What is an ETF?
ETF stands for “exchange-traded fund”. It’s an investment vehicle that contains a variety of assets, such as bonds, stocks, and real estate. The value of an ETF fluctuates throughout the day as investors buy and sell. This makes ETFs different from mutual funds, which only change prices when the market closes.
Because ETFs hedge against risk by investing in multiple assets and let people trade throughout the day, many experts see them as a balance between trading individual stocks and buying mutual funds.
ETFs contain a variety of assets owned by the fund provider. The assets in the ETF can include a broad range of options, including stocks, precious metals, bonds, and currencies. The fund provider uses money from investors to purchase underlying assets. In return, individual investors and institutional investors receive payments based on the ETF’s performance.
The value of an ETF doesn’t always correspond to the precise value of the underlying assets within the fund. Instead, the ETF’s value can increase and decrease according to market interest. In that way, its value works much like shares of a company. When a lot of investors buy shares of, say, SPDR S&P 500 ETF Trust (SPY), the price goes up to reflect the growing interest. When investors start selling their shares, the ETF’s price drops.
What affects an ETF’s value?
What makes the value of an ETF go up or down? Practically anything can influence the price of an ETF’s shares. If the ETF has a sizable investment in a company that has a disappointing quarter, the price might decrease. If an ETF hires a new manager who has a long history of success, more investors can feel encouraged to buy. That drives the value up.
Keep in mind that ETFs usually contain dozens, if not hundreds, of assets. Because of that, an ETF probably will not lose too much of its value just because one company’s stock falls. It can happen, though—imagine that a fund manager sees extraordinary potential in Ford stock. In response, they dedicate 20% of the ETF’s funds to buying Ford shares, which is fine until Ford releases a product that fails. Suddenly, Ford shares fall and drag the ETF’s value down with them.
When comparing ETFs, it often makes sense to look for plenty of diversity within the fund. More diversity adds balance and reduces risk. As long as the overall economy performs well, an ETF with diversified assets should maintain most of its value even during trying times. Remember, though, that investing never comes with a guarantee.
What are the biggest ETFs?
Even experienced investors can find it challenging to decide which ETFs to choose. There are so many options that you might feel overwhelmed while exploring your opportunities.
It can help to focus on certain types of ETFs. For example, some ETFs invest heavily in the technology sector. Other ETFs put their money in real estate. If you feel particularly attracted to a certain sector of the economy, you might want to put your money in an ETF that shares your interest.
You might also want to focus on buying into some of the biggest ETFs. While not always the case, large ETFs tend to perform well because they have experienced managers and plenty of capital.
Some of the biggest ETFs include:
- Vanguard Total Stock Market ETF (VTI)
- Invesco QQQ (QQQ)
- iShares Core S&P 500 (IVV)
- Vanguard FTSE Emerging Markets ETF (VMO)
ETF case study
ETFs can seem a bit mystifying when you’re just getting started as an investor. The following fictional case study might help you grasp how ETFs work.
Big Fruit ETF specializes in buying assets in the fruit industry. Currently, it has a portfolio that includes oranges, apples, bananas, and strawberries. This year, all of these fruits had terrific seasons. There was plenty of fruit to sell, and everyone wanted to buy. Investors got interested in the Big Fruit ETF, so they bought into it. As more of them invested, the price went up, and everyone profited!
The following year didn’t go as well for the fruit industry. A virus killed most bananas; a drought limited the supply of oranges; pests ate nearly all of the apples; and strawberries died in a sudden frost. These unexpected events scared investors, so they started to dump their shares. The price fell rapidly, and a lot of people lost money.
The next year, however, showed the benefit of choosing Big Fruit ETF instead of putting all of your money into one type of fruit. Oranges and apples didn’t do well that year. A large harvest and a new diet fad, however, made bananas and strawberries very profitable.
Big Fruit ETF’s investors were protected from significant financial loss because bananas and strawberries performed so well. They felt much better than the investors who chose to only invest in oranges. Those people lost a lot of money overnight!
Big Fruit ETF’s investors didn’t end up making as much money as the people who gambled everything on bananas, though. The oranges and apples lowered the ETFs value.
At the end of the three years, most people who held their investments were happy to have made some money without putting their wealth into a high-risk asset.
The bottom line
Exchange-traded funds contain numerous assets to lower risk while rewarding investors. Many people say that ETFs combine features of mutual funds, which contain multiple assets but only trade at the end of the day, and stocks, which trade throughout the day but only represent a single asset. If you know that you want the safety of diverse assets without losing the control to buy and sell when you want, ETFs might meet your expectations.