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What is an Exchange Traded Fund (ETF)?

Jack and Nick Author Pic
Jack Kramer & Nick MartellJune 17, 2019
Forbes 30 Under 30 in media, appeared on CBS, Cheddar. Registered representatives of Robinhood Financial LLC.
definition

An Exchange Traded Fund (ETF) tracks multiple stocks or other securities to conveniently let you invest in a sector, industry, or even region, so you don’t have to pick individual stocks.

Companies in the graphic above are shown for illustrative purposes only. The listed companies are not intended to be representative of companies that comprise any particular or actual ETF.

🤔 Understanding an ETF

Some people want stock in exactly one company. Others want stock in one type of company. ETFs are for the latter — each ETF is made up of several investments in different underlying stocks or other securities. There are different flavors of ETF depending on their investment focus, which can be a certain industry (automotive or tech), a certain region (European or emerging market stocks), or other certain categories of securities, for instance. ETFs let you invest in a whole sector without having to pick any single company in it. And you can buy or sell ETFs just like you would a stock.

example

If you believe cybersecurity is a smart investment, but don’t know which single cybersecurity company to invest in, you may not have to pick one. Instead, a cybersecurity ETF includes shares of a variety of cybersecurity companies, giving you a more diversified investment in the cybersecurity industry.

Takeaway

An ETF is like an investment smoothie…

Similar to a smoothie, it’s one thing you can invest in that’s made up of a mix of ingredients, available in different asset flavors (i.e., industries, sectors, etc.).

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Common ETFs
Are ETFs the same as mutual funds?
Advantages of ETFs
Disadvantages of ETFs

Common ETFs

Smoothies come in a variety of flavors, sizes, and tastes — similar to your ETFs. Sometimes they track stock indexes, such as the S&P 500. But they can also provide access to other types of securities. There are a variety of different types of stock ETFs. You can also find ETFs that track an underlying mix of currencies (foreign money), bonds (corporate debt), or even commodities (such as undifferentiated products, like oil or orange juice).

Some common ETFs frequently traded that you might find on the shelf are:

  • SPY: The SPDR S&P 500 ETF is intended to track the S&P 500 stock index, which is made up of 500 of the largest publicly traded US companies based on their value by market capitalization. It offers a certain taste of the general US stock market (i.e., large-cap stocks). This ETF typically rises and falls in a closely correlated fashion with the S&P 500 stock index.
  • GLD: SPDR Gold Shares ETF is intended to closely track the price of a certain amount of gold (it’s even become one of the world’s largest holders of gold). This is an ETF basically made up of one type of ingredient. It lets you own something very much like gold, but in ETF form.
  • EEM: iShares MSCI Emerging Markets ETF is intended to provide exposure to the general movement of over 800 medium and large publicly traded stocks from developing economy countries. This ETF may be held by investors with a craving to diversify their portfolios with foreign stocks, certain potential for growth, and a greater willingness to take risks. But investors in this ETF are typically exposed to the same political, currency, and market risks that affect the fund’s underlying emerging market companies.

Are ETFs the same as mutual funds?

Both contain the word “fund,” but they’re not exactly the same. Mutual funds and ETFs similarly can provide access or exposure to a wider range of investments in one, bundled, fund. Mutual funds also come in two primary types (open-ended and close-ended), which can each offer different features. But while ETFs and mutual funds both provide investment diversification, they differ in their structure, their benefits, and their risks (mutual funds are not offered by Robinhood Financial LLC). Here are a couple differences: 1. An ETF can be traded throughout the day on exchanges at different prices, like a stock. But many mutual funds (like open-ended mutual funds) are only priced once daily, at the end of a trading day, and can only be redeemed after that price is determined daily once trading ends. 2. ETFs typically aren’t actively managed. They’re usually designed to passively track a particular industry, index, or bundle of securities, so management fees can be lower. Mutual funds tend to be actively managed by a fund manager.

Advantages of ETFs

ETFs provide a variety of benefits relative to other types of funds, such as mutual funds. Keep in mind that despite these advantages, all ETFs carry risk based on the underlying investments they hold (and which you, as the investor, would gain exposure to as a holder of an ETF, for instance):

  • “Intraday” trading: Just like a stock, ETFs prices can move during the day and can be traded throughout trading hours. For example, day traders may buy an ETF in the morning, sell it at lunch, and then buy it again in the afternoon. An open-ended mutual fund, on the other hand, can only be redeemed once a day, after the market closes, at the fund’s end-of-day price.
  • Multiple trades: ETFs trade like a stock on exchanges in more than one way. In addition to buying single shares of ETFs, with some brokerages (though not Robinhood Financial LLC), you can also sell some ETFs short or buy certain ETFs on margin.
  • Lower fees: Mutual funds are generally actively managed by a fund manager, so they typically charge fees for this service. But since ETFs often passively track the movements of an index or security without much active human direction, they typically don’t charge as much of a management fee. They do have ratio fees, like other types of funds, which cover the fund company’s expenses.
  • Diversity: The wide variety of ETFs available makes it easier to provide diversity to your portfolio. Different and increasingly niche ETFs specialize in certain sectors, areas, and securities that can help balance out your other investments.
  • Dividends and Profits: ETF holders are indirect owners of the underlying companies that the fund holds stock in, so they receive some of the benefits of the underlying stocks in which the ETF invests, including the dividends that are distributed to shareholders.

Disadvantages of ETFs

Investing is serious, no matter the type of investment — stocks, commodities, mutual funds, or ETFs. In addition to an ETF’s benefits, there are also important disadvantages to keep in mind. And just like any investment, ETFs carry risk, whether that’s the risk of the general market or the specific risk of the companies in which it’s invested. Here are some key disadvantages to keep in mind:

  • Variety: While ETFs can bring diversity into a portfolio, they aren’t all themselves diverse. Some provide access to a wide variety of stocks within a specific region, sector, or topic, but not all do. Make sure you’re aware of exactly what the ETF in which you’re investing includes and whether that actually diversifies your investments, if that’s what you’re aiming for.
  • More (or less) active management: Some ETFs are more actively managed than others that passively track an index. Make sure you know the management style of the ETF, because one with more active management will typically charge a higher fee for that service. Fees can erode returns or exacerbate losses.
  • Market instability: ETFs have been getting some serious attention. The growth in ETF popularity over the last decade has resulted in a surge of funds tracking various indices or industries. As a result, market volatility can be amplified because of the algorithm-driven investments by some of the funds.
  • Tradeability: ETFs can trade throughout the day like a stock, but that doesn’t mean they’re necessarily easy to trade. Some ETFs that focus on more niche or obscure sectors may have relatively few buyers and sellers, making it harder to trade your ETF shares quickly at a price you want.
  • Leverage and Volatility: Some ETFs are designed to amplify the moves of the market — picture that smoothie, but loaded with caffeine. One could be structured to track the broader market, but it might be leveraged so that it rises three times greater than what the index did — that also means it falls by three times the amount when markets turn down. Caffeine highs can lead to caffeine crashes.

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This information is provided for educational purposes only and is not and should not be construed as an offer to sell or a solicitation of an offer to buy any security. In addition, this information is not intended to serve as a recommendation to buy or sell any security or other investment product. This information is not individualized, does not constitute a research report and is not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security, or financial product does not guarantee future results or returns. Before making decisions with legal, tax, or accounting ramifications, you should consult appropriate professionals and/or an investment adviser for advice that is specific to your situation. Securities offered through Robinhood Financial LLC, member FINRA/SIPC. The information used to create this content is based upon information reasonably available to Robinhood Financial LLC as of the date of publication.