Financial Literacy Friday: Exchange Traded Funds

Welcome back to another edition of Financial Literacy Friday, where today we’ll be looking at what an Exchange Traded Fund (ETF)  is and how it works. ETF’s have become quite popular investments as they offer a good amount of flexibility and liquidity while still working in similar ways to an index fund.  Because of their rise in popularity and the interest that they generate as viable investments, I’m excited to break them down and share their value with all of you.

What Are They?

ETF’s are securities that can track an index like the S&P 500, a commodity, bonds, or a group of assets in much the same way as an index fund.  They are also traded as a common stock on stock exchanges which means that they are far easier and simpler to buy and sell, which gives them increased liquidity (the ability to buy and sell quickly).  Along with this higher level of liquidity, they typically have lower fees that mutual fund shares which makes them attractive investments for many people. The mechanism by which an ETF operates is that the ETF owns the underlying assets whether they are stocks, commodities or whatever else it could be, and then divides the ownership of those assets into common stocks.  It’s almost like a time-share, there’s an underlying asset which is the property and then time slots are sold to numerous people so that more people can reap the benefits of that property. It’s not a perfect analogy, I know, but hopefully it helps get a sense of how these funds operate.

Value of an ETF

We’ve already gone over some of the value of an ETF, namely its high levels of liquidity and its typically lower price, but there are a few more advantages to know.  Because they are bought and sold like a common stock, you have the ability to buy on margin or sell short which could be important for those who do margin trading. They also provide similar levels of diversification as an index fund depending on the type of ETF you’re buying, and as we all know diversification is an important part of your investment experience.  There are also no minimums when purchasing ETF’s because they are traded as common stock, so you can buy as little as 1 share of an ETF. This is different with other funds that can require a minimum deposit in order to buy in. Because ETF’s can be relatively narrow or very broad, I would make sure that you’re aware of what the underlying securities are in the ETF or what index it’s tracking so that you don’t end up with an investment that’s much riskier than you were intending.  

Exchange Traded Funds can be a valuable addition to your investment portfolio, and even if you’re not interested in them you should now have a better sense of some of the options out there.  What are your thoughts on this kind of strategy? If you’re interested in learning more about how ETF’s can be a part of your investments, send me an email and we’ll look at what makes sense for you.