What is an ETF?
Unfortunately ETF doesn’t stand for Extra-Terrestrial Friends, though hopefully in a few minutes this term, and its function in your investment-savvy future, will feel a little less alien.
Much of what you need to know about these marketable securities is right there in the name, Exchange-Traded Funds.
An exchange-traded fund is a basket of investments bundled into a fund that is traded on an exchange.
What does this mean?
Marketable security = financial instrument that can be turned into cash quickly — this is also called liquidity.
Let’s use an analogy to break this down.
Do you remember those Now That’s What I Call Music! albums from the late 90s and early 2000s? In the United States, the first Now That’s What I Call Music! was released in 1998, and they are still churning them out in 2017! (Now That’s What I Call Music! 61, anyone?)
In case you are somehow unaware of this compilation album phenomenon, these albums bring together some of the most popular music from a given moment and put them on one handy CD. The very first Now That’s What I Call Music! released in the U.S. included such late-1998 hits as “MMMBop” by Hanson, “Zoot Suit Riot” by Cherry Poppin’ Daddies, “Say You’ll Be There” by the Spice Girls, and “Fly Away” by Lenny Kravitz. #nostalgia
Exchange Traded Funds and Compilation Albums…Wait, What?
Now hold onto your hats… ETFs are kind of like Now That’s What I Call Music! albums. And the comparison goes beyond them both having their origins in the late 20th century.
In this analogy the Now That’s What I Call Music! album is the ETF, the genre of music it contains (pop) is like an index, and the individual songs are the underlying assets!
A compilation album is not the entire pop music industry, but it seeks to represent it on a small scale. It buys the rights to some of the songs that it needs to represent the industry or genre. Similar to how an ETF buys up stocks, bonds, or other assets and bundles them together to have them track a particular index, for instance, the S&P 500.
ETFs and Indices
The S&P 500 is like the popular music of indices. It’s a list of 500 of the largest companies in the United States.
And just as Janet Jackson might be represented on several Now That’s What I Call Music! Albums (and she is), one company can be represented on multiple indices and in the variety of ETFs that track them. For instance, Microsoft is a top holding in Blue Chips, Do the Right Thing, and American Innovators.
So instead of running out and buying stocks, bonds, and other assets from each of your favorite companies and industries, you can buy an ETF which has exposure to each of the companies and/or industries that you’re interested in. You don’t have to buy all of Janet Jackson’s albums to hear some of her hits and benefit from their groove.
ETFs and the Stock Market
And now we come to the traded and exchange part of Exchange-Traded Funds. ETFs are traded publicly on an exchange (e.g., NYSE or NASDAQ). And they can be traded multiple times a day, which sets them apart from mutual funds.
They are also passively managed, which means that they track an index. This often makes them attractive from a tax and fee perspective.
So Who Makes an ETF?
Technically, anyone can create (or launch) an ETF, provided you have the buying power and jump through all the regulatory hoops — and there are a lot of them, this is finance we are talking about. So, practically speaking, not anyone.
Launching an ETF requires buying the underlying assets that compose a particular index. And the reputation of the maker (technically called a ‘fund sponsor’) comes into play. This is similar to how you probably consider who is making a compilation album, and whether they have a track record of efficiently compiling the kind of music you’re looking for.
ETF shares are created and redeemed. This process is actually called Creation and Redemption (yes, that’s the real name).
It’s also important to note that ETFs aren’t sold directly by fund companies to investors, so you need a broker.
Good thing you have Stash! As a registered investment advisor, we connect you with a broker. One less step for you!
Footnotes*The S&P 500® ("Index") is an index of 500 stocks seen as a leading indicator of U.S. equities and a reflection of the performance of the large cap universe, made up of companies selected by economists. The S&P 500 (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. **This process is regulated by FINRA and the SEC (Securities and Exchange Commission).
Before investing in any exchange-traded fund, consider your investment objectives, risks, charges, and expenses.