What is an ETF and How Does it Work?

by Miranda Marquit on October 11, 2012

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One of the fastest growing investing products is the exchange-traded fund, or ETF. ETFs haven’t been around for very long, but they are quickly gaining in popularity, due to how easy it is to trade them, and the relatively low costs that come with them. Undoubtedly, most investors have heard of ETFs, yet many are still wondering exactly what an ETF is and how it works.

What is an ETF and How is an ETF Created?

At the most basic level, an ETF is a collection of assets. The entire collection is treated as a single unit. Here is a simple breakdown of the ETF creation process:

  • A large institution takes some of its holdings (it can be any asset — stocks, bonds, commodities, currencies, etc.) and assembles a basket of investments.
  • This basket of assets is deposited with a holder.
  • The holder then breaks the basket up into “creation units.” This process is used so that large institutional investors can buy into a fund without needing cash.
  • Institutional investors buy these creation units — which often have as many as 50,000 block shares.
  • Institutional investor can then break down the larger creation units into ETF shares. Each ETF share holds little portions of each of the investments in the unit.

These individual ETF shares, no matter what assets they are based on, are traded as individual stocks on an exchange. One of the things that makes an ETF so attractive is that it makes it fairly easy for regular investors to gain exposure to a wide variety of assets (including some that are considered more complex, like commodities) that they might not ordinarily want to purchase.

Trading ETFs

Because ETFs are traded like stocks, on an exchange, they come with the same transaction fees that stocks have. So, if your broker charges $4.99 a trade, that is what you will be charged each time you buy or sell an ETF share.

However, it’s also important to understand that ETFs are also funds. This means that you have to pay annual expenses that come with funds. The good news is that most ETFs are very inexpensive. While an actively managed mutual fund might charge as much as 2% or more, and an index fund might charge between 0.40% and 0.75%, it is fairly easy to find ETFs that charge 0.35% and less.

If you are looking to trade ETFs, it’s easy to do so. They are available with most online discount brokers, as well as with other brokers. Many of the major index fund players, including Fidelity and Vanguard, also offer a variety of ETFs. And, because ETFs trade like stocks, you can buy and sell in real time if you want.

ETFs can be in tax-advantaged accounts in the United States and in Canada. You can hold them in your IRA, 401(k), 403(b), RESP, RRSP, and TFSA.

Creating a Diverse Portfolio with ETFs

Some investors are using ETFs to create entire portfolios. Because almost any asset can be included in an ETF, it’s possible to create a diverse portfolio using nothing but ETFs. There are ETFs based on most of the world’s major stock indices, as well as those that contain groups of investments from various sectors, industries, and geographies.

There are ETFs based on bonds and bond funds, as well as those based on currencies and commodities (watch out for contango in these cases). You can create a classic stock/bond allocation with nothing but the appropriate ETFs, as well as add a little more risk — and growth potential — to your portfolio with the help of more exotic ETFs. There are even cash-based ETFs if you are looking for a little more safety.

Even dividend investors can get in on the act with ETFs. There are dividend ETFs that will pay out regularly, based on the holdings included in the ETF. It’s one way to build up your income portfolio without a lot of fuss.

Bottom Line

Like any investment, there are risks involved when you invest in ETFs. Many people see them as less risky than some other investments, but you can still lose money. Before you invest in an ETF, it is a good idea to at least have an idea of how the underlying investments function — especially if you are interested in ETFs based on commodity and currency futures.

As you would with any investment, carefully screen your ETFs. Do your research, and understand how potential ETFs actually fit into your investment goals.

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This post was written by...

– who has written 12 posts on Excess Return.

Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.

{ 1 comment… read it below or add one }

Kevin Williams October 14, 2012 at 3:51 pm

So it sounds like a portfolio can contain multiple ETFs? Is it recommended to create these ETFs by focusing on various categories or industries? For instance, having an ETF made up of only retail stocks while having another made up of property-type stocks. Or should any ETF be a collection of varying stocks to avoid overt risks?

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