What is an ETF?

(For total beginners)

This article is intended for readers unfamiliar with the finance and banking industry. I will be as simple as I can on Exchange-Traded Funds.

My initial portfolio (June 2023) was constituted of 7 Exchange-Traded Funds (ETFs) and 1 stock.

What is an Exchange-traded fund (ETF)? For an initial definition (incomplete), it is a group of securities or commodities (assets) intended to be offered in a single ‘package’. These groups are called the underlying of the ETF.

What is a security (it has nothing to do with safety measures)? A tradable financial asset.

What is a financial asset? It is a contract that gives you a claim on something valuable, something that holds value.

Why is it called tradable? It means that it can be bought and sold on a securities exchange or bourse.

What is a securities exchange or a bourse? The equivalent of a supermarket but for financial assets. Just as you buy cheese and meat at your local supermarket for groceries, you buy listed securities on a bourse. “Listed” means that they are available for trading.

For example, an Apple stock (AAPL is its ticker symbol. The capital letters which identify a financial asset) is a tradable financial asset on a securities exchange called the National Association of Securities Dealers Automated Quotations (NASDAQ).

Securities can be stocks (e.g., Apple stocks APPL) or bonds (a debt that can be traded).

In contrast, commodities are natural or agricultural resources (basic goods) such as oil, grain, lumber, and gold.

So what is an ETF again? It regroups securities or commodities which can be bought and sold on the bourse, usually at accessible prices for small investors or beginners. Thus, an ETF lets you buy a small portion of many different companies all at once. This is having a little bit of ownership in lots of different companies. Diversification!

What are the types of ETFs? Determined by the nature of their underlying securities or commodities.

Please note: Don’t be intimidated by the terminology used in the examples. The financial companies that engineer and sponsor ETFs assign a specific brand (name) for their ETFs.

  • State Street Global Advisors (SSGA) is an investment management firm that has the Standard & Poor’s Depositary Receipts (SPDR, pronounced “Spider”) as their ETF brand.
  • BlackRock, one of the largest asset management companies globally, has iShares as its ETF brand.
  • Direxion, a private company, owns the Direxion ETF brand.
  • ProShare, a subsidiary of ProFunds Group, owns the ProShares ETF brand.

All of them are based in the United States but have offices across the world.

  1. When a group of securities constitutes an index, we get an index-based ETF. It tracks the variation of the index. For example, SPRD (Standard & Poor’s Depositary Receipts) S&P 500 ETF Trust (ticker: SPY) tracks the famous S&P500 index (largest 500 companies by market capitalization on the New York Stock Exchange). The best choice to diversify broadly!
  2. When a group of securities consists of bonds (tradable debt), we get a bond ETF. It provides regular payments to investors. For instance, the iShares 20 Plus Year Treasury Bond ETF (ticker: TLT) tracks long-term US Treasury bonds. Easier to buy for small investors than bond offerings on the secondary market that require a minimum investment amount.
  3. When a group of securities constitute one specific sector or industry, we get a sector ETF or industry ETF. For example, the Technology Select Sector SPDR Fund Technology (ticker: XLK) tracks companies in the sector of software & computer hardware sector. The best choice to diversify across a specific sector.
  4. When a group of securities is issued (created) in the face of commodities (gold, oil, corn), we get a commodity ETF. For instance, there is a gold-based ETF called GLD. GLD issues 100,000 shares for every 10,000 ounces (10,000 x 28.349g) of gold. It tracks the price of gold divided by 10. Precious metal ETFs are among my favorites for value preservation.
  5. A leveraged ETF is designed to multiply the returns or prices of a targeted group of securities, usually by 2× or 3×. For example, Direxion Daily Financial Bull 3x Shares (ticker: FAS) tracks 1000 financial services companies and multiply their performance by 3. Great for short-term investment by taking advantage of waves!
  6. An inverse ETF moves in the opposite direction of the returns or prices of the targeted group of securities. For example, the ProShares Short S&P 500 (ticker: SH) tracks the S&P 500 index but multiplies its performance by -1, providing the inverse result.

What is so great about ETF? The simplest and cheapest way to diversify your investment. Here are a few reasons:

1) They are traded on stock exchanges, just like stocks.

2) often offered at a tenth of the group price.

3) includes a lot of companies in one purchase.

Where to read about a specific ETF? Each ETF has a prospectus that presents all its characteristics in detail. Each ETF has an official page on the website of its sponsor. Moreover, several decent databases exist such as etf.com and etfdb.com that gather ETFs from all sources and ease comparison among characteristics. Use an ETF screener!

Do ETFs pay dividends? Most ETFs do pay dividends. Few ETFs don’t pay dividends at all. Check the prospectus for your chosen ETF.

You can also know the dates when the dividend payment is due, and most importantly by which day you should own the ETF to be eligible for the upcoming dividend payment.

The payment frequency of equity ETFs is usually quarterly (since stocks usually pay on a quarterly basis), however, some ETFs pay dividends on a monthly or on an annual basis.

Usually, ETFs lose a bit of value, after a dividend payment. Some investors wait for the dividends, before selling their positions. Supply is higher than demand, so lower prices.

Nevertheless, the market maker (manager and sponsor) will intervene to adjust the ETF price by selling when demand is high, and buying when supply is high, to preserve the consistency of what the ETF is actually designed to track.

Even ‘bond ETF’ (the underlying are bonds) pay dividends from the interest revenues of the bonds.

What are the costs associated with building an ETF, and who pays them? Like any product or service, ETFs have expenses. These expenses are paid by the clients, in this case, the investor purchasing the ETFs. The expense ratio is calculated below:

indicates the annual commission (fee) paid by the investor as a percentage of the managed assets.

This payment is not shown as a separate item in the statement of accounts since it is automatically accrued from the ETF daily returns. The market value of the ETF already reflects the net value, after deducting the operating expenses.

In other words, ETF commissions (ETF fees) are not directly paid as a monthly electricity bill or apartment rent.

An expense ratio can be as low as 0.2%. For example, an expense ratio of 3% means that for a $100 ETF, the investor pays $3 annually in expenses (accrued daily).

My personal rule is that an expense ratio below 0.75% is good enough. If it exceeds 1.25%, I judge it too expensive. I try my best to exclude all ETFs with an expense ratio above 1.25% since there is in general another similar ETF which charges far less fees!

For ETF tracking indexes (passively managed), the expense ratio can be as low as 0.04%, since its construction and maintenance don’t require much work; while actively-managed ETFs (tracking much more complex underlying) always have higher expense ratios as 0.5% or 0.6%.

Please be aware that some fund managers propose a low expense ratio (close to 0% for example 0.02% or 0.05%) in the 1st year of holding the ETF, but charge higher fees (2%-3%) in later years! Make sure to read the prospectus of the ETF before buying it.

Can an ETF close (stop operating and liquidate) and what happens to its holders? Yes, an ETF can close as any stock or business. The scenarios are as follows:

  1. The ETF value could theoretically reach 0 when all constituting underlying touch 0. The investor loses all his money. However, it is very rare in practice, so the other scenarios are mostly likely.
  2. The fund manager decides to liquidate the ETF due to unsustainable expenses (a very competitive industry). He must announce an upcoming liquidation date. It is the day of closure of the fund when investors will receive the fair value (net asset value) of the underlying.

However, I advise you to sell your positions, before the liquidation date, since you may lose value due to unexpected complications.

  • The last scenario is not exactly a closure, but a delisting.

What is a delisting? When ETF is no more listed (quoted) on the stock market, it is said to be delisted.

Then it is traded over the counter (via dealers). The ETF is not closed as in the previous scenarios, but inactive on stock markets.

For example, instead of buying and selling the ETF on the New York Stock Exchange, you will have to contact a dealer (phone call, or email) to arrange a trade. This is known as the over-the-counter market. It is a significantly less liquid market but it is still possible to sell the delisted, yet held ETFs at a good price.