The Motley Fool

What is an Exchange-Traded Fund (ETF)?

exchange-traded funds

From the Motley Fool Staff

It’s no secret: when you’re a DIY investor, figuring out the right diversification of your investments can be tough. 

Not only do you have to pick stocks from companies and industries that you’re probably unfamiliar with, but you also have to balance those stocks with other investments (bonds, real estate, commodities) to create the right risk portfolio. On top of that, buying and selling individual stocks can start to get costly, as management fees and commissions add up, putting additional pressure to “get it right” fast.

What if someone just picks the right mix of investments for you? What if they put this mix in a basket and sold it to you? And what if you could buy and sell these baskets during normal trade hours like you would an individual stock?

Well, in a nutshell, that’s an exchange-traded fund.

What Is an Exchange-Traded Fund (ETF)?

An exchange-traded fund (ETF) is simply a basket of different investments (stocks, bonds, commodities) that you can buy or sell during normal market hours.

Most ETFs track the performance of an index, a particular sector of the economy (like healthcare, industrial, or energy), or even an international market.

ETFs allow you to spread your money across a broad range of companies without you having to hand-pick those companies yourself. Not only does that save you time, but it can save you money, too: ETFs are surprisingly affordable. Since the majority are passively managed, meaning they track an index rather than follow an investment professional’s strategy, you typically pay fewer management fees than similar investing products.

How Does an ETF Work?

An ETF works like this: an ETF provider scans the universe of investments, including stocks, bonds, international markets, currencies, real estate, or commodities, and bundles their top picks together.

This bundle could have a theme, like “best fruit producers” or “high-performing German cars,” or they could simply track a sector of the economy, such as healthcare or energy. Once the ETF provider has created their basket of investments, they sell shares to the public.

When you buy a share of an ETF, you don’t own the underlying investments. You own a share of the basket itself. When that basket of investments does well, you and everyone who’s bought in will get a portion of the gains, which comes to you in the form of a dividend. Finally, if you want to buy or sell your ETF, you can trade it on an exchange like you would a stock.

What’s the Difference Between ETFs and Mutual Funds? 

At this point you might be thinking, “a basket of investments—isn’t that just a mutual fund?

Yes, like ETFs, mutual funds give investors the opportunity to pool their money and spread it over a variety of companies. However,ETFs and mutual funds have some profound differences that every investor needs to understand.

The first is in ETF’s name, exchange-traded. ETFs can be bought and sold throughout normal trade hours.

Mutual funds, on the other hand, can be bought or sold only once, precisely when the market closes. Why does that matter? Well, trading ETFs during the day allows you to take advantage of price movements: if you get significant gains that you believe will disappear, you could sell immediately and make a profit. With mutual funds, you’d have to wait until the end of the day to cash in.

Another key difference is in the cost.

Mutual funds are actively managed, meaning a human being is somewhere in the world (probably in a swivel chair) looking after your investments. That human being makes money managing your account, which will come out of your mutual fund’s account value. On the contrary, since ETFs track an index, they’re typically managed by computers (exceptions exist, of course).

Computers don’t charge an hourly rate like humans do, making ETF costs significantly less.

What’s the Difference Between ETFs and Stocks?

A stock is a share of one company—Microsoft, for instance. When that company does well, the value of your stock goes up (the same if it does poorly: the value goes down). An ETF, on the other hand, allows you to invest in multiple companies, which helps you reduce market risk.

Think of the difference between the two like this—Buying an ETF versus an individual stock is like buying a multi-store gift card versus a gift card redeemable at one store. With a single-store gift card, you have one chance to get it right. But with a multi-store gift card, your money has options.

What are the Advantages of ETFs?

Fairly simple, Canadian-born (issued first in Toronto—take that Wall Street), ETFs are becoming all the rage in the investing world.

ETFs have these three advantages:

1. Diversification

Yes, if there’s one thing an ETF can promise, it’s increased exposure to various markets. An ETF can be your gateway into a world of investing options, one that spans sectors and countries, helping you hedge market volatility.

2. Tax-advantages

Everyone pays taxes on capital gains. There’s no way around that, but, when compared to mutual funds, ETFs are usually more tax efficient. That’s because mutual fund managers typically buy and sell underlying investments frequently, creating a tax liability for everyone who holds shares. Because ETFs usually track an index, the underlying investments don’t change often, meaning you’ll pay capital gains only when you sell the ETF.

3. Time efficiency

Normally, if you invest in an index, you handpick your companies. For example, if you wanted to invest in the S&P 500, you’d have to peruse five-hundred companies and choose the ones you want to invest in. With an ETF, a fund manager has essentially done the hard work for you. They’ve chosen an index to match, or a sector to follow, and they’ve repackaged these investments in a simple fund.

What are Disadvantages of an Exchange-Traded Fund?

ETFs can help you diversify your portfolio, sure, but they do have some shortcomings. Before you buy an ETF, you should be aware of these three disadvantages.

1. ETFs can still be costly

You should expect to pay operating expenses, which are expressed as a percentage called an expense ratio. You’ll pay operating expenses every year, and they’re deducted from your account value.

For example, let’s say you put $15,000 in an ETF with an expense ratio of .50%. If you made no money during the first year (rare, but, come on, it’s an example), you would pay .50% of $15,000 or $75 in operating fees.

Additionally, you’ll pay commissions for every trade you make. If you invest in an ETF for the long run, this won’t be a problem. But if you’re constantly buying and selling, these commissions can add up fast.

2. ETFs have investing risks

Yes, investing money in an ETF is far less risky than investing in single stocks. But they’re not totally unaffected by market volatility: you can still lose money in an ETF. Some ETFs will perform worse than others, while other ETFs will perform so poorly, investors will sell too quickly, causing the ETF to go bankrupt. You should always buy an ETF as you would any investment: with an investing strategy, knowledge of what you’re buying, and a focus on long-term gains.

3. ETFs are easy to liquidate

Because an ETF trades like a stock, you have more buying and selling flexibility. But that also means you can easily cash out an ETF due to irrational fears, like those felt during a market dip, correction, or crash. Even if market swings don’t prompt you to run, you might sell an ETF too quickly, causing you to miss out on gains.

ETF or not, Get Our Pick of Canada’s Top Stocks 

An ETF can help you spread your money around, especially if you don’t have time to handpick individual stocks.

If you’re ready to invest better, Motley Fool Stock Advisor Canada can help. You don’t need a broker or a degree in Finance to grow your wealth. You just need a few minutes a month, and some great stock recommendations – and that’s what we’re here for.

Stock Advisor Canada has more than 4Xed the S&P/TSX Index over the last 7 years!

Stock Advisor Canada members gain unlimited access to our library of expert stock recommendations inside the service, each carefully aimed at multiplying your net worth. Members also receive 2 new stock picks – each and every month – from legendary investor and Motley Fool Canada Chief Investment Advisor, Iain Butler.

Click here for the latest stock picks!