Have you ever had a craving for pizza, but couldn’t decide on which kind to get? What if you could only get one? Wouldn’t it be great if you could have a couple slices of lots of different flavors, or different types of crust, maybe even a bread stick or two all in one pizza? This is pretty much how an exchange traded fund or ETF works. Here are some basics about ETFs:
An ETF compiles lots of different stocks into one group or basket- kind of like a pizza made from lots of different styles, toppings, and flavors, but sold as one pizza.
Exchange Traded Funds get their name because they are traded on an exchange just like a stock. This means they can be bought and sold throughout the day, unlike their cousin the mutual fund, which we learned about last week.
At first glance ETFs can look a lot like mutual funds; they are both collections of stocks, bonds, or securities, but there are a few key differences.
Mutual funds are actively managed so that assets within the fund are bought and sold to gain the most profit. ETFs are more passively managed and typically track or mirror specific indexes.
Mutual funds typically have a minimum investment requirement, whereas ETFs typically do not have a minimum. In some cases may even be purchased in fractional shares
ETFs are more tax efficient than mutual funds.
ETFs allow you to keep more of the profits compared to mutual funds because they typically have a lower management expense.
ETFs can hold hundreds of different stocks across myriad industries, or it can be focused on a single sector or industry. This allows the investor to create a balanced portfolio between risk and potential returns.
If we go back to our pizza analogy, we could say that you are an adventurous eater and like trying new things. It would be nice to be able to order just one slice with crazy flavors, rather than the whole pizza, and still get some tried and true flavors, because what if you end up not liking the new one? With an ETF, you can have a lot of diversification, meaning if one company’s stock (or slice) doesn't do well, there's plenty of other really great tasting stocks to make up the difference. This means you don’t feel the loss as greatly as you would if the whole pizza had been made up of the new adventurous but not-so-great-flavor.
There are some negatives to ETFs. At times they can be a little more complex than traditional mutual funds, this can be overcome with the help of a knowledgeable advisor. Another downside is they pay lower dividend yields-because ETFs track a broader market the yield is averaged out and will end up being slightly lower. There is no one perfect type of investment, and the bottom line always comes down to knowing and understanding what you're investing in, both the good and the bad.
"An investment in knowledge pays the best interest."
-- Benjamin Franklin