EXCHANGE TRADED FUNDS
What is an ETF? ETF stands for Exchange Traded Fund, and what are they and how do they work? Are they something a newbie should look at as a legitimate possibility to invest their money? As we mentioned in the previous section, there are some similarities between mutual funds and ETF’s. One of the important similarities is that they both represent a basket of similar securities that could be equities (stocks) or bonds or both. When we mention similar securities, we are referring to sectors of the economy. So, most ETF’s will reflect a particular business area like the mining, energy, financial or technology sections. These are only examples, as we divide the economy into dozens of different areas.
One of the bigger differences between mutual funds and ETF’s is that mutual funds are actively managed by professional money market people and ETF’s are not. What does this mean? As we learned previously, the active management of mutual funds adds to the cost of owning mutual funds and we, as investors, pay for that in yearly fees charged to the funds we own. What that means in dollars and cents is that if we purchase $10,000.00 worth of mutual funds, then every year they will charge the value of our investment approximately 3% or $300.00 for the management services, administration and marketing. We have to rely on the professional managers to earn over that amount in order to increase the value of our investment.
ETF’s mimic existing investment groups such as the Standard and Poors 500, the various sub-indices of the stock market like the mining, technology and other categories that make up the overall market. Let’s try to put this in plain language. If you are reading this information, then you are probably also more aware of some business news that is provided by the various news outlets. You may be familiar with the terms Dow Jones Index and Toronto Stock Exchange Index. The newscaster will solemnly inform us that the “Index” has gone up or down by a certain number of points today. This is just a snapshot of what the investing world did in a general sense during the day. If the index reading is down, that only represents the specific stocks that are part of the index, it does not mean that every company trading on the exchange was down.
We have various stock market indices, which are then broken down into many sub-indices that are composed of specific companies in that sector. Specifically, if we were looking at the mining sector sub index, then it comprises the major mining companies in the country. The stock market would track the price of those major companies, and the index would reflect the combined prices and report them daily. Not every mining company is included in this index, and the stock exchange changes them from time to time. They are only the senior well-known companies. The company that creates an ETF would buy shares in each of those companies represented in the same ratio that the stock exchange used to create their index. If the stock exchange removes or adds another company, the ETF does the same. They require no management or research to do this. It is simply adjusting to reflect the stock market index itself. The upside of this for the investor in ETF’s is that the management fees are significantly lower than for mutual funds. They are often below 1% as compared to the 3% range for mutual funds.
There are hundreds of choices in ETF’s that reflect many investment niches. You can buy an ETF that follows commodity prices like gold or foreign stock markets, niches like bonds, utility stocks, energy stocks and so many more. The downside for the investor, and the opportunity to keep more of their money by lower fees, is that the investor has to take some responsibility for finding appropriate ETF’s. Through their own reading and thinking, they will want to determine what parts of the economy they feel comfortable investing in. We should emphasize that an ETF is a basket of companies, so it mollifies the risk. If one company goes down substantially, its effect on the overall value of the ETF is not as significant. Conversely, if a company goes up significantly, it also does not affect the overall value substantially either. In this case, there is safety in numbers for the investor while they enjoy the benefits of participating in a market segment that they have some knowledge of because of their own investigation.
In summary, mutual funds and Exchange Traded Funds are excellent investment opportunities for the new investor who wants to take part but also wants to keep their risks low. We should mention that not only “new” investors use these investment vehicles, but many very large funds like pension plans use them as well. Sometimes the number of choices can overwhelm, but if you consider your personal investment goals and knowledge and use these as a starting point, you will do well. A quick point about investment goals: consider these four points, safety, income, growth and risk. As you think about these four principles of investing, assign a percentage to each area that you are comfortable with. Naturally, the four percentages should add up to 100. We will talk more about this later on, but you could use this personal information as a guideline to your comfort in buying stocks or any kind of investment.
ETF’s and mutual funds are an excellent method for people to gradually increase their savings over time as they periodically invest money every month or so.
We will take a very shallow dive into the cryptocurrency market next to give you an idea about what they are and how they work.