What is an ETF (exchange traded fund)?

Key Takeaways

• Many exchange-traded funds (ETFs ) are designed to track a particular market index passively. These ETFs aim to achieve the same return as the index that they track by investing in all or a representative sample of the stocks included in the index.

• ETFs may help provide portfolio diversification, but it is important to understand some ETFs have a very narrow investment focus and are considered non-diversified funds.

• Many different types of ETFs invest in many different securities, such as but not limited to stocks, commodities, and bonds. ETFs may also invest across many different market sectors and countries.

To many novice investors and busy investors, the most difficult part may be finding a good company to invest in.

Therefore, Warren Buffett, famous for his successful career picking stocks, shared a tip for his believers. He said most investors are better off with a simpler approach that's still very effective: Invest in index funds.

In my view, for most people, the best thing to do is to own the S&P 500 index fund.-Buffett said in Berkshire Hathaway's virtual annual meeting on May 2.

So, what is an Exchange Traded Fund (ETF)?

ETFs are a type of exchange-traded product that offers investors a way to pool their money in a fund that makes investments in stocks, bonds, or other assets and, in return, receive an interest in that investment pool. ETF shares are traded on a national stock exchange and at market prices that may or may not be the same as the net asset value ("NAV") of the shares, that is, the value of the ETF's assets minus its liabilities divided by the number of shares outstanding. ETF share prices fluctuate all day as the ETF is bought and sold.

There are numerous variations, but the majority seek to track an index passively. Depending on which index the ETF is supposed to track, it will typically just buy the underlying investments of that specific index.

This means for this specific type of ETF, there is no fund manager actively trying to pick the investments, and its performance should be very similar to the index it is tracking (passive funds). For example, the S&P 500 index in the US market rose by 26.89% in 2021. So, you could assume that an ETF designed to mirror the S&P would have similar performance before factoring in fees and expenses.*

The idea is that you get a similar performance of the index, with typically lower expenses when compared to active funds, since there is no active fund manager to pay. It also gives you the diversification of the index; in our example, these 500 stocks of the S&P 500 Index.

For some investors, it might be appealing because they are immediately spreading risks due to the ETF consisting of 500 American stocks, and they don't have to buy all the stocks individually themself. It is a diversified investing alternative. Please understand that diversification is a tool used to help manage risk; it does not ensure a profit or protect against loss.

In conclusion, an ETF is a security that consists of a selection of securities (often stocks) with individual weights based on the index rules of the index the ETF is aiming to track. In general, actively managed ETFs cost more than passively managed index ETFs. Low cost may have a massive impact on the value of your investments over time.