What’s an ETF — The Ultimate Guide
Written by: Andrew Goldman
What is an ETF?
An ETF is a collection of stocks or bonds that may be purchased for one price. Unlike mutual funds, ETFs may be bought and sold during the entire trading day just like a stocks on an exchange. Many popular ETFs track well-known stock indexes like the S&P 500.
You could say that the ETF is a relative of the mutual fund, which is another way to purchase many stocks at one time. But there are a few major differences between ETFs and mutual funds. Whereas mutual funds tend to have human mutual fund managers who actively trade stocks in and out of the fund based on which ones they predict will go up or down, the vast majority of ETFs are unmanaged by humans.
Instead, many ETFs are programmed with an algorithm that simply track an entire economic sector or index, like the S&P 500 or the US bond market. For this reason, mutual funds are generally referred to as being “actively managed” and ETFs “passively managed,” though there are many exceptions to this rule. Unlike mutual funds, which are priced just once a day, ETFs can be bought and sold during the entire trading day just like individual stocks. This explains why they’re called “exchange traded” funds.
Stock Market Tracking ETFs
ETFs that mirror indices like the stock or bond market have attracted by far the most investment from individual investors. Also known as index ETFs or bond ETFs, since they track a particular market index, they’re a particularly popular way for investors to own a small stake of the American economy is to invest in ETFs that seek to mirror the S&P 500, an index of the 500 publicly-traded American companies with the highest market capitalizations. Since the S&P 500 or other large indexes like the Dow Jones Industrial Average or the NASDAQ-100 naturally favors the largest companies, those who seek to diversify their equity with smaller companies may consider ETFs that track, say, the S&P 400, or the Russell 2000, which track, respectively, midcap and small-cap publicly traded companies.
International ETFs
Those who want exposure to international stocks, may choose to invest in one of several types of international ETFs.
ETFs that focus on all economies outside the US.
An ETF like Vanguard’s Total International Stock ETF (VXUS) seeks to “track the performance…of stocks issued by companies located in developed and emerging markets, excluding the United States.” So one price will buy you exposure to most all economies outside of the US. You can also invest in ETFs that track the stock markets of specific countries, like the Toronto Stock Exchange (TSX) or the Tokyo Stock Exchange (TYO).
ETFs that focus on developed markets
Developed markets are the markets of countries that have well established economies, generally an established rule of law and are technologically advanced relative to other countries in the world. A few examples of developed countries are Australia, Japan, and Germany. A developed market ETF would provide broad exposure to all developed markets. BlackRock’s iShares MSCI EAFE ETF (EFA) is a prominent example.
ETFs that focus on emerging markets
The term “emerging markets” was coined in 1981 by economist Antoine van Agtmael when he was working for The World Bank’s International Finance Corporation (IFC) as an alternative to the negative connotations suggested by the term “third world.” Emerging economies like those of Brazil, China, Russia and Turkey are countries with relatively low per capita average salaries that are less politically stable than developed markets but open to international investment. Though investing in emerging markets tends to be riskier than developed ones, the risk is somewhat mitigated when an ETF invests in many, many emerging markets. Vanguard’s FTSE Emerging Markets ETF (VWO), the largest of the type by assets under management (AUM), seeks to “closely track the return of the FTSE Emerging Markets All Cap China A Inclusion Index.”
ETFs that focus on the economy of one country outside the US.
Got a — inexcusably cheesy pun alert — yen to invest in the Japanese economy? BlackRock iShares MSCI Japan ETF (EWJ) promises investors the ability to “access the Japanese stock market in a single trade.” There are multiple ways to invest in any economy. And if you ever read up on how difficult it is to buy some foreign stocks, like South Korea’s Samsung, you might decide it’s preferable, and a lot easier to buy, for example a South Korea ETFs, like iShares MSCI South Korea ETF (EWY), which will not only get you a stake in the Galaxy maker, but also a bit of Hyundai motors for diversification’s sake.
ETFs Versus Mutual Funds
Mutual funds are assembled bundles of stocks actively traded by fund managers and priced and traded just once a day. ETFs tend to be passively managed and trade throughout the day on indexes alongside stocks. In most cases, ETFs’ management expense ratios are lower than those of mutual funds.
