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,
I somewhat alluded to ETFs in my post on investing in commodities.
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:
- Pick the banks that you like best and hope that they outperform the banks you didn’t buy.
- 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?
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:
- 2x leverage
- 3x leverage
- 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.
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!
DC @ Young Adult Money says
Thanks for sharing, Troy. I really like ETFs and I’ve been looking into some Vanguard ETFs to invest in my IRA. Looking forward to learning more about them, and other investment vehicles, in the future.
DC @ Young Adult Money recently posted…How Much Money Would you Need to Live off Dividend Income? [Free Download]
JC @ precious metals ira says
I personally would not buy gold ETFs,but rather buy physical gold and store it at my own risk,concerning some drawbacks to ETFs is that there is a small asset management fee charged by the fund house, so the return is slightly less than the actual increase in the gold price. Moreover, there are additional costs involved at the time of buying and selling in the form of brokerage or commission.
JC @ precious metals ira recently posted…How to Buy Precious Metals ?8 Killer tips you must know
Done by Forty says
Great stuff. Can you explain the advantages/disadvantages of an ETF, compared to an index mutual fund? Is there a huge difference?
Done by Forty recently posted…Girls Just Want to Raise Funds
Mrs. Snarkfinance says
Thanks Troy for the informative article
Mrs. Snarkfinance recently posted…Exceeding My Parents as a Young Professional
Hello, this weekend is nice designed for me,
since this time i am reading this enormous informative article
here at my house.
Trustjackermethod.com recently posted…Trustjackermethod.com
Great post. I think ETFs are a good idea when someone knows the area they want to invest in but aren’t sure which company is going to perform best (e.g. a cutting edge industry with several new companies all looking to launch new products)
This is a really good tip particularly to those new to the blogosphere.
Brief but very precise info… Thank you for sharing this one.
A must read post!
Gonzalo recently posted…Gonzalo