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What are Exchange-Traded Funds (ETFs)?

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What are Exchange-Traded Funds (ETFs)? They are investment funds that hold underlying assets like a mutual fund, but are traded on the stock exchange like individual stocks. To better understand ETFs, here are some of the characteristics grouped into their similarity with mutual funds and individual stocks.

ETF Characteristics

ETFs are Similar to Mutual Funds

  • An ETF is an investment portfolio consists of many underlying stocks, but the price does not necessary match the Net Asset Value (NAV) of the underlying stocks. It could be traded at a premium above the NAV or at a discount below the NAV.
  • ETFs are categorized similar to the way mutual funds are — e.g., small-growth, mid-blend, large-index, specialty-real estate, international, etc.
  • ETFs have expense ratio similar to mutual funds, but these expenses are usually much lower than mutual funds of the same asset class.

ETFs are Similar to Individual Stocks

  • ETFs can be traded throughout the day.
  • Investors can short or buy ETFs on margin.
  • Stock brokers charge trade commission to buy and sell ETFs.
  • ETFs suffer from bid-ask spread, meaning you have to buy at a higher ask price and sell at the lower bid price; effectively, losing the 1/8 spread.

Why ETFs are Great Investments

In the post How 1% Expense Ratio Kills Your Investment Returns, I showed you how investing in mutual funds with high expense ratio can cost you as much as 18% of your potential gain over 30 years.

With this in mind, I went back to review my portfolio and found a fund that charges 1.23% (above my maximum tolerance). This does not seem expensive, but it can cost me a lot of money if I keep the fund for 30 years. Also, as I mentioned earlier, ETFs tend to be more tax efficient than equivalent mutual funds making them more appealing in a taxable account.

Right now, I have enough money invested such that it is more expensive to invest in mutual funds than ETFs. So today, I went ahead and sold HFCGX and traded it for VB.

Inverse ETF and Leveraged ETF

In addition to the standard ETFs, there are also Inverse ETFs. These are a class of ETFs that rises in value when their underlying asset falls, similar to short selling a stock.

An Inverse ETF can also be leveraged. Many Inverse ETFs are leveraged and aim to return twice or thrice the fall in the index value.

For example, the ProShares UltraShort QQQ ETF will rise 2x, if the Nasdaq-100 Index® falls. Here is the description:

ProShares UltraShort QQQ seeks daily investment results, before fees and expenses, that correspond to two times the inverse (-2x) of the daily performance of the Nasdaq-100 Index®.

This short ProShares ETF seeks a return that is -2x the return of its underlying benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. Investors should monitor their holdings as frequently as daily…

As you can see from the description, Inverse ETFs is not a good fit for most typical investors.

Bottom Line

ETFs are great alternative to individual stocks and mutual funds when investing in the Stock Market. They combine the best characteristics of both stocks and mutual funds. There are so many ETFs to choose from that you can tailor just about any portfolio to meet your needs using just ETFs.

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PinyoNicholas JayJoePinyoLazy Man and Money Recent comment authors
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Lazy Man and Money
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I love VB and own that instead of a mutual fund. I also have VTI and Vanguard’s Health care ETF, VHT. I love ETFs.

Pinyo
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Pinyo

Lazy – hi again! I am just getting into ETFs. I sold some of my high expense mutual funds and now own some shares of VB, VBR, and VGT. I just love Vangard super low expense ratio, and great high yield / low PE combination.

Joe
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Joe

That’s a great post Pinyo. I am thinking of “owning the world” through 2 etf’s – VTI and VEU. I haven’t gone as far as %-age exposure to bonds yet 🙁

Nicholas Jay
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Nicholas Jay

Pinyo: Do ETF’s actually own shares of the individual stocks listed in their “holdings list” or do ETF’s “create” a mimic of the share at a given price the stock represents? An example would be a holding of ishares IVV where they have 3.51% in Exxon Mobil Corp? Does IVV actually own the Exxon Mobil Shares?

What are Exchange-Traded Funds (ETFs)?

by Pinyo time to read: 2 min
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