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What Is An ETF?

What Is An ETF?
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ETFs are increasingly central to many traders’ and investors’ portfolios. Today, more than 15 million Americans (12% of the total population) hold one or more of the 3,100+ individual ETFs in US markets that offer wide-ranging exposure to asset classes, sectors, and more – for much cheaper and with greater flexibility than past options.

To understand why we at Bull Oak take advantage of ETFs’ many benefits or start including some as part of your self-directed strategy, you must first understand what ETFs are – and why they’re such a powerful investment tool for professionals and retail investors alike.

How do ETFs Work?

At a very high level, an exchange-traded fund (ETF) is a collection or basket of many stocks that trades like a single stock. For example, the popular S&P 500 ETF, SPY, holds a slice of each of the 500 stocks comprising the index within a single “share.” Those individual stock slices are proportionate relative to their respective index weights. 

SPY’s top ten holdings and their relative weight per share.

What Is An ETF?
SPY’s top ten holdings and their relative weight per share.

Each share of SPY is tradable during market hours, and per-share pricing goes up and down according to buyer and seller behavior. This contrasts with legacy index-based investing options like mutual funds, which “settle” at the end of the trading day. The difference in this case is that, with ETFs, you’re directly interfacing with the opposing buyer/seller party on a secondary market (stock exchange). 

Mutual funds are directly bought from or sold to the fund itself. The fund’s trade pricing is based on the fund’s net asset value (NAV), or the total value of all assets within the fund at the end of the trading day. 

As with stocks, easier access to brokerage account trading also means that you can buy and sell ETFs more cheaply compared to mutual funds, many of which are load mutual funds that charge a fee, commission, or sales charge when buying into the fund. Likewise, you don’t need $500+ to buy a single share of SPY – if your brokerage allows for fractional trading, you can often buy a bit of the ETF share for as little as $5.  

But that isn’t all – ETFs offer a wide range of benefits, both on their own and when compared to mutual funds. 

ETFs Offer Diversification

One of ETFs’ primary benefits is pure diversification, often within the ETF itself and as part of an overall portfolio through strategic ETF allocations. 

Within a wide-ranging ETF, you’re less exposed to fluctuations and company- or stock-specific risk than through individual stock selection. Even if you like playing stock jockey – and there’s nothing wrong with that, when done as part of a strategic investment plan – you’re still facing idiosyncratic risk, which describes the risk associated with a specific company or sector. 

To offset the risk, ETFs like SPY offer a slice of each of the companies within the index, and the performance of 499 companies can offset the idiosyncratic risk of 1 stock. For example, if you heavily weighted your portfolio with individual Boeing stock holdings in 2024, you’d have a rough year as the stock is down more than 30% year-to-date. However, by holding SPY, you’re exposed to the stock’s potential upside (if and when it recovers), while the remaining companies help balance out Boeing’s losses on the year. 

What Is An ETF?

Intra-Portfolio Diversification

At the same time, effectively diversifying your entire portfolio is much simpler through ETFs. If you’re bullish on big tech, healthcare, and financial services, you could pick and choose your preferred stocks – or invest in ETFs like the iShares Global Tech ETF (IXN), iShares US Medical Devices ETF (IHI), and iShares US Aerospace & Defense ETF (ITA). This strategy, again, reduces some idiosyncratic risk associated with select stock picking and offers exposure to sectors’ “best in class” stocks while offsetting the potentially poor performance of just a few.

To that end, some ETFs also offer access to stocks that are otherwise inaccessible or tough to buy through standard means. For example, the iShares Global Tech ETF holds foreign companies within the ETF, like Samsung, that only trade shares on their host nation exchanges. 

What are the Best ETFs to Buy for Diversification?

While everyone’s circumstances differ, our favorite “all-weather” ETF portfolio offers wide-ranging diversification across multiple asset classes and regions to reduce overall portfolio risk:

  • Core Position: iShares Core S&P 500 ETF (IVV) 
  • Diversify Internationally: iShares Core MSCI EAFE ETF (IEFA)
  • Generate Income: SPDR Portfolio Aggregate Bond ETF (SPAB)
  • Speculative Small-Caps: Avantis US Small Cap Value ETF (AVUV)

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ETFs are Low-Cost

Though most brokerages offer low- or no-fee and commission trading, individual assets sometimes have fees baked into the business model. We already covered load mutual funds, which charge fees to buy the asset, but it doesn’t stop there. Because mutual funds and ETFs are essentially financial products, the companies offering the product must make a profit, usually in the form of expense and management fees embedded within its structure.

ETFs generally have some sort of fee, but since many of the top ETFs are passive funds – meaning they’re holding stocks associated with a benchmark – reduced buying and selling within the ETF means less work and overhead for the fund manager and reduced fees. 

To determine an ETF’s fees, look to the overall expense ratio, which bundles each of the fund’s fees into a single percentage amount you’re “charged” annually. Though fees are generally deducted from the fund’s performance, so you don’t necessarily notice the cash is “missing,” higher fund fees can eat into long-term performance. You can easily find the overall expense ratio on most trading platforms’ research portals, and the fund management team or parent company posts them on their website or within the fund’s prospectus. 

For example, IVV’s overall expense ratio is just 0.03%, or $3 annually, on a $10,000 investment. Compare that to even a passive S&P 500 mutual fund, like the Invesco S&P 500 Index Fund’s (SPIAX) 0.12% ratio and the incremental expense ratio reduction is significant. 

Actively managed mutual funds have even higher overall expense ratios, like ARK’s Venture Fund (ARKVX), which has a whopping 5.76% gross expense ratio – that breaks down to more than $500 in annual fees for each $10,000 invested.

ETFs Offer Flexibility and Liquidity

While we don’t generally recommend taking an active approach or trying to “time the market,” we recognize that you sometimes want to buy and sell based on news or market sentiment, and time is of the essence. Since ETFs trade actively on stock exchanges throughout the day, you can react quickly to news items like the Federal Reserve’s periodic updates and dump ETF shares if you think the Fed will take a hawkish approach – whereas, with mutual funds, you’re subject to the overall price dropping following announcements as the fund isn’t sellable until after hours.

ETFs also offer liquidity with many buyers and sellers transacting, which helps ensure you get a preferred price. This is because the bid/ask spread is narrower as more transactions occur actively. The bid/ask spread is the difference between the seller’s requested selling price (ask) and what a buyer is willing to pay (bid). 

With illiquid stocks, like biotech companies, the spread can be quite wide, and your execution price could “drift” far from where you’d like to buy or sell and eat into gains. In contrast, biotech ETFs that hold the same shares have far greater liquidity and improved spreads that help capture your preferred pricing.

ETFs Offer Tax Efficiency and Benefits

While the structural mechanisms are complex, when selling ETFs, your tax burden is generally based solely on your gain from the specific transaction. For example, if your cost basis for SPY (original purchase price) was $300 and you sold at $500, you’d be taxed on the $200 gain. 

On the other hand, mutual funds sometimes have internal tax events that create a surprise bill at the end of the year. Mutual funds often create taxable events when buying and selling within the fund; for example, a fund with a low Nvidia cost basis could realize substantial profits if management sold today – and you’d be on the hook for the bill, even if you didn’t sell your mutual fund holdings. This is why, sometimes, mutual fund holders pay taxes even when the mutual fund itself posts an annual loss!

What Kind of ETFs Can I Buy?

In this article, we primarily focused on passive ETFs that buy individual stocks against a specific benchmark, like the S&P 500 (SPY), or a sector-specific benchmark, such as the MSCI World Information Technology Index (IXN). But these are just a few of the many ETFs available across the market that offer varied asset class exposure, risk, and upside opportunities:

  • Active ETFs: Active ETFs hold a basket of actively managed stocks, or companies that a portfolio manager thinks will outperform the market or provide some other benefit over passive funds. Cathie Wood’s many ARK Invest offerings are a common example of actively managed ETFs. But beware – though active ETFs can post massive gains during strong periods, they’re also prone to significant downside with less intra-fund diversification than benchmarked ETFs.
  • Wide-ranging asset classes: We mentioned large-cap ETFs, small-cap ETFs, and bond ETFs, but you can also diversify your risk by investing in ETFs across many asset classes, including real estate, commodities, and even crypto. 
  • Sector-specific ETFs: Like asset class diversification, ETFs offer access to a broad sector by holding individual stocks comprising the industry, such as healthcare, biotech, financial services, and more. 
  • Long, short, & leveraged ETFs: We definitely don’t recommend these to most, but short-term traders can maximize potential gains from a specific investment thesis by using uniquely structured ETFs. For example, a bear betting against tech could buy the ProShares UltraPro Short QQQ (SQQQ), which generally inverses the NASDAQ-100’s performance (SQQQ’s price rises as the index falls). 

Conclusion

ETFs are one of the best ways for investors to cheaply gain exposure to a wide range of investment opportunities to ultimately boost long-term portfolio performance. As ETFs become increasingly popular, many mutual fund managers are even trying to convert existing funds to ETFs!

While ETFs are a valuable tool in the retail investors’ kit, they’re also invaluable for us as wealth managers. ETFs help us diversify your holdings according to unique quantitative principles that, in the long run, may help capture maximum market upside while helping shield from downturns. 

To find out more about how we leverage ETFs as part of a comprehensive investment and wealth management strategy, reach out – we can talk about ETFs’ benefits all day and would love the chance to do so with you.

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