WTF is an ETF?

I know I’m often guilty of simplifying the investment process for you. Something that I’ve spent over 10 years studying is second nature to me, but it’s likely still foreign to you. I’ve mentioned before that the use of ETFs can be the easiest way to invest. Knowing what an ETF is is one of the basics of investing. But I’ve never explained just what an ETF is. So, WTF is an ETF? Let’s discuss.

“ETF” stands for “Exchange Trade Fund”. The “exchange traded” part refers to the fact that an ETF can be bought or sold at any time while the stock market is open. This is one of the biggest distinctions between ETFs and Mutual Funds (which you are likely familiar with if you invest in a 401(k) or 403(b)). Mutual funds technically only trade once per day – right after the New York Stock Exchange closes at 3:00p CST. This isn’t necessarily a bad thing; it’s just how they work. ETFs, on the other hand can trade all throughout the day. You could buy an ETF at the open and sell it before the close on the same day, if you wanted to. It’s a dumb idea, but you can do it.

The “fund” part of ETF means that they are baskets of stocks, bonds, and/or other assets grouped together into one thing. The great thing about funds is that they give investors the opportunity to own pieces of many things, instead of being tied to one company or asset at a relatively cheap cost. For example, say an individual investor wanted to buy one share of every company in the S&P 500 index. To buy even 1 share of all 500 companies would cost hundreds of thousands of dollars. OR! Our investor could buy shares of an ETF that tracks the price movements of the S&P 500 index at a much more reasonable price. ETFs allow for diversification, which is the name of the investing game.

ETFs can come in all types of flavors. They can focus on stocks, they can focus on bonds, they can focus on commodities. They can even focus on futures contracts or cryptocurrencies or any combination of the above (do NOT get me started). Some hold thousands of names. Some hold just a handful. It’s up to the investor — or their advisor. Hi! — to decide what is appropriate for their portfolio.

WTF are the pros and cons of an ETF?

Like most things in life there are pros and cons to ETFs.

Some of the pros, I’ve already mentioned: trading all day, diversification. Another is how ETFs are taxed. It’s really not so much a pro for ETFs as it is a con for mutual funds, but here we are. This gets a little weird, but stay with me: when a mutual fund sells any of the individual names within its fund it will log either a loss or a gain. A good manager will try to balance out the gains and the losses in a year. But since we hope the mutual fund goes up in value there should be more gains than losses.

Near the end of the year the mutual fund company tallies up all their activity and reports on what gains they realized during the year. They then pass these gains on to their current investors. The investors have to pay taxes on the portion of the fund they own, no matter when they bought it. Meaning: if you purchase shares of a mutual fund and the very next day the fund pays out its annual capital gains, you will be on the hook for the full taxes on those gains even though you just bought the fund. Wait… what?

Yeah. It’s not just the first year you buy-in, either. It’s every year the fund reports capital gains. And this is in addition to any price appreciation you will be taxed on when you sell your actual shares. Oof. Now, most people will only ever own mutual funds in a tax-preferenced account (such as a 401(k)), so this doesn’t matter in many cases. But it can become a big ole headache in brokerage accounts. For this reason, I prefer ETFs. ETFs will only be taxed when you sell your shares.

Another “pro” ETFs have over mutual funds is cost. All funds (exchange-traded, mutual, hedge, private equity, etc.) have some kind of cost to them. This cost is quoted as a percentage — usually a fraction of a percent — and is called an “expense ratio”. ETFs almost always cost less than mutual funds. Research has found that low-cost is one of the biggest keys to success in investing, so this is something to watch.

Of course, it would be cheaper to just own the stocks outright (assuming you have enough money to get good diversification). In this way, an ETF can be less desirable. But for most investors, this is a moo point since you need the investment diversity of funds.

Another potential con to using ETFs is that they are a popular investment vehicle. This shouldn’t be a problem, but with popularity comes posers. There are many ETFs being offered now that are marketed to sound good, but may not deliver. Many new funds use what’s called “backtesting” to show that their concept is a good investment. But of course, hindsight is 20/20. An investor needs to be careful when considering what their ETF is holding.

Let’s wrap this up

Hopefully this explainer has helped you. The next time someone asks you “WTF is an ETF?” at a party, you can thoughtfully swirl your bourbon and reply, “It’s an Exchange Traded Fund, darling”. At least, I hope you learned that ETFs are baskets of securities which are typically cheaper than mutual funds. But that they can give an investor easy diversity without the tax issues mutual funds can have.