ETF's (Part One)
I touched briefly on ETF’s in an earlier post called Stockpicking v. Bundling (ETF’s, Mutual Funds, etc.). While I thought I could ignore ETF's for the time being, given their complicated and unfriendly name, I have determined I can no longer avoid a post on ETF's as I see them mentioned in just about everything I pick up. I decided I should delve into the research on this product sooner rather than later.
Interestingly, this phenomenon of learning or hearing about a piece of information and then encountering it again very soon thereafter, often repeatedly, is known as the Baader-Meinhof phenomenon. We give new information that we find interesting more attention than the thousands of other pieces of information we absorb every day and that is really why it seems like a coincidence. There is your interesting fact for the day!
Back to ETF’s, what are they? First off, ETF stands for Exchange Traded Fund. It is a basket of securities (a security is any sort of investment or financial instrument issued by a company or government that gives you ownership in something, evidences a debt owed to you, gives you a right to share in earnings or a right to be distributed some property) that can be traded, through a broker or brokerage firm, on a financial market like a stock exchange. The securities contained in the basket can contain almost anything that the issuer decides to put into it. For example:
· Index ETF’s: These ETF’s attempt to replicate the performance of specific index. What is an index you ask and why is that important? An index itself is calculated from the prices of a select group of stocks. From that, investors determine what the return of a certain index is and how their returns compare. When people talk about what the “market” is doing or how to “beat the market” they are likely talking about how a set index is doing and whether they are getting a better or worse return than the index or “market”. Some popular indexes that I'm sure you will have heard about at some point include: S &P Global – averages stocks from multiple regions around the world; S & P 500 – averages the top 500 US companies; Wilshire 5000 – stocks of nearly every publicly traded US Company and the Dow Jones Industrial Average – covers 30 large publicly owned US companies. You can also follow or base your Index ETF on such things as an ethical stock market index which would include only companies following a social or environmental criteria. Thus, an Index ETF would attempt to track the performance of a particular index by holding in its portfolio the contents of that index or a representative sample of such contents. The idea is your ETF (which would already be set up for you by a firm and you would “buy” it from them) would track that particular index in terms of its returns. You can buy an ETF from a discount brokerage like Questrade.
· Stock ETF’s: While similar to Index ETF’s, Stock ETF’s track stocks but are not as tied to mimicking an index. For example, a Stock ETF may track those stocks that pay dividends and build a fund on that basis or contain stocks in one particular sector such as energy or technology. You might also want to buy a Stock ETF based on solely large cap companies for example.
· Bond ETF’s: These ETF’s invest in bonds. I have not covered Bonds yet, but look for a post in the near future.
· Commodity ETF’s: This type of ETF invests in, wait for it, commodities! Commodities are things like precious metals (gold, silver, etc.), hydrocarbons and agricultural products such as pork bellies! And on that note, just because I can’t resist a good movie quote (Have you read my post How’s Your Portfolio? I’d Say Strong to…Quite Strong?), remember this gem from the movie Trading Places with Eddie Murphy back in 1983 (courtesy of Wikiquotes):
Randolph: Exactly why do you think the price of pork bellies is going to keep going down, William?
Billy Ray (Eddie Murphy): Okay, pork belly prices have been dropping all morning, which means that everybody is waiting for it to hit rock bottom, so they can buy cheap and go long--which means that the people who own the pork belly contracts are goin' batshit. They're thinking, "Hey, we're losin' all our goddamn money, and Christmas is around the corner, and I ain't gonna have no money to buy my son the G.I. Joe with the kung-fu grip, right? And my wife ain't gonna f... my wife ain't gonna make love to me 'cuz I ain't got no money, right?" So they're panicking right now, they're screaming, "SELL! SELL!" 'Cuz they don't wanna lose all their money, right? They're panicking out there right now! I can feel it! They out there!
[on the ticker machine, the price keeps dropping]
Randolph: He's right, Mortimer! My God, look at it!
Billy Ray: I'd wait till you get to around sixty-four, then I'd buy. You'll have cleared out all the suckers by then.
Randolph: (on telephone) This is Randolph Duke. Advise our clients interested in bellies to buy at sixty-four. Mr. Valentine has set the price.
I am not sure why all I mainly remember from this film is pork bellies but for some reason, I do and who knew 34 years later it would come in handy!
· Currency ETF’s: An ETF that tracks major currencies.
· Actively managed ETF’s: Actively managed ETF’s are set up to BEAT the market and not just mimick an index. This involves having a manager actively monitor the ETF and while they may use an index as a benchmark, they will be trading and otherwise making decisions in an attempt to do better than the index. This is in contrast to a Passive ETF whose goal is to simply track the index and not require a great deal of trading or active management to achieve a goal, ie. doing better than the index. Passive ETF’s will have much lower fees than an Actively managed ETF because you are not paying someone to actively manage the account. However, the fee may be worth it on an Active ETF if the fund makes more money than the Passive ETF.
· Inverse ETF’s: This ETF is designed to profit from a decline in the underlying benchmark (like an index) and is similar to short selling. Further detail is probably beyond the scope of most of us for now!
· Leveraged ETF’s: These are also likely way beyond our scope as they are complicated and involve an attempt for the ETF to achieve a return that is multiple times the index in both a positive and negative direction.
· Exchange traded ETF: This type of ETF is a debt security issued by a bank and provides access to a basket of stocks from a particular industry. Again, these are likely beyond the scope of most of us beginners.
The above is an outline of what an ETF is and what sorts of ETF’s are available to purchase. In essence, they trade like a stock but provide the diversification of a mutual fund. My next post on ETF’s will delve into the pros and cons and a provide a more detail as to how they actually work as there is a great deal more information on this product that needs to be understood.
** Top photo by Spencer Watson on Unsplash