An Exchange Traded Fund or ETF is an investment fund that trades like a stock. ETFs, like other types of funds, pull together money from investors into a basket of different investments, including stocks, bonds, and other securities.
By spreading the fund’s money into different securities, ETFs can generally provide investors with diversification, which can help balance risk. And because ETF shares are traded on a stock exchange, they’re bought and sold like stocks and usually incur commissions and other related fees.
Just like there are a variety of mutual funds, there is a variety of different ETFs, each with different objectives. Some ETFs invest in a variety of stocks and bonds.
Some replicate the performance of a stock index, like the JSE Top 40 Index, or America’s S&P 500 and others track the performance for a particular market sector, like technology or pharmaceuticals.
However, different ETFs offer different amounts of diversification. For example, ETFs that focus more on specific sectors typically offer less diversification than those that are designed to replicate an index.
Let’s look at an example of investing in an ETF. Suppose an investor wants to make a diversified investment that is designed to mirror the performance of a major stock index like the S&P 500.
After researching different ETFs and finding the one he wants basing on his objective, he purchases shares of it through his broker, just like he would an individual stock. Now that he owns shares, the investor has a stake in each of the fund’s basket of investments, while only having to purchase one ETF.
Participating in the wide market with only a single purchase instead of multiple purchases can save an investor research and analysis time.
So how can an investor potentially achieve a positive return from the ETF? Similar to a stock, he can earn a return two ways– a rising ETF market price and dividends. Typically, if the value of the ETF’s investments increases, so does its price.
If our investor purchased a hypothetical ETF at R40.00 and a year later it was selling for R50.00, our investor could profit R10.00 per share by selling his position. Of course, if the ETF’s price dropped, our investor would have lost money if the position was sold at the lower price.
Because many ETFs are traded on a stock exchange, they can be bought and sold throughout the day. However, not all ETFs are widely traded, which can cause difficulty when trying to fill orders.
Now, compare this to a mutual fund. Most mutual funds are only priced and traded at the end of the day. Separate from changes in price, our investor could potentially gain income if the ETF pays its investors a dividend, which is a payout of part of the fund’s earnings and capital gains.
Not all ETFs pay dividends. Many instead reinvest earnings into the fund’s holdings. One of the ways to tell whether a fund pays dividends is to look at what’s called its dividend yield.
This yield is the amount that the fund pays out compared to the current market price of a share. ETFs have other attractive qualities. While most mutual funds require a minimum investment, which can be substantial, an ETF investor can just buy a single share plus any commissions and fees.
Also because most ETFs aren’t actively managed, they typically have lower management fees than mutual funds. There is a wide variety of ETFs that attempt to track assets, like corporate bonds, stocks in remote countries, commodities, and even currencies among many other investments.
While these assets carry unique risks, the ETFs that track them offer investors a practical way to analyze and potentially find opportunities in a number of markets.