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Introduction to ETFs

Introduction to ETFs

An ETF or an Exchange Traded Fund is an investment fund that trades on a stock exchange.  An ETF is designed to duplicate the performance of an index such as the Dow Jones Industrial Average or the S&P 500.  ETFs also exist that track commodities such as gold, silver, oil or corn.

To get a better understanding of an ETF it’s important to explore what is an index.  An index is a method used to measure the value of a section of the stock market.  Think of this as a tool to describe the performance of a sector or the stock market as a whole.  Listening to a business news channel such as CNBC you will hear phrases such as “The Dow is up 4% today” or “The S&P 500 is down 1%”.

It is impossible to invest in an index directly since they are mathematically constructed by financial information companies such as Dow Jones Index and as such only exist on paper.  One of the most widely used indexes, The Dow Jones Industrial Average tracks the performance of a weighted average allocation of 30 of the largest American companies.  Another large index, the S&P 500 tracks the performance of the 500 largest American companies that trade on major exchanges.  This is where ETFs come in!  An ETF is an investment fund that is composed of the exact same stocks in the exact same proportion as an index.  If an index rises by 1.5%, then the ETF will rise by the same amount because the ETF is a real life trading instrument that is identical to the index.  ETFs trade on stock exchanges such as NYSE and Nasdaq and can be bought and sold just like a regular stock.  ETFs are managed by investment management firms such as BlackRock who manages some of the largest and most popular ETFs.

The largest and most known ETF is the S&P500 index which trades under the ticker “SPY” and is operated by the second largest investment management firm in the world, State Street Global Advisors.  The stated objective of the ETF is to be “a fund that, before expenses, generally corresponds to the price and yield performance of the S&P 500® Index”.  An investor would want to invest in ETF such as SPY if they believe that the US companies that compose the index will experience growth.  Investing in the ETF directly gives the investor access to a diversified portfolio as buying SPY represents holdings in all 500 companies.  ETFs are similar and often compared to mutual funds in that respect with the key difference being that ETFs trade on stock exchanges while mutual funds do not.

Looking at the chart below we see that the ETF has fulfilled it’s objective of providing a return approximately equal to that of the index. SSGA charges a small annual fee for investors that hold the ETF of around 0.2% of the asset value.

Source: https://www.spdrs.com/product/fund.seam?ticker=spy

 Some of the other widely known and used indexes and their corresponding ETFs are:

Index Name Description ETF Ticker
Dow Jones Industrial Average Composed of the 30 largest American companies each representing a unique sector. NYSE: DIA
Nasdaq 100 100 of the largest tech companies that trade on the Nasdaq exchange. NASDAQ: QQQ
Financial Sector Index 82 of the largest companies that deal in the ‘financial sector’. NYSE: XLF
Gold Price of gold. NYSE: GLD
Silver Price of silver NYSE: SLV
MSCI Emerging Markets Index 71 companies that are located in ‘emerging markets’ such as China or India. NYSE:VWO
MSCI US Broad Market Index Composed of 99.5% of all companies trading on US exchanges. NYSE: VTI
Russell 3000 Index Composed of 3,000 of the largest US companies. NYSE: IWV
Volatility Index Measure of the implied volatility of S&P 500 index options NYSE: VXX

 

Conclusion

ETFs provide investors with the ability to easily hold a diversified portfolio of companies.  Investors can also gain international exposure through the use of ETFs as many foreign indexes have corresponding ETFs that trade on American exchanges.  For example the MSCI Brazil Index Fund trades on NYSE under the ticker EWZ.  The MSCI Tawain index fund trades on the NYSE under the ticker EWT.  Exposure to international ETFs can be specific to an industry such as the India Infrastructure ETF that tracks 30 Indian based companies that compose the Indxx India Infrastructure Index.  The ETF trades on NYSE under the ticker INXX.

 

ETFs are far more complex and the table above includes some of the most common ETFs that are straightforward and easy to understand.  In recent years ETFs have grown complex in nature for example there exists ETFs that are designed to yield returns that are triple (300%) the inverse of an index.  These types of ETFs are not intended for novice investors as they are considered to be risky.  By following the ETFs in the table above an investor can find suitable investment choices that are used already by millions of investors in regular brokerage accounts, retirement accounts and pension plans.

 

About the author: Jayson Derrick is the director of trading at PromptTrader, an international proprietary trading firm that trades in US equities and options. 

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