Come on, admit it. We’ve all opened a quarterly financial report sometime in our investment lives, winced at the numbers, and asked one simple, elegant question -why can’t I just put my money into something that will match the market?
Exchange traded funds, or ETFs in market shorthand, are a relatively new group of financial instruments created to answer that question.
The concept is simple. Buy a bunch of stocks that match the ones in the Dow Jones 30 Industrials, Standard & Poor’s 500 or whichever market index you want to match, then let the money ride until you want to cash out. The same idea works for bonds, commodities and presumably just about anything else bought and sold in a formally organized public marketplace.
Many ETFS have colorful names, often based on pun on the fund’s name or trading symbol. SPDRS, the Standard & Poor’s Depository Receipts fund tracking the S&P 500 and the first ETF traded in the U.S., are known as Spiders. The Diamond, listed on the ticker as DIA track the Dow Jones Industrial Averages. Qubes, named for its symbol QQQQ tracks the Nasdaq 100 index. And the list goes on.
Industry watchers at the Investment Company Institute and Morningstar Research count more than 840 different funds traded on U.S. securities and commodities exchanges, with combined assets of more than $608 billion. Trading volume climbed from a dead start zero before U.S. trading began in 1993 to more than 1 billion shares a day in 2006, according to market mavens at Northern Trust.
So, how do they work?
As with mutual funds, ETFs are built around diversified baskets of securities, which for most funds are chosen to duplicate a market index you want to track. But where mutual fund builders ask for cash when they begin building those baskets, ETF sponsors ask their institutional investors to deposit the actual securities in the fund. In return, the sponsor refashions this megamillion collection of securities into so-called creation units that securities firms can divide into more manageable chunks for retail investors to buy.
What the retail investors get is an ETF that looks like a mutual fund but acts very differently. To over simplify, mutual funds buy and sell securities to hit their chosen performance targets while ETFs stick with the securities they start with and see where the targets take them.
This creates many practical differences for retail investors too. Investors can trade ETFs throughout the day like stocks and, if they choose, buy on margin or sell short. Mutual funds trade once a day, based on closing market prices.
Gene Meyer is a freelance writer and former staff reporter at The Kansas City Star and The Wall Street Journal who for two decades has been following personal finance matters faced by individuals and families. He is a contributor and editorial advisor to The ETF Store.