Although we take it for granted, what stock markets do is actually pretty cool. Say you wake up one day and decide you want to own some of Apple—one of the largest companies on earth. Since Apple is a public company, anyone can buy a part of it. You don’t need to have a friend at Apple, or have any special connections or anything. You just go to an online broker, click buy, and viola, you own part of Apple.
But what if you want to invest in a group of stocks? One way to do it is with an Index fund. (We covered them in this previous post.) They allow you to passively invest in a group of stocks. They’re a great way for beginners to invest in the markets and are regarded as the way most people should invest long term. However, they are not particularly nimble and often have minimum investment amounts in the thousands of dollars. What if you want to passively invest in the markets, but don’t have that kind of money? Or what if you want to do something a little more complicated, a little more interesting? Well, you could look into exchange-traded funds (ETFs).
How Are ETFs, Index Funds, and Mutual Funds Different?
An Exchange Traded Fund is exactly what it sounds like. It’s a fund (a collection of assets) which is traded (bought or sold) on an exchange (a marketplace). You’ve heard the phrase “don’t keep all of your eggs in one basket.” When it comes to investing, that means you don’t want to be invested in a single asset or company. You want diversification. If one company tanks and all your eggs are in that company’s basket, well, there goes your money. Investing in a fund instead of a single stock allows you to achieve diversification and to make investments you wouldn’t otherwise be able to easily make.
People often ask about the difference between a mutual fund, index fund, and ETF. A mutual fund is a broad term to describe a collection of investments. And, as MONEY explains, index funds are a subset of mutual funds. You’ve heard of the S&P 500, right? It’s an index that measures 500 of the world’s most economically powerful companies. Index funds are designed to mimic specific indexes, like the S&P. And ETFs are a subset of index funds. They, too, measure specific indexes, and they offer a little more flexibility.
ETFs Make Passive Investing Easy (and Cheaper)
If you have a pool of money you’d like to put to work in the market, an ETF that mirrors a general index like the S&P 500 might be a good idea (VTI is one example of a stock market ETF). ETFs are an easy way to passively invest in an index, just like index funds. But ETFs are a lot more approachable for a couple of reasons.
First, they don’t come with the high minimum investments that mutual funds often have ( which can be anywhere from $3,000 to $10,000). So if you don’t have a lot of money to invest, you can start small with ETFs. You can typically buy one with just a hundred bucks or so. Second, you can buy ETFs during normal market hours, just like you would any other stock. Mutual fund trades, on the other hand, are executed at a specific hour.
ETFs also allow you to invest in more obscure or exotic groups of assets for further diversification. Let’s say you want to invest in regional banks. Investing in that directly sounds pretty hard—but there’s an ETF for that: SPDR S&P Regional Banking ETF (KRE) You simply buy the ETF, and now you’re invested in a basket of regional banks. Or say you want to invest in gold miners. You could buy a collection of gold mining stocks, or you could simply buy an ETF like the VanEck Vectors Junior Gold Miners ETF (GDXJ). Now you have exposure to the sector without having to go through each gold miner one-by-one. Again, you can do this with index funds, too, but ETFs let you buy in without a minimum–it’s cheaper to get started.
Using ETFs for Active Trading
There are two kinds of investing: long-term, buy-and-hold investing and active trading. Most personal finance experts recommend long-term investing because it’s less risky and meant for slow and steady growth. If you’re an average investor saving for retirement, you want a long-term, buy and hold portfolio.
But then there’s active trading–timing your investments according to your predictions of how the market will perform. It’s a totally different kind of investing and a lot riskier, especially if you don’t know what you’re doing, but active traders sometimes use ETFs to short the market.
When most people think of investing, they think of investing in companies that are gaining value. But there are actually many ways to make money off of something that is falling in value. It’s called going “short” or “shorting the market”. What does “shorting the market” mean? It means betting against the market. So, if you short Microsoft stock, you make money when the stock goes down, and you lose money if the stock goes up. Many of these strategies are out of reach to a normal investor, but short ETFs have brought this ability to the masses.
Let’s say you think the US stock market is going to fall today. You could use complicated options strategies that are hard for beginning investors to understand. Or, you could just buy a short ETF like the Direxion Daily S&P 500 Bear. If the S&P falls by 1%, you should make a return of 1% before fees. But if the S&P rises by 1% you should lose 1%.
Active trading gets complicated and, chances are, if you’re reading this site, you should probably just stick with long-term buy and hold investing.
Don’t Get in Over Your Head
Index ETFs are a conservative way to passively invest in the market, but other ETFs are an entryway into the complex world of sophisticated financial instruments. While many ETFs are quite simple, some, like YANG, a triple-levered short-China ETF, are much more complicated. ETFs are fascinating because they can be a very stable investment suitable for beginning investors—and they can be a wild ride more appropriate for advanced traders. Be sure you understand what you’re getting into before you pull the trigger.
ETFs make it easy to make relatively complicated financial investments. It’s pretty amazing that you can invest in a fund that earns you money if a group of stocks falls in value. It’s even cooler that you can buy a fund that doubles or triples your profits (and losses). But all this complexity comes with extra risks, and for that reason, many ETFs should be used with caution.
What do you think about ETFs? Do they sound exciting? Are you planning on investing in one? Let us know in the comments!