What are ETF’s

Good morning! Today Troy continues with the investing for beginners series. You can check the previous posts:

What are stocks and how to value them,

How does Currency Trading Work, 

How are Currencies Traded, 

Investing in Commodities, 

What Fundamentals Affect Commodity Prices

I somewhat alluded to ETFs in my post on investing in commodities.

Basic Definition

An ETF is known as an “exchange traded fund”. It’s somewhat similar to a mutual fund, minus all the DSC (deferred service charge) and the fact that you need a fund manager to run a mutual fund (when in reality, most mutual funds can be run by ham sandwiches).

Let’s just skip all the boring stuff from Wikipedia. What an ETF essentially does is that it allows investors like you and me to buy/sell in markets that we could not previously. If you’ve read my post on commodities, you’d know that 20 years ago, average investors could not directly invest in gold, silver, oil, copper, etc. An ETF goes around these restrictions by artificially replicating a market. Take gold for example (which I mentioned in the previous post). A gold ETF such as GLD will buy physical gold (the ETF has enough space to actually store millions of ounces of gold). Thus, when you buy GLD, you are technically buying the gold – all that GLD does is provide you access to buying gold.

Thanks to Wall Street and all their financial “innovation”, many new markets are now accessible. Let’s assume that you’re bullish on the banking sector. 20 years ago when ETF’s did not exist, you had one of two choices:

1. Pick the banks that you like best and hope that they outperform the banks you didn’t buy.
2. If you don’t know which banks will perform the best (but you are bullish on the banking industry in general), you can buy every single bank stock.

Now obviously, buying every single bank stock is a huge hassle. What a bank ETF like XLF will do is create an investment vehicle that will synthetically “represent” the entire banking industry. It’s beautiful. 😀 ETF’s simplify things.

In another example, let’s assume that you’re bullish on the entire U.S. stock market, aka the S&P500. 20 years ago, you would have had to buy all 500 stocks. Considering how the S&P500 is weighted (not all companies are weighted equally in the S&P500), the effort of balancing all these shares in your portfolio is too time consuming. But nowadays, ETF’s such as SPY (the largest ETF out there for stocks) is dedicated to tracking the S&P500. Thus, when you buy SPY, you are artificially buying the S&P500. Cool, isn’t it?

Leveraged ETF’s

Over the past 10 years, leveraged ETF’s (a special branch of ETF’s) have gained in popularity. For guys like me, the S&P makes me want to cry. Over the past 6 months, the S&P500 has gained a grand total of 5%. That’s chicken scratch! What a leveraged ETF does is it multiplies the gains and losses of the underlying security. There are 3 types of leveraged ETF’s:

1. 2x leverage
2. 3x leverage
3. 4x leverage

Here’s an example of what a leveraged ETF will do. Let’s say you the S&P500 increased by 2% in one day. SPDR (the 2x leveraged S&P500 ETF) will increase by 4% (2×2=4). On Day 2, let’s say that the S&P500 fell by 3%. SPDR will fall by 6%.

Unfortunately, leveraged ETF’s having matching problems. They generally don’t track the underlying security as well as non-leveraged ETF’s do. Here’s an example.

Let’s say that the S&P500 fell by 40%. A 3x leveraged ETF will not fall by 120% (40×3=120) – an ETF cannot have negative value! This phenomenon is because of the way ETF’s are calculated (Gr. 12 math).

The implications of a leveraged ETF is obvious – it increases volatility. Now I generally don’t touch 4x ETF’s (and rarely do I touch 3x). The volatility is just too much for me to take.

Conclusion

An ETF is just an investment vehicle. Nothing more. It’s not like investing in a hedge fund where a hedge fund manager actively buys and sells markets. An ETF only seeks to match the underlying market as closely as possible.

Once again, I hope you learned something from reading this post about ETF’s!

 

Author bio: Hey, I’m Troy! I started a blog about blogging (yea – sounds sorta like one of those “I make money online by teaching you how to make money online” scams). But no, that’s not what this is about. I’m trying out a new blogging platform called Ghost. So if you’re interested in a minimalist way to blog (clearing out all the clutter that WordPress has), just check out my site!

 

This post was featured on the Carnival of Financial Camarederie, Carnival of Financial Planning B, thank you!