks:

1. Selling a stock that has appreciated in value: let's say you buy three shares of stock in company XYZ that are priced at $20 per share. This price means it costs $60 to purchase the shares in total (3 shares x $20 price). Now let's assume that because of increased demand, the share price for XYZ rises to $30 per share. While you still own the same number of shares, 3, the value of those shares has risen from $60 to $90 (3 shares x $30 share price). If you want to 'realize' this gain (in other words, actually receive the money), you can sell the 3 shares for a profit of $30.

2. Receiving a dividend: some companies want to incentivize you to hold on to their stock. One way they can do so is by sharing their wealth with their shareholders. When corporations have excess profits, they can distribute them to shareholders by issuing a dividend. Companies may decide to issue a dividend of more stock in the company to each shareholder, or they may choose to distribute profits via cash dividends. Some investors choose to actually take the cash, while others use the cash dividend and reinvest it to buy even more stock. But dividends are another way to profit by owning stock.

When can stocks be traded?

Stocks can be traded throughout the day when the stock market is open for business. If you try to buy or sell a stock during trading hours, the transaction can be completed.

What is a Bond?

Unlike purchasing stock, when you buy a percentage of ownership in an organization, buying a bond essentially means you are loaning money to an organization. Bonds are issued at what's called Par value, or $1,000. Bonds have many features that may seem confusing, but once you understand that a bond is a loan they all start to make sense. There is a bond's maturity, which is the length of time you are lending the money. At a bond's maturity date, the organization to which you've lent the money has to return it in full. There is also the coupon rate, which is a percentage of the $1,000 bond that the organization borrowing your money will give you each year as an interest payment. Bond payments are typically paid twice per year. So if we have a $1,000 bond with a 5 year maturity and a 10% coupon rate, we are loaning $1,000 and each year we'll receive two payments of $50 each (10% coupon rate x $1,000 bond = $100 year in payments, which will be distributed as two payments of $50 each). At the end of the 5 years, we will get our last $50 payment AND have our original $1,000 returned to us as well.

People buy and sell bonds as well, and their prices can rise or fall based on the coupon rate offered by each bond. Remember that bonds are worth $1,000 at par value. But that doesn't mean you can always sell your bond for what you paid for it. Let's say I have a bond that matures in 3 years and has a coupon rate of 5%, meaning it issues payments of $50 per year (5% of $1,000 value). Well maybe I want to sell that bond to someone else instead of waiting the 3 years to collect my $1,000. When I go to the marketplace to sell my bond, however, I find that there are new bonds being sold that mature in 3 years as well, except they offer a 7% coupon rate! The new coupon rates are beating the one offered by my bond by a full 2% per year. This difference means to make my bond competitive, I will have to drop the price to attract buyers. Instead of charging someone it's full $1,000 par value to take it off my hands, I might need to sell it at $900 so that the buyer's return is closer to what they would receive if they'd bought one of the new bonds. 

The same principal is true in reverse: if I own a bond and I go to the marketplace to sell it and find that the interest rates on new bonds are BELOW my bond's interest rate, buyers will now have to pay MORE than the $1,000 value if they want to purchase it. These are a few of the ways that investors make profits using bonds.

When can bonds be traded?

Bonds can also be bought and sold during trading hours

What is a Mutual Fund?

A mutual fund is a collection of stocks AND bonds! When you invest in a mutual fund, you send money to the fund and its placed in a pot with the money from all other investors in the fund. That money is then invested in a range of different stocks, bonds and even other mutual funds. The investment makeup for some mutual funds are determined by a group of people called fund managers, who compile a list of investments in the fund based on trying to satisfy their investors' tolerance for risk (for example, aggressive investors or conservative investors) or even tracking an industry such as companies in the tech industry. Other funds called index funds may not even use human managers, but instead set computer algorithms to track the movement of market indices such as the S&P 500.

When can mutual funds be traded?

Mutual funds can NOT be traded throughout the day like stocks and bonds. With stocks, you might place what's called a market order to buy a share of company XYZ stock while it's at $30/share, and at the end of the day your purchase at $30/share could be worth $35/share. With a mutual fund, any orders placed during trading hours will not be filled until AFTER trading hours. And THIS wrinkle is what makes Exchange-Traded Funds a unique vehicle.

What Is An ETF?

An ETF, or Exchange Traded Fund, is a fund that blends components of mutual funds with those of stocks and bonds. Like a mutual fund, ETFs are often comprised of an assortment of stocks and bonds to diversify and spread out risk. But unlike mutual funds, ETFs can be traded on exchanges throughout the day like what you see with stocks and bonds. Since they can be traded during the day, one might have more control over the price they pay for a share of an ETF than they would in purchasing a mutual fund and waiting until the market closes to find out the price of the fund.

ETFs can also represent a more cost-effective way for investors dipping their toe into the market. Many mutual funds and index funds have minimum initial contributions. While some might range from $500- $1,000, there are funds whose minimum initial contributions can be as high as $3,000. Exchange Traded Funds can be purchased for the price of one share of the ETF, which might be as low as $50, a much more palatable entry point. Any fund will have operational expenses that they charge as a fee, be it a mutual fund, index fund or ETF. ETFs often have expenses that are more cost-effective than that of a comparable mutual or index fund.

There are downsides. Exchange Traded Funds do not allow you to make automatic, regular purchases or withdrawals into or out of the fund, while mutual funds and index funds do have this capability.

Why Are ETFs so popular?

In the age of the internet, automation and access to technology have opened doors for many investors who would have been priced out of certain opportunities in years past. Whereas an investor might have needed $100,000 to have access to a money manager that could create a custom portfolio decades ago, now this same level of oversight could be available for as little as $1,000. Specifically, in the past decade we've seen the rise of robo-advisors; investing platforms that use computer algorithms to manage investors' funds at a fraction of the price charged by human beings. A typical investment management agreement with an advisor might see the advisor charge a fee of 1% of the assets under their management, while each fund in which they invest might charge its own fee as well. Conversely, a robo-advisor might charge 0.25% as a fee to that same investor, lowering the cost of management and even offering access to planning services such as banking and securities-backed loans.

Robo-advisors often invest exclusively in ETFs because of their flexibility in terms of trading and their low cost structure. Robo-advisors can use diversified ETFs and trade them throughout the day, either to hopefully mitigate losses or even to try and take advantage of upswings in the market. 

Make no mistake, as a financial advisor I certainly believe in the value of human advice. And ETFs can be used by people like me in the course of planning. But the first goal is making sure that you as a consumer understand what you're investing in, regardless of who is overseeing the process. There are so many different platforms out there for those interested in investing, and ETFs are one form that is increasing in popularity with each passing year. By understanding how all of these tools work together, you can start to edcuate yourself on the right blend for your own finances.

Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary.  Therefore, the information presented here should only be relied upon when coordinated with individual professional advice. In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Mutual Fund investments are not guaranteed by any source and can lose money including principal invested. Note: Differing classes of shares have varying expenses, loads, fees and breakpoints. These differing classes also have time line holding periods which are appropriate depending on the investor objectives and goals. ETF products, like all investments, are subject to market risk, which may result in the loss of principal. Risks vary depending upon the strategy used by the fund as well as the sectors in which the fund invests.