ETFs explained in simple terms (With Examples)

If you’re into investing, chances are high you have heard about ETFs. They combine all the ease of stock trading with the high diversification that comes with mutual funds.

They are quickly becoming the most popular way to invest for both beginners and more advanced investors because of their relatively low costs and ease.

The cash invested in ETFs has increased from $0.7 trillion in 2008 to $7.7 trillion in 2020. A staggering 1000% growth in 12 years. Much of the money is coming from investors leaving mutual funds, which still is a $21 trillion business.

What is an ETF?

Simply put, an ETF is a bunch of securities packaged together into a basket. The basket can contain a mix of anything from stocks to bonds, commodities, and currencies. They are a great way to invest, offering new investors with small means the chance to adequately diversify their portfolio with a single purchase.

Now you might be thinking, “Hey, that sounds an awful lot like mutual funds!” And that’s true they have a lot of similarities but also some key differences.
To better understand what an ETF is, you need to know what a mutual fund is and how the two differ.

A mutual fund is a pool of money contributed by investors and managed by the fund’s manager. The fund manager decides how to invest the money and what securities to buy. But having your money managed by a professional isn’t free. The fund takes a cut, known as an expense ratio.

There’s been a big debate about this lately. Is it actually worth paying high fees to have a professional manage your money? There’s some pretty solid evidence stating that most fund managers can’t beat the market in the long run.

That is probably one of the main reasons investors are pulling huge amounts of money out of mutual funds and putting them into ETFs.
Now let’s look at some key differences between the two.

Differences between an ETF and a mutual fund

Both ETFs and mutual funds are baskets containing many different securities, like stocks or bonds. But they can also contain things like currencies, commodities, etc.

Exchange-traded funds have no minimum amount required to invest, which makes them great for beginners or people wanting to invest small amounts.
Some mutual funds have no minimum requirements, but most of them require an initial investment of $500 to $5000.

ETFs tend to be passively managed, while mutual funds are usually actively managed. But there are active ETFs and passive mutual funds.

Since most ETFs are passively managed their fees are usually a lot lower. And since mutual funds are often actively managed, the manager takes a cut, making their fees much higher.
According to Morningstar, in 2016 the average expense ratio (the annual fee) was 0.44% for ETFs, 0.73% for passively managed mutual funds, and 1.45% for actively managed mutual funds.
Now that might not feel like much of a difference when just looking at the percentage. But for $100,000 invested in an actively managed mutual fund, you would pay $1,450 each year and only $440 for an ETF.

ETFs can be bought and sold instantly over the stock exchange. That’s why they’re called Exchange-Traded Funds.
Mutual funds are traded once a day after the stock market closes, and the transaction can take anywhere from one to three days.

ETFs are required to disclose their holdings every single day. Mutual funds disclose them quarterly.

Now that we know what an ETF is and how they’re different from mutual funds, let’s look at some different types of ETFs.

Different types of ETFs

Stock ETFs are the most common type. They come in all shapes and sizes. Some are composed to track an index, while others are sector focused. An example of the former is the SPDR S&P 500 ETF, which tracks the S&P500 index. BETZ is an example of the latter. It offers the investor exposure to the sports betting and iGaming industry.

Bond ETFs is a great way for investors to gain exposure to the bond market. And because they are exchange-traded, it’s as easy as buying a stock.

Then there are commodity ETFs, making it easy to invest in commodities like oil, gold, and silver.

There’s also currency ETFs, where you can invest in a single currency or a basket of many different.

Inverse/short ETFs track an index, but they profit from a decline in the index. For example, if the S&P500 drops 2%, an inverse S&P500 ETF would gain 2%. And if the index rises 2%, the ETF would lose 2%.

Leveraged ETFs use debt to leverage investments. You’ll notice these by the 2x, 3x in the name. If you buy an S&P500 3X ETF, a rise of 3% in the S&P500 index would mean a 9% gain for the ETF. Conversely, if it drops 3%, it would mean a 9% loss.

Which ones you should go with is up to you and your risk tolerance. But if you’re new to investing and not entirely sure, maybe you should stick to a mix of stock and bond ETFs. And stay away from the leveraged ones. Leverage introduces an unnecessary element of risk to your portfolio.

The case for ETFs vs Mutual funds

We touched on the fact that most ETFs are very cost-efficient because of their passive nature, requiring very little work from management. But there’s one more cost involved in investing in them. That is the transaction fee, also known as the brokerage fee.

The transaction fee depends on the broker you use, most cost between a few dollars up to $20. But there are brokers offering zero commission investing.

With most mutual funds being actively managed and therefore having relatively high fees, you would expect them to achieve higher returns than the passive funds just following an index. After all, that’s why you would pay higher fees, right?

But the fact is, most active fund managers don’t outperform their respective benchmark. 80% of large-cap fund managers underperform the S&P500, according to the yearly SPIVA report. Eighty percent!

The ensuing argument from mutual fund proponents when this fact is stated usually goes something like this:
“But the mutual funds’ main objective isn’t to grow your capital. The main objective is to protect it during downfalls in the market.”

But that doesn’t seem to be the case either. According to a study conducted in 2004, I know, a little outdated, actively managed mutual funds underperform during bear markets.

Some good active managers actually do outperform the market, but they are few and far between. And picking them would consist of hours of research, and if you’re going to spend hours on research, you could research and invest in stocks instead. And since you’re looking at ETFs, I’m guessing you either don’t have the time or the interest needed for spending hours researching.

In any case, paying large fees and getting nothing in return can’t be justified in any way, and that’s why ETFs have proven to be superior. At least historically.

Conclusion

ETFs are for everyone. From beginners to experts, there’s something for everyone. They offer opportunities for investors to buy stuff that is otherwise harder to invest in than stocks, like commodities and bonds. And since there are no minimum amounts required, and you can pick one which adequately diversifies your portfolio, it’s very easy for someone with little money to start investing.

More and more people are pulling their money from mutual funds and into ETFs because of the ease of investing in them, the instant transactions, and the low costs.

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