What the ETF?



Posted on September 9th, 2023

If you're starting your investing journey, you've likely heard acronyms being thrown around and are wondering "What the ETF?" Heck, you might even be invested in one, or a few, without knowing what they are. Let’s change that!

What is a diversified portfolio?

To understand ETFs you need to understand diversification. Think of a picnic basket; you don’t just pack a PB&J. Baskets are filled with a variety of snacks, sandwiches and drinks to help minimize the risk of becoming too hungry, too thirsty, and to make sure the day isn’t ruined when something you’re eating inevitably falls on the ground.

A diversified portfolio is essentially a well-planned picnic basket of stocks. That way if one stock has a bad day, you have another stock having a good day to balance things out. The more variety in your basket, the less you’ll be affected by the ups and downs of the stock market.

So, what is an ETF?

An ETF, or Exchange-Traded Fund, is a type of investment fund that trades on the stock exchange, similar to individual stocks. It is a way to pool together your money to purchase a share in a fund that can include a variety of assets such as stocks, bonds, or commodities. These funds offer more diversity than purchasing individual stocks.

How do ETFs work?

ETFs can be made up of a variety of assets and are designed to track the performance of a specific index, sector, or asset class. For example, an ETF might track the performance of the 500 of the largest companies listed on stock exchanges in the United States, which is known as the S&P 500 index. By investing in this fund, you are essentially buying a small piece of each of those 500 companies. So, if the overall value of the S&P 500 index goes up, your investment value should increase proportionately. Similarly, if the index goes down, your investment value would likely go down as well.

ETFs are often passively managed. This means that their goal is to achieve a similar return to the market index they track, without trying to beat or outperform it. This hands-off approach aims to capture the overall performance of the market rather than trading in and out, actively trying to select winning stocks. This approach is always the best option for long-term investments, because as the adage says: “Time in the market always beats timing the market.”

Benefits of investing in an ETF

Diversification: Investing in an ETF can give you instant diversification, as ETFs hold a basket of assets. This reduces the risk associated with investing in a single stock or security. This kind of diversification has been proven over time to be best-in-class when it comes to long-term investing.

Liquidity: Liquidity is a measure of how quickly an asset can be converted into cash. High liquidity investments are desirable because they ensure that you can quickly buy and sell stocks or assets without significant price impact. Because ETFs are traded on stock exchanges throughout the day, they allow investors to buy or sell shares at market prices. This liquidity provides flexibility and ease of trading.

Cost: Due to their scale and the fact that they’re usually passively managed, ETFs generally have lower expense ratios compared to actively managed funds. Higher returns over time at a lower cost? Sign us up!

Transparency: A lot of the finance industry can feel intentionally opaque, which can leave the everyday investor unsure of their choices. One of the significant advantages of ETFs is their transparency. ETFs are required to disclose their holdings on a daily basis, which allows you to easily keep track of the fund's composition and make informed decisions. Pro tip: Make sure you understand the management, investing methodology and thesis before buying an ETF.

Flexibility: Whether you're interested in investing in a specific sector (ex. clean energy), a region (ex. emerging markets), or investment strategy, (ex. total stock market), chances are there's an ETF that suits your needs. This flexibility allows you to easily choose a more diverse portfolio that aligns with your investment goals, risk tolerance, interests and ethics.

Accessibility: With a brokerage account, you can purchase ETFs at a share price, making them more affordable compared to some mutual funds or individual stocks.

Tax Efficiency: ETFs often offer tax advantages due to their unique structure. Since most ETFs are passively managed, they tend to have lower turnover in their holdings (i.e. less buying and selling of individual stocks), resulting in fewer taxable events. By investing in an ETF you only pay capital gains taxes when you sell your shares, giving you more control over your tax liabilities.

ETFs, particularly those that track the total stock market, regularly result in higher returns over time than almost any other investment strategy. With fewer highs and lows than you would experience by trying to pick stocks and time the markets, 9 out of 10 hairdressers report that ETFs result in fewer gray hairs*.

ETFs can, however, get a little bit convoluted, so it's important to look at the prospectus of the ETF, make sure you understand what it's investing in, how it balances itself, what the actual objective of the fund for which you are buying an ETF in, is set up to do. As with any investment, it's wise to do your own homework and not blindly follow every hot tip you hear at the neighborhood barbecue. That being said, in general, ETFs check all the boxes for what we like to see in investments: lower cost, diversified risk, less volatility, and increased liquidity, which is why we're big fans.

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* Ok, so maybe only one hairdresser said that, but it still sounds like a solid observation.

This blog is for educational purposes only and does not constitute financial advice.

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