What is an ETF?

by | Mar 26, 2021

An ETF or Exchange Traded Fund is a fund that trades just like a stock on an exchange.

A fund will pool together money from many investors and use it to buy stocks, bonds, real estate and other assets.

ETFs have become increasingly popular because they provide a wide range of diversification while keeping things cheap and simple. 

Types of ETFs

ETFs will vary based on their objectives. 

An ETF that invests in stocks could have the objective of replicating the returns of a stock index such as the S&P 500.

Some ETFs will track a particular industry such as technology or pharmaceuticals.

Others will offer a diversified portfolio investing in different asset classes such as stocks, bonds and commodities. 

One example of a diversified ETF is VDHG. VDHG or Vanguard Diversified High Growth Index ETF is an Australian based ETF that invests in a variety of different markets such as the Australian stock market, Emerging markets, bonds, international shares and fixed interest.

Why Investors Like ETFs

When you buy a stock you are investing in a single company. When you invest in an ETF you are investing in many companies. If you buy an ETF that aims to track the S&P 500 you will be investing in hundreds of the most successful stocks which trade in the US such as Apple, Microsoft, Amazon and Facebook. 

By diversifying your money into many different stocks, industries or assets you lower the risk of being exposed to any single stock, industry or asset class.

Say you invest all of your money into a single stock. If that stock goes bankrupt you will lose all of your money. If you invest in 100 different companies the chances of them all going bankrupt is very small and chances are that many of them will grow over time. 

Investors like ETFs because they have a large amount of diversification. Obviously, the level of diversification will vary depending on the objectives of the ETF. An ETF that invests solely in technology stocks will be less diversified than an ETF that aims to track an index such as the S&P 500.

Another reason investors like ETFs is that they offer simplicity. While you could replicate the returns of the S&P 500 yourself by buying each of the stocks which it contains, this would involve buying 500 different stocks. If you wanted to invest in the S&P 500 every month this would take an enormous amount of time. ETFs allow you to invest in each of the 500 companies which make up the S&P 500 with a few clicks. 

ETFs also save you money. Depending on where you live you will likely have to pay brokerage costs each time you buy a stock. Say you wanted to invest in the S&P 500 and it costs you $10 each time you buy a stock. Buying each of the 500 stocks in the S&P 500 would cost you $5000 just in brokerage. Instead, you can buy shares in a single ETF that tracks the S&P 500 and pay just $10.

ETFs also generally charge lower fees than other funds such as mutual funds. This is because ETFs are mostly passively managed whereas many mutual funds are actively managed.

In a passively managed fund, the fund will invest in the same companies which make up an index. All of the shares and the amounts are predetermined by the index.

In an actively managed fund, the fund will pay researchers, analysts and a fund manager to try and pick ‘winning’ stocks. All of these employers need to be paid and so the fees for an actively managed fund will be higher than those of a passively managed fund. 

How to make money from ETFs

There are two ways you can make money from an ETF.

  1. The price of the ETF can go up
  2. The ETF can pay dividends

When the price of the assets the ETF invests in go up so too will the price of the ETF. If you buy an ETF at $50 per share and sell them at $60 per share you will profit $10 per share.

An ETF may also pay a dividend to its investors from its earnings and capital gains. Not all ETFs pay a dividend however instead they reinvest their returns back into the assets which it holds. 

To see if an ETF pays a dividend you should look for its dividend yield. The dividend yield is the amount the fund pays out compared to the market price of a share.

For example, if the ETF pays a yearly dividend of $1 and its current market price is $20 that ETF will have a dividend yield of 5%.

How to Invest in ETFs

Investing in ETFs is as easy as buying a stock.

First, decide on your investment objective. Do you want to invest in a broad index such as the S&P 500, the technology industry, bonds or something else?

Do some research into some ETFs which have similar objectives to you.

Some of the largest ETF providers are

  • Vanguard
  • State Street SPDR,
  • and Ishares

If you don’t already have a broker open an account with one of the many online brokers.

Decide how much you want to invest and how many shares you want to buy.

Place a buy order through your broker.

Summary

  • An ETF or Exchange Traded Fund is a fund that trades just like a stock on an exchange.
  • ETFs will vary based on their objective. 
  • ETFs can invest in stocks, bonds, real estate, commodities and other assets
  • ETFs are popular because they provide diversification, they are a cheap way to invest in many different assets and they are generally cheaper than other types of fund.
  • You can make money in 2 ways from ETFs
  • When the price of the ETF goes up
  • When the ETF pays you a dividend
  • You can purchase ETFs through your broker just like buying stocks

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