All About the ETF

Edited Photo. Source: Flickr - Carlos ZGZ

One thing I will be talking about a lot in my blog is the ETF -- or Exchange Traded Fund. While an overview of the ETF might be a bit elementary to more experienced investors, it is important to understand everything you invest in. I hope this explanation will help describe ETFs and their history to newer investors and hopefully persuade them on their value when comparing to individual stocks. I believe that ETFs are truly the greatest invention since Index Funds, and the Index ETF well... magical!

Stocks

To explain ETFs in detail, we first need to explain stocks -- sometimes called shares. Stocks on the stock market are simply an ownership stake in a company that is open for trade to the public. For example, when you buy Royal Bank stock (trades as RY.TO), you are actually buying a tiny ownership stake in Royal Bank. You benefit from their profits, will receive a dividend payment each quarter, and can even attend shareholders meetings and vote on decisions proposed by the Board of Directors.

At a basic level it is no different that purchasing an ownership stake in a local business in your neighbourhood. Some of the biggest differences are: strict legal requirements imposed on companies that trade on the stock market (to prevent fraud), less control as companies that trade on the stock market are generally huge so you only own a minute piece, and increased liquidity -- stocks that trade on the stock market can be bought and sold within seconds at a low cost. Stocks can be purchased individually through brokerages, including online brokerages such as Questrade.

Assessing the value of a stock is difficult and dependent on many factors. This is why individual stock prices can change in value a lot for seemingly little reason. Banks and investment firms spend billions of dollars each year paying very smart people a lot of money to try value individual stocks. This is time consuming, costly, and ultimately an impossible task. It is generally agreed that even the smartest investors cannot accurately value stocks and achieve index-beating returns over an extended period of time.

For this reason, I have moved my own investments over to Index Funds where I don't have to worry about trying to value individual stocks. Instead I benefit from the collective movement of the stock market as a whole. History has told us one thing with certainty: over time company earnings, collectively, go up and, in the long run, the value of stocks are closely linked to their earnings. I rest at night knowing that over my entire investing career it is very unlikely that I will be able to beat index returns by researching and choosing individual stocks.

Index Funds

For a long time stock market analysis companies have developed measures of the stock market called indices. The most popular index in the world is the S&P 500 Index which tracks the stock market value of approximately 500 of the largest companies on the US stock markets. The S&P 500 Index was designed by Standard & Poors to give a snapshot picture of the overall performance of the US stock market because those 500 large companies make up about 80% of the entire value of all companies on the US stock market. Because the S&P 500 Index is just an index that tracks the value of companies, we can't directly invest in the S&P 500.

Enter Jack Bogle, the founder of one of the world’s largest investment firms, Vanguard. In 1975, Mr. Bogle decided not to spend time evaluating individual stocks in his new funds. Instead, he assembled a fund that simply held the same companies in the same proportions as the S&P 500 Index. So the Vanguard 500 Fund doesn't invest directly in the S&P 500 Index, it just replicates it at a very low cost. This fund, and others like it, were eventually called Index Funds, because their investment criteria was based on market indices instead of stock analysis. As no time is spent trying to value individual companies and decide which ones will be winners or losers, the cost of managing index funds is extremely low. Over time the winners form larger parts of the index fund and the losers slowly drop off.

The first Index Funds were formed as mutual funds. Mutual funds are a large pool of money from many investors which is then used to purchase many different stocks according to criteria specified by the fund manager. The big benefit of mutual funds is diversification -- it is much safer to own 100 companies than it is to own 5 companies. If you have to purchase 100 different companies individually, you would pay an arm and a leg in trading costs relative to the value of your portfolio. By using a mutual fund your portion of the trading costs is minimal.

To buy mutual funds, your broker either had to manage the mutual fund, or have a business relationship with the mutual fund's manager. This made mutual funds a bit of an exclusive item because the trading of fund units was controlled by a small group of people. In Canada, many mutual fund providers charge exhorbitantly high fees because of this control (often 2-3% of assets). This fee comes straight out of your returns and costs you a lot of money over your investing years.

Exchange Traded Funds

Exchange traded funds – ETFs – are built on the same concept as mutual funds. It is a pool of money from investors that is used to purchase stocks according to specified criteria. However, ETFs, unlike mutual funds, are traded on stock exchanges just like stocks. The exclusivity element of mutual funds is gone! This means that anyone with a brokerage account, such as a Questrade account, can buy or sell ETFs for an extremely low cost – generally less than $10 per trade. ETFs have created a very competitive environment, so they are managed at extremely low costs such as pennies per thousand dollars of value (0.1-0.25% of assets). The ease of purchasing ETFs and unbeatable value of ETFs is why I choose to use ETFs exclusively for my investing. ETFs combine the best elements of stocks (liquidity and legal protection) with the best elements of mutual funds (diversification and low management costs).

Click here for a great, in-depth description of ETFs by NASDAQ.

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