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Investing 101: What is an ETF?

In our Investing 101 series, we tackle basic financial topics that many people might be afraid to ask about.  No worries, this is a safe place.  First off, ETF stands for Exchange Traded Fund.  The very first ETF was created in Canada back in 1990.  The goal was to create a basket of securities that could be bought and sold on an intraday basis.  The concept arrived in the U.S. in 1993 with the “Standard & Poor’s Depositary Receipts” (SPDRs) which were offered by State Street Global Advisors.  Today there is more than $2 trillion invested in over 1,600 ETFs3.  Like mutual funds (See “What is a Mutual Fund”), ETFs offer investors the opportunity to buy a group of securities.  In many instances, buying a single ETF can be more efficient than going out and buying dozens of individual stocks to achieve the same exposure.  So how are ETFs different than mutual funds?  Below are two sentences that sum up the key difference:

  1. ETFs can be bought and sold on an intraday basis. 
  2. Mutual funds can be bought and sold daily.   

Let’s use an illustration to highlight the exact differences in those statements.  Michael and Suzanne are investors who each own baskets of dividend paying stocks.  They both are looking for long-term growth and appreciate the consistency of dividend income along the way.  Michael owns a mutual fund, while Suzanne owns an ETF.  One morning there is a negative economic report that sends stocks sharply lower.  Both Michael and Suzanne notice the report and become uneasy as to the possible negative implications to their holdings.  Given they both have some relatively short-term liquidity needs, both enter a partial sale order at noon the same day.  Because ETF’s have intraday liquidity, Suzanne is able to sell her ETF at the market price when she enters her order.  In Michael’s case, his mutual fund will not price again until the market closes at 4 pm EST.  Michael will effectively get the closing daily price on the basket of securities that he owns.  If the stock market had been down 2% when both orders were entered, then Suzanne would have exited her position with a 2% loss that day.  If the market continued to head lower during the afternoon and ended up down 5%, then that’s the level at which Michael would have sold his position. 

To many investors, and especially large institutional investors, having intraday liquidity is extremely important.  To most long-term individual investors, the difference between buying and selling at the market’s closing price versus the real-time market price is largely irrelevant. 

All investors choose an asset allocation that they feel meets their risk tolerance and can help them meet their long-term financial objectives.  Today’s investors have plenty of choice in how to go about executing their asset allocation strategy.  Choosing whether to own an individual stock, a mutual fund, or an ETF is all about strategy and risk management.  As in most of life’s tasks, the tools used will be important, however, the strategy and execution will determine success or failure. 

Check out our other Investing 101 topics:

What is a Stock?

What is a Mutual Fund?

What is a Bond?

 

3 Source: Vanguard and Bloomberg as of December 31, 2015