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Exchange Traded Funds (ETFs)

TL;DR

  • Type of security that tracks another asset but can be traded on stock exchanges

  • ETFs can contain one asset or thousands of assets from different industries

  • Good source of diversification - low risk, lower return

  • Thematic ETFS are popular today


What is an ETF?


An Exchange Traded Fund (ETF) is a security that tracks another asset (index, commodity, industry) and can be traded on the stock exchange like any public equity. ETFs can track individual commodities (like gold or timber) but also a large collection of securities (space exploration stocks). Since an ETF has more than one underlying asset, it can be a good source of diversification as an ETF can include hundreds to thousands of stocks. As a result, ETFs have lower risk and a lower expected return.


A well known ETF is the SPDR S&P 500 ETF which tracks the performance of the S&P 500. Not only can an ETF include commodities and stocks, but also bonds, real estate or other investment securities. Its defining factor is that an ETF can easily trade on a stock exchange since it is a marketable security; hence affected by price fluctuations everyday.


Thematic ETFs


Today, a lot of the ETFs trading on American stock exchanges are thematic ETFs: focused on a specific industry or trend. As a result, an investor does not need to do any due diligence and is simplifying buying a trend. By buying one share of an ETF, you are taking a stake in all the companies in the fund and gaining exposure to the overall theme. For example, Cathie Wood’s ARK fund released a lot of thematic ETFs based on a trend such as ARKX. ARKX is a thematic ETF focused on growing space exploration companies like Trimble and Lockheed Martin. As an investor, by owning one share of ARKX, you are fractionally exposed to all the companies in the fund.


Benefits and Drawbacks


The benefit of being exposed to so many companies by purchasing 1 share allows investors to face lower average costs, since they only need to execute one transaction to increase/reduce their exposure to so many companies. Compared to individually investing in each company in the ETF, with only one trade, brokerage fees are also fewer.


However, the above benefit is valid if an ETF is not being as frequently rebalanced. In the case that you invest in actively managed ETFS, fees are much higher as more trades occur. Additionally, if a thematic ETF is focused on one industry like space exploration, diversification is not as great compared to investing in different asset classes. Lastly, liquidity for ETFs are not as high as common stock since they are less frequently traded.