What is an ETF? ETF is short for Exchange Traded Fund. Exchange Traded Funds allow an investor to participate in the movement of a market, sector, industry, or commodity without the capital outlay needed to buy all companies that make up a particular market, sector, or industry. Created in 1993, ETFs trade like stocks on an exchange, and like stocks an investor can buy, sell, and short ETFs throughout the day when the market is open. ETFs are seen as generally good investment vehicles for investors who don't have the time to research companies for individual stock purchases.
As stated earlier ETFs can be used to track a market, sector, industry, or commodity. The first ETF traded was the SPDR S&P 500 ETF, better know as the SPY. The SPY (and SPY is the ticker symbol) attempt to mimic the performance of the S&P 500.
From the table above the SPY did a pretty good job of tracking the S&P 500's returns and losses. The SPY isn't the only ETF that tracks the S&P 500, there are several others. There are ETFs that track the NASDAQ, the Dow Jones Industrial Average, the S&P 400, the Russell 2000 and on, and on, and on. There are also ETFs that track commodities like god, grain, and oil. If an investor is convinced that oils is going to rise in the near future, but the investor doesn't have the time to research oil companies or the capital to invest in several oil companies, buying an ETF that tracks oil will the all the investor to gain exposure to the oil markets and participate in the rise of oil (if it does rise).
ETFs are great investments vehicles for the set it and forget it investor, especially those that have conviction in a particular market, sector, or industry. Warren Buffet has stated that ETFs are the best place a person who can't research individual companies to put their money.
If an investor wants to diversify their portfolio with foreign investments ETFs can help the investor do that as well. There are ETF's that track European markets and industry, Brazilian markets and industry, China's markets and industry, Emerging markets and their industries. There is an ETF for almost everything, even for the investor who feels the market is heading down. Inverse ETFs can be used to bet against what a particular market or sector is doing. For example if an investor feels that the S&P is going to decline in the near future, she can purchase an inverse S&P ETF like the ProShares Short S&P 500 ETF (SH).The ProShare Short ETF will rise as the S&P falls, allowing an investor to make profits while the market declines.
ETFs can be a great way for a beginner to get involved in the market, they offer diversity and low fees, but there are some disadvantages of investing in ETFs. Like a stock purchase and sale, there is a commission attached to ETF purchases and sales (click here to see what brokerages charge for ETF purchases). Another disadvantage is that some ETFs are thinly traded which creates a large spread between the bid and the ask price. When this occurs it makes it harder for an investor to sell their ETF at their desired price. And while diversification was touted as a benefit of ETFs, it can also be a disadvantage. There are times when an individual company outperforms an entire industry, but the ETF's performance is weighed down by the sluggish companies in the sector. Below are charts of XRT, an ETF that tracks the retail sector and Amazon a retailer.
The charts above are from September 1, 2016 to September 1, 2017. The XRT ETF declined 11.4% in the time period covered in the chart, Amazon on the other hand increased by 27.6% in the same period. This is a case where an investor would've done better going with a single stock over an ETF. Amazon's great gains weren't enough to help investors of XRT.
ETFs have their risk and disadvantages like all investments do. Before investing in an ETF, an investor should review their investment plan to determine if ETF's fit the plan.
I hope we were able to shed a little light on what ETFs are. There is a wide selection of ETFs, more than we covered here. The variety of ETFs available allows an investor to gain exposure to many types of markets. Before investing in an ETF be sure to do the research before the trade.
Keep an eye out for more articles coming to the Beginners Block. If you want to get updates on new articles and reports, leave us your email.