An ETF, or Exchange Traded Fund, is a security that tracks an index, commodity, or sector. ETFs are comparable to mutual funds in that both hold a pool of assets. Generally, when you buy a share of an ETF, you are buying a slice of a diverse basket of securities.
At Wealthjar, our portfolios are generally made up of ETFs that seek to mirror an index or sector. This produces cost effective portfolios that allow investors to harness the return of entire indices or sectors by investing in a single fund.
Ownership of the ETF
The shareholders of an ETF indirectly own the underlying assets that make up the fund and earn a proportion of the profits derived from the assets. The fund itself owns the underlying assets and ownership of those assets is divided into shares. In order to trade directly with the fund, a broker-dealer must be an “Authorized Participant” or “AP” in the fund. The AP buys blocks of shares from the fund and then sells single stocks to retail investors. This unique mechanism allows even the smallest retail investor to own a slice of a diversified portfolio made up of broad and often expensive securities.
For example, a commodity ETF may consist of futures and derivative contracts of a certain commodity or stock of a company that deals in the commodity. This allows the fund to track or “mirror” the price of the underlying commodity. Thus, buying shares of the commodity ETF would allow a retail investor to diversify their strategy with the performance of a certain commodity without bearing the cost of purchasing an entire basket of securities.
There are ETFs available for every major commodity or asset class. But historically, ETFs were set up to track a benchmark index, giving the investor an affordable market matching strategy. The SPDR S & P 500, one of the first index tracking ETFs, set up in 1993, [ticker symbol SPY], indirectly holds shares of common stock in all the companies in the S & P 500. The stated objective of the SPY SPDR is to provide investment results that correspond generally to the price and yield performance of the S&P 500 Index. Thus, investors in SPY are able to invest in the entire S & P 500 by purchasing a single share of the ETF.
The following data shows how SPY has historically performed in line with its native index: In 2009, the S&P grew 26.46%, while SPY delivered a return of 26.37%. In 2010, the S&P grew a 15.06% while SPY delivered a return of 15.06%. In 2011, the S & P grew 2.11% and SPY delivered a return of 1.89%. Like SPY, the underlying securities of some ETFs replicate the exact composition of their benchmark index, while others track their benchmark index with a representative sample of the securities in that index.
Low Cost, Flexible, & Efficient
Merely trying to mirror the market means that indexed ETFs are constructed to employ a passive investment strategy, incurring less administrative costs than an actively managed fund. This is because once a fund is set up, shares are only bought and sold for rebalancing or mechanical changes, delivering lower costs than an actively managed portfolio. Fewer trades translates into fewer taxable distributions and fewer transactional costs. Giving the investor an efficient return on their investment.
Unlike mutual funds, which may only be bought and sold at a single price determined at the close of the trading day, ETFs can be bought and sold throughout the trading day [or “intraday”] and at their real time market price. This gives investors the flexibility to trade the security like a stock. Yet, since the underlying value of an ETF is based on an entire market or sector rather than a single company, an ETF generally offers greater diversification than a traditional stock.
While the ETF industry is relatively new in comparison to the mutual fund and hedge fund industries, their popularity is growing rapidly. Today, ETFs are a $2.971 trillion dollar global industry, out-sizing the hedge fund industry by $2 billion dollars.