Kirby on Finance

An ETF Primer, Part #1

In addition to regular personal finance articles, this week I’ll start a discussion regarding ETF’s. This series will cover the basics of ETF investing, including ways to evaluate ETF’s, how to purchase them, and some of the advantages and disadvantages in comparison to other investment vehicles.

Exchange-traded funds, or ETF’s, comprise a basket of securities that mimic the results of various indices including the stock and bond market, various industry sectors, and international equities. They’re awfully similar to a regular stock in that ETF’s are traded daily on the stock market just like Google (GOOG) or Apple (AAPL). However, they’re more similar to mutual funds in that they usually comprise dozens, hundreds, or even thousands of stocks.

It’s important to not confuse a mutual fund with an ETF. I’ll get into more detail on how the two are different in a later post of this series, but for now just understand that generally speaking, ETF’s are cheaper and easier to buy than mutual funds and are a lot less expensive in terms of management fees. Again, I’ll cover this in more depth later.

One of the most popular EFTs is one you may have heard of before. It’s QQQQ, which is the Nasdaq 100 tracking stock. QQQQ is a great example of why ETF’s are a great investing vehicle. When you buy a share of QQQQ you’re getting the collective gain (or loss) of owning the top 100 stocks traded in the Nasdaq.

Let’s say you think energy stocks are a great investment right now. You could pick one company, like Exxon and invest your money into that particular stock or you could buy an ETF that tracks the energy market. Buying a basket of stocks through an ETF allows you spread your risk among many stocks rather than hedging your entire bet on the performance of one company. You could do this on your own, but investing in a basket of stocks through an ETF allows you to save a tremendous amount of money in brokerage fees.

Keep in mind that while spreading risk across a basket of stocks is usually a good thing, it does come with a few downsides. Chiefly, you limit the upside growth of any particular stock to the percentage share that stock holds of the basket you purchased. That’s why it’s important you buy an ETF of a sector that you think should do well rather than one particular stock you like in an otherwise meek sector.

Later this week I’ll discuss ways to evaluate ETF’s and how you go about buying one once you’ve found a few you like.

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