An ETF (Exchange-Traded Fund), is a hybrid financial product that merges stocks with the structure of mutual funds. It is similar to a mutual fund, but unlike the latter, it is listed on a secondary securities market or stock exchange.
To get a more precise idea, we can imagine an ETF as a diversified basket of securities or financial assets. This basket may contain shares of companies, bonds, commodities, indices… Therefore, its price rises or falls depending on the performance of the benchmark index or of the listed securities that make up that basket.
Background of ETFs and their rise in popularity
ETFs have an early antecedent in 1989 when the S&P 500 index participation shares were designed. However, a federal court in Chicago ruled that the fund functioned like futures contracts, even though they were guaranteed and collateralized like a stock. The next attempt to create the modern ETF was undertaken by the Toronto Stock Exchange in 1990 and was called the Toronto 35 Index Participation Units (TIP 35). It was a certificate of deposit or receipt-based instrument that tracked the TSE-35 index.
State Street Global Investors launched, in 1993, the S&P 500 Trust or SPDR ETF. However, the first actively managed U.S. ETF came to market 15 years later. Barclays entered the ETF business in 1996 and Vanguard in 2001. As of December 2019, according to research firm ETFGI, approximately 7,000 ETFs were being traded across the globe.
Indeed, since ETFs were created their popularity among investors has only increased, and with each passing year, the money invested through this innovative financial product grows.
But what is the reason for the boom in the popularity of ETFs? To answer this question we have to analyze the advantages offered by this financial investment product.
What advantages do ETFs offer to investors?
Flexibility and immediacy
To begin with, ETFs are listed on the secondary stock market and therefore their price can be followed at all times during the session. In the case of traditional mutual funds, we can only know their value and price at the end of the day, when the stock exchange closes.
ETFs can be bought and sold at the price at which they are trading at the time of the transaction. That is, we can open and close ETF positions at any time of the day (as long as the market is open) knowing exactly the price at which we are buying or selling.
By contrast, in the case of traditional funds, the value of the holding can only be calculated when the market closes. Likewise, to buy or sell a traditional mutual fund it usually takes a few days from the time we place the order until it is successfully executed.
Fully passive investment
With ETFs the investment is passive since it only seeks to replicate the behavior of the index or of the securities contained in the ETF’s “basket”, without the intervention of a fund manager.
This, which a priori might seem a disadvantage, represents a great attraction for many investors. As economics professor Kent Smetters of the Wharton School of Business (University of Pennsylvania) explains, passive investing outperforms managed funds 97% of the time.
Paradoxical as it may seem, fund managers only manage to outperform their benchmark indexes 3% of the time; so statistically speaking we have a much better chance of higher returns investing in a passive, index-linked investment product, such as ETFs. (A little further on we recommend the best passive index-linked ETFs).
When buying ETFs, commissions are paid to the exchange-traded fund manager and to the broker (or not, some brokers offer commission-free ETFs). These commissions are usually very low, generally ranging between 0.03%-0.5%. In the case of traditional funds (especially actively managed funds), they are higher since the fund manager’s “salary” has to be paid, often regardless of the results achieved.
The low fees of ETFs are also a great incentive and reason for the success of this product. Although a savings of 1% or 2% per year in management fees might not seem like much, if we add that savings year after year — and by the effect of compound interest — we can achieve drastically higher returns as time goes on.
Very low barrier to entry
Exchange-traded funds can be purchased with very little money: the broker we recommend below allows you to invest in ETFs starting at just $50.
Just to exemplify, imagine investing $50 in an ETF that is composed of shares of the top 100 US tech companies (Amazon, Apple, Netflix, Google, Tesla…) in one click and pay a commission of only 0.05% to the ETF manager.
Now, for a moment, imagine trying to do the same thing manually: Buying small portions of shares of each of these 100 companies, and paying commissions individually for each transaction… It would be completely unfeasible.
When you buy a sector-specific ETF you buy a group of shares of several companies. In the case of index-linked ETFs, they are an accurate reflection of the entire market. And so whatever the asset or instrument to which the ETF is benchmarked.
If we decide to invest all our capital in Amazon (or any other company) it is clear that if something were to happen to Amazon our capital would be drastically exposed to the event. But… What if we invest in an ETF benchmarked to the 100 US technology companies? In such a case, even if Amazon went under, the effect such an event would have on our diversified portfolio would be minimal.
ETFs are diversified by antonomasia and this perhaps constitutes their main advantage and strength. Diversification protects the investor from unexpected events.
ETFs are heavily traded products in the market since they attract numerous institutional funds (including pension funds), moving billions every day.
As ETFs are constantly bought and sold around the world they enjoy great liquidity. Getting in and out of the exchange-traded fund is very easy, a great advantage of these instruments, as liquidity is one of the variables to take into account when structuring any portfolio, no matter how small.
As an investor, one of the worst situations you can face is a lack of liquidity. That is, you try to sell an asset and there are no buyers available.
With ETFs, being listed on the stock exchange, it is possible to follow their price at any time of the day. In addition, with ETFs, we can always see their composition (which shares or securities compose it). All this information is public and easily available.
ETFs allow us to invest in a very wide variety of financial assets. And we don’t just mean in variety within the ETF but in variety of ETFs available.
For example, imagine that you have $200 to invest. Thanks to ETFs you can get a portfolio like the following with little effort:
- $50 in an ETF composed of the main US technology companies (100 companies)
- $50 in an ETF comprised of shares of pioneering biotechnology and biomedical companies (50 companies).
- $50 in an ETF made up of China’s most promising start-ups (35 companies).
- $50 in an ETF that gives you exposure to the oil market, taking advantage that due to the coronavirus crisis, it may be a good time to invest in oil.
Do you get the picture? With just $200 (and 4 clicks) you’ve created a promising investment portfolio that gives you exposure to 185 pioneering companies around the world and the oil market.
Are ETFs ideal financial instruments for inexperienced and/or small investors?
In the long term investing in the stock market is usually the best option for a prudent investor, whether “novice” or experienced. However, investing in the stock market “manually” (i.e., selecting the companies that will make up the portfolio individually) is a titanic task and beyond the reach of most mortals.
This is where ETFs and their diversification come in: why look for which companies to invest in when you can invest in all of them, diversifying, mitigating risks, and saving a lot of time?
ETFs facilitate the access of new and small investors to a diversified instrument that can easily and safely replicate any index. Thanks to them, and without the need to invest a lot of time and effort, investors can obtain the benefits of capital markets which, as empirical evidence shows, outperform managed funds 97% of the time.
In case you still have any doubts, ETFs are ideal instruments for small investors and for people who are just starting out in the world of investments. They are very easy to understand, statistically speaking they can give you more benefits than almost any other instrument, they have a moderate risk and allow you to become familiar with concepts such as diversification, risk, profitability, indexes, or stocks, among others.
How to invest in ETFs?
First of all, in order to invest in ETFs, you need a broker. Remember a few paragraphs above we said that ETFs are listed on the secondary market? Well, the broker is the intermediary that “opens the door” to the secondary market.
One of the most recommended brokers we found for investing in ETFs is eToro.com. It is an investment platform used by more than 10 million users, based in London and authorized by CySEC and the FCA (the UK regulator).
In addition, when it comes to investing in ETFs, eToro has more than 145 different ETFs from some of the world’s most reputable fund managers: iShares (owned by BlackRock), Invesco, Vanguard, SPDR, etc.
Which are the most popular and (potentially) profitable ETFs?
SPDR S&P 500 (SPY) | The ETF that includes the 500 largest U.S. companies | 10-year yield: ~260%
The SPDR S&P 500 (Symbol: SPY) is the first and largest U.S. ETF in terms of assets under management. Specifically, this ETF has a volume under the management of $266,416.4 Million (source).
This ETF is benchmarked to the S&P 500 index, so it includes the 500 largest U.S. companies, including Microsoft, Apple, Amazon, Facebook, Visa, JP Morgan, Intel, Mastercard, Bank of America, AT&T, Walt Disney, Nvidia, Pfizer, Pepsi… In other words, by investing in this exchange-traded fund we are investing in the top 500 companies in the US (and, consequently, in some of the largest companies in the world).
In terms of performance, the ETF has managed to give its investors a return of close to 300% over the past 10 years. While it is true that it had a good “stumble” with the coronavirus crisis, as of the writing of this article it has already managed to recover more than half of the fall.
How to invest in this ETF?
Vanguard Total Stock Market (VTI) | The ETF covering all publicly traded U.S. companies | 10-year yield: ~150%
Portfolio diversification taken to the highest level: The Vanguard Total Stock Market exchange-traded fund (Symbol: VTI) is composed of shares of all 3,513 companies listed on the US stock market, as detailed by Vanguard.
It is the 3rd largest ETF in the world by funds under management, and by investing in it we get exposure to the entire US economy (including large and small companies in every sector you can imagine).
Due to its high diversification and the fact that it includes fewer “leading” companies than the first ETF we have seen, its return is more modest:
As we can see in the chart, its return over the last 10 years — taking into account the drop caused by COVID-19 — is around 150%.
How to invest in this ETF?
Invesco Powershares (QQQ) | The ETF that includes the 100 U.S. tech stocks | 10-year yield: ~230%
The Invesco Powershares (Symbol: QQQ) is another of the world’s most popular ETFs and one that has given its investors the highest returns. Its return over the last 10 years is around +230%.
This exchange-traded fund is benchmarked to the Nasdaq 100 index, so it is composed of the 100 largest U.S. technology companies: Apple, Amazon, Alphabet, Facebook, Cisco, Adobe, Booking, eBay, Intel, Netflix…
As we can see, this exchange-traded fund has had a steeper return over the last 4 years. It is worth mentioning that this ETF, as of writing, has almost completely recovered from the fall caused by the coronavirus, as there have been many technology companies that have come out stronger from this recent crisis.
How to invest in this ETF?
What other interesting ETFs can we find to invest in?
Although to talk about the most interesting ETFs in the market we would need a whole article, we would not like to end this article without briefly mentioning the following exchange-traded funds:
- Vanguard FTSE Emerging Markets ETF (VWO): The ETF par excellence that will give you exposure to emerging markets (the economies with the most growth potential in the world). Geographically, it focuses on companies in China, Brazil, Taiwan, and South Africa. Sector-wise, it mainly covers technology, finance, communications companies, and consumer goods. You can find it on eToro.com at the following URL: https://www.etoro.com/markets/vwo (or search for it by its symbol: VWO).
- SPDR Gold ETF (GLD): The largest exchange-traded fund backed by physical gold bullion in the world. Want to invest in gold without having to keep the bullion under your mattress or having to pay custody fees for the precious metal? This fund is created precisely for that, to invest in physical gold with a single click. You will find it at https://www.etoro.com/markets/gld
- Vanguard Value ETF (VTV): This exchange-traded fund offers us the value investing philosophy applied to ETFs. It is composed of large U.S. companies that, in Vanguard’s opinion, are among the safest in the world and offer the best returns. And there is no doubt about it: in the last 10 years it has given its investors a return of more than 110% (not counting the dividends it distributes every few months). To invest in it just go to: https://www.etoro.com/markets/vtv.
- iShares Nasdaq Biotechnology ETF (IBB): When talking about biotechnology and pharmaceutical innovation one of the benchmark ETFs is this exchange-traded fund. This ETF gives us exposure to the top companies in biotechnology, medicine, and pharmaceuticals. A great option to include in the portfolio of any investor in current times, with a huge historical return: in the last 10 years, it has given gains of 410% to its investors, not counting dividends distributed. You’ll find this ETF at: https://www.etoro.com/markets/ibb.
- United States Oil Fund ETF (USO): This ETF, as in the case of the SPDR Gold, allows us to invest in commodities in an easy and agile way. In this case, the United States Oil Fund gives us exposure to oil, specifically this exchange-traded fund replicates the price of a barrel of West Texas crude, a benchmark in the oil industry. This ETF might not be of much interest under normal circumstances, but given the recent drop in the price of oil and the eventual recovery expected as soon as the world recovers from COVID-19, investing in oil can bring us substantial returns in a very short time. To invest in this ETF just go to https://www.etoro.com/markets/uso.