In the past few years, ETFs have gone from rare to commonplace. But what are these things that everyone talks about?

An Exchange Traded Fund, or ETF, is a security that trades on a stock exchange that tracks a sector, index, commodity, or a group of assets.  Essentially, instead of buying a specific stock, such as Apple (AAPL), you could buy a technology ETF. This ETF would then shield you from some of the risks associated with Apple specifically, such as poor iPhone sales, but still allow you to capture the upside of a thriving sector.

In that sense, an ETF is a mutual fund that is traded like a stock. There are broad ETFs such as the VOO, that track the S&P 500, as well as very specific ETFs such as CGW that tracks the global price of water. An ETF holds a group of securities that relates to the goal of the ETF that then reflects the price.

For example, the Guggenheim S&P Small-Cap 600 ETF (RZV) holds many positions in Small-Cap companies ($200 Million to $2 Billion in market capitalization). The ETF performs based on the performance of the stocks it holds, and Guggenheim Partners buys and sells stocks within that ETF vehicle to keep a specific, predetermined composition of assets.

ETFs continue to take greater shares of the entire marketplace, so let’s take a deeper look at their impact as we step closer towards achieving financial fluency.

 

Why are ETF’s Important?

ETFs are important because they allow investors to easily diversify across a sector or index. Instead of purchasing 30 or more stocks to be best diversified in their desired investment field, they can purchase one ETF. In the days of the high transaction fees, this was huge; but now with Robinhood’s commission-free trading, the real value in ETF’s is the diversification without research.

These products make investing more convenient. So what’s in it for the Deutsche Bank’s (DB) and Guggenheim’s of the world that manage these ETFs?

Every ETF has an expense ratio which is generally between .05% and 1%. This expense ratio is an annualized percentage of how much the company who created the ETF will charge you to hold it on the idea that the ETF will outperform the expense ration easily. So for example, say you hold $100 in an ETF with an expense ratio on the higher side of 1%. If you hold this ETF for one year, the company will receive approximately $1. But say you only hold the ETF for 3 months, the company will only receive 25 cents from you.

Whatever the duration, you are holding that ETF with the understanding that the 1% is a price worth the potential upside of the ETF increasing in value.

This is why we have seen such a dramatic shift of funds from active management like hedge funds into the passive management of ETFs. Investors are putting more and more money into ETFs because they’re easier. They can hold 4 or 5 ETFs and be spread across Large-Cap, Small-Cap, foreign and domestic equity, emerging markets, and bonds.

A portfolio like this can be created with about half hour of research into the best ETFs. Whereas if you wanted to create a portfolio that is diversified with those same exposures, it could take days of research to find the best equities and bonds to purchase in each sector.

 

But where do ETFs fit into the future of our markets? Let’s ponder their potential impact as we inch closer to achieving financial fluency.

Are ETF’s the Future?

Now some have claimed that ETFs are the future; that the dominating presence of hedge funds in the financial markets have run their course. Then again, of course people are favoring passive management. Since 2009, the S&P 500 has risen over 250%. Every single year, the market has achieved positive returns.

Without delving too deeply into the workings of hedge funds it should be apparent why ETFs are becoming more favorable: there’s no value to hedging. There has been no reason (or no high returns related to) protecting yourself when the market continues to go up.

But ETFs are not a transformative investment vehicle that some claim because guess what? Markets go down. If you bought SPY, the ETF that tracks the S&P 500 at the height of 2007, it would have taken you 6 years to recover your money, and that’s only if you held it after your position lost over half of its value.

It’s for this reason, that ETFs relate to the same old adage: buy low and sell high. Even the best ETF has risks and “buying the market” which seems to be the latest craze, might not necessarily be a smart investment.  Buying the market at the market’s peak is actually the worst type of investment because you suffer the downside of every single company declining.

 

Bottom Line

From the dot-com bubble in 2000 to the height of the financial crisis in 2007, the S&P 500 ETF, SPY, increased 3% which is less than half a percent each year. As the markets continue to rise for their 8th straight year, perhaps there is a good argument to buy the market: there certainly was a reason back in 2009 when the stock market began recovering. Then again, what if the market has reached it’s peak? Should we be greedy as others flock into broad-based ETF’s? Or should we be fearful by other’s greed like Warren Buffett advises?

Only time will tell, but ETFs are not going to replace active managers anytime soon. By surrounding yourself with a greater understanding of the markets, you can continue to step closer to financial fluency.