M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.
What is an ETF?
Drew has one of those problems that everyone wants to have. He just inherited a sum of money from his late uncle, and he doesn't know what to do with it!
Just putting it in the bank wouldn't earn much interest, and he is young enough to take a chance on the stock market. He knows about mutual funds because his father invested in those, but someone at work told him ETFs are better. So just what is an ETF?
First let's review what a stock index is. An index is a collection of stocks representing a common theme. The Dow Jones Industrial Average is an index most people have heard of. An exchange traded fund (ETF) is a marketable security that tracks the price movements of an index, commodity or other basket of assets. An ETF is able to replicate the price movements of an index because it owns shares of the stocks that make up that index.
There are literally thousands of exchange traded funds out there that track the price movements of many financial indexes and asset classes. So when the price of the underlying index or assets goes up 5%, the ETF that tracks it also goes up 5%.
Not all ETFs track stock indexes. Some also track agricultural commodity prices, or spot prices for assets like gold and precious metals or oil.
Why Investors buy Them
Many exchange traded funds replicate the price movements of major financial indexes. The biggest ETFs track the major stock market indexes, like the Dow Jones Industrial Average and the Standard and Poor's 500.
Investors seeking to replicate general market returns can accomplish their objective with an ETF. Indexes also track many different sectors of the economy like technology or transportation, and there are ETFs that track their price movements.
Drew is getting excited by what he is finding out. He loves technology and would like to invest some of that money in technology companies. Instead of buying shares of ten or so technology stocks and paying the commissions, all he needs to do is buy shares in one ETF that tracks a technology stock index and he can share in the gains when the stocks go up!
Advantages of ETFs over Mutual Funds
Drew is also finding out why ETFs are better than mutual funds.
- ETFs trade like common stocks; they are listed on the major exchanges. Investors have the power to sell short and buy on margin that aren't available in mutual fund investments.
- Prices of an ETF change instantly just like a stock price. This is an advantage over mutual funds whose prices only change at the end of each trading day when the net asset value is calculated.
- You can own an ETF by buying as little as one share. Mutual Funds usually have a minimum investment amount, typically $3,000.
- ETFs have lower expense ratios than mutual funds, so the commission and fees for ETFs are much lower.
ETFs and Trading Opportunities
ETFs can create arbitrage opportunities for professional traders. Arbitrage is the practice of buying an asset cheaply in one market and selling the same asset for a higher price in another.
Jenny works at the trading desk at a major bank. She has several computer terminals on her desk. One of the things she follows on them is the prices of the 30 stocks that make up the Dow Jones Industrials and the ETF that tracks them.
When she notices the prices of the Dow Jones stocks have jumped up and the price of the ETF hasn't changed to reflect that, she has a momentary opportunity until it does! She can buy the ETF for a lower price than she can sell the stocks that went up. When she does that she makes the difference in profit for the bank.
Jenny also trades in derivative products like inverse ETFs that have the opposite price changes as the ETF they are based on. When the price of the ETF goes down 5%, the price of the inverse ETF goes up 5%. This allows traders like Jenny to profit when the price of stocks is falling.
There are also leveraged ETF's for traders not afraid of risk. A 2X leveraged ETF, for example, will return two times the changes of the underlying index price.
An exchange traded fund (ETF) is a marketable security that tracks the price movements of an index, commodity or other basket of assets. Many ETF's track indexes, which are collections of stocks that have a common theme. The ETF does this tracking by owning shares of the stocks the index is tracking.
Exchange traded funds have advantages over mutual funds to the investor. They are traded like stocks on exchanges, and shares can be purchased at up to the minute prices. ETFs can also be shorted or purchased on margin. ETFs have no minimum investment requirement aside form the price of one share.
Arbitrage is the practice of buying an asset cheaply in one market and selling the same asset for a higher price in another. ETF's create arbitrage opportunities for traders, since the ETF and the underlying assets making up the index are traded separately and may have different prices.
There are also inverse ETF's that have the opposite price changes as the ETF they are based on. Leveraged ETF's return two times the changes of the underlying index price.
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