What is an ETF? Explained Plain and Simple

23 May, 2020 5 min read
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ADMIN EDIT: In this article, I mention a few stocks and ETFs. I do not own any of the stocks or ETFs mentioned in this article and have no intentions on buying any within the next 72 hours. This article contains affiliate links at absolutely no additional cost to you. If you choose to open a Questrade Account to start investing, please consider doing so through this site: to learn more, click here.

One of the most common questions I get asked is, “Which stock should I buy?”

Of course, this is not an easy question to answer. The response depends heavily on a multitude of factors, including how the person copes with risk, how much risk they can tolerate, their time horizon, their overall goals and objectives, so on and so forth.

For those who are new to the investing game, I’d recommend they do their own research on ETFs. I’ll explain what an ETF is in a way that was explained to me in my first lecture on finance.

Let say you’re interested in buying a stock. Your choices are BANANAS, ORANGES, KIWIS, and BERRIES. Now, there are a lot of different valuation models that can be used in an attempt to find the strongest choice, but risks are still present. For example, if you choose to buy BANANAS and BERRIES, you might miss out on a record year of returns for KIWIS. Similarly, if you buy KIWIS during a bad year, you could face losses while ORANGES and BERRIES skyrocket.

What’s an investor to do?

Instead of having to choose between a couple of the above choices, why not just create a basket that has a little bit of each one in it? That way, it doesn’t matter if some prices go up and others go down; as long as FRUIT increases in value as a whole, profit is earned.

This may be a bit of a silly analogy, but it’s one that helped me really understand ETFs when I was learning about them in Finance 101. An Exchange-Traded Fund (ETFs) is a basket of securities that can contain a mixture of stocks, bonds, commodities, or any other type of financial asset. They usually are designed by financial professionals to achieve a goal or objective. For example, some ETFs are created to mimic the S&P500, with others are created to mimic the opposite of the S&P500 (imagine you think the market is going to tank in a few months; buying ETFs of the latter type would result in a profit from a declining market).

An Exchange-Traded Fund (ETFs) a basket of securities that can contain a mixture of stocks, bonds, commodities or any other type of financial asset.

Using our example above with the various types of FRUIT, the holdings of an ETF may look like this:

  • BANANAS (45%)
  • ORANGES (25%)
  • KIWIS (20%)
  • BERRIES (10%)

Moving away from our example, let’s look at a popular ETF that is meant to copy movement in the S&P index. SPY is one of the most well-known and heavily traded ETFs available on the market. Its holdings include:

  • MSFT – Microsoft (5.68%)
  • AAPL – Apple Inc. (5.41%)
  • AMZN – Amazon (4.12%)
  • FB – Facebook (2.29%)
  • GOOGL – Alphabet Inc. (Google) (1.72%)
  • JNJ – Johnson & Johnson (1.54%)
  • V – Visa Inc (1.33%)
  • and so on…

The reason they’re called Exchange-Traded Funds is because they trade on the stock market just like any other stock. Even today, if you wanted to go onto your online broker and purchase an ETF, you could do so just as easily as if you were to purchase stock from a company. Also, many ETFs make payments to you in the form of dividends; investors seeking to increase income may find this option attractive.

Advantages

This little basket offers a lot of advantages, the most obvious being diversification. With an ETF you get a taste of a bunch of little pieces of many companies in many different industries, and since the S&P500 has recovered from every economic downturn and returned to new record highs, many investors believe an index matched ETF is a great option to add to the portfolio.

When you purchase an ETF, you are purchasing a basket of securities that someone else has already pieced together using all their experience, education, and knowledge.

Another advantage is peace of mind. The best investors and financial professionals in the world spend hours trying to find the optimal portfolio for themselves or for their clients. This includes taking into account the risk-return relationship given their tolerance for risk. It’s a lot of work. But when you purchase an ETF, you are purchasing a basket of securities that someone else has already pieced together using all their experience, education, and knowledge. Not only that, but changes to the holdings are constantly happening in the fund. A company that is in SPY today may not be there tomorrow due to poor performance or any other multitude of factors.

Finally, buying an ETF reduces the average costs of investing. If you were to purchase every stock in the SPY holdings, you would be spending a lot on brokerage commissions. On the other hand, purchasing an ETF requires only one transaction, and some brokers even let you purchase an ETF for free and only charge a commission when you decide to sell (see the banner below).

Disadvantages

Of course, there is a trade off. Since ETFs are created by professionals, they expect something in return. An expense ratio is charged to the investor when they purchase an ETF. SPY uses an expense ratio is 0.09% because it is passively managed – meaning that it makes an attempt to match the S&P500. But many actively managed ETFs can charge much more since the portfolio managers are more involved – and those expense ratios can cut into your returns.

It is important that investors research how the fund is managed, whether it’s actively or passively managed, the estimated returns, and the expense ratio before making a decision.

Final Thoughts

ETFs can be a great tool to help accomplish an investors financial goals. If your goal is to increase the amount of payments coming to you every month or quarter, look into dividend ETFs. If you’re interested in a particular industry like technology, do some research into ETFs that incorporate technology companies in its holdings. They also allow new or young investors to get into the market without large amounts of capital, and can follow trends such as only holding environmentally friendly companies.

As always, there is no substitute for expert advice that is tailored to your situation. Ask questions, do your research, and seek the advice of professionals within your area.

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