What is an Exchange Trade Fund (ETF)?
Exchange Traded Funds are securities that are created to track the perfomance of an Index or Sector. Lets use the S&P500 index as an example which is an index that tracks the perfomance of the 500 companies on the NYSE or NASDAQ with the biggest market cap like Apple, Microsoft, Google, Amazon, among others.
If the during the current year the S&P500 has a 20% gain, then an S&P 500 ETF that track it must have an equal or similar perfomance, so if you hold said ETF, you can expect around a 20% increase on your portfolio!
Please check our post if you want to know about Exchange Trade Funds vs Mutual Funds
How is this achieved?
Institutions that creates the ETFs (Vanguard, Blackrock, Horizons, etc.) need to buy the securities that the ETF will track, so, if they want to track the S&P500, they need to buy the majority, if not, all the companies that are in the S&P500 and include those shares on their holding.
This is great, but, why should you buy and ETF when you can easily buy the underlining shares that the ETF has?
Why should you buy ETFs?
The main reason for this is how much capital the investor has. Its a well known saying that nobody should put all of their eggs on the same nest and on the Stock Market this means, do not hold a 100% of your portfolio on 1 stock or 1 sector only.
In order to create a well diversify portfolio, you need to own at least 10 to 15 different type of companies, and if you have less than $5,000 to invest, you can spend a lot of money just on fees to buy 10 different shares.
Fees on trading Stocks vs ETFs
You can easily pay $10 per transaction, and if you buy 15 companies to diversify your portfolio, you just paid $150 just in fees. In order to recover this, your portfolio must go up by 4%
You may say that this is not much, but, in order to capitalize your gains, you will need to sell your share, which mean, you could pay $150 more, totalling $300 on transaction fees.
If you buy the ETF U.S. Total Market Index (VUN) you will pay the 10$ on fees for this transaction, but in return, you now own 3,606 companies! This how diversified and ETF can be!
Management Expense Ratio (MER) on ETFs vs Stocks
It would not be a fair and complete comparison if we don’t discuss the MER associated with owning and ETF.
When you buy a stock, you will only pay a transaction fee when you buy/sell said stock.
This is not the same for ETFs and for U.S. Total Market Index (VUN) you will be charged a MER of 0.16% yearly, this means that if you have $1000 on VUN, you will pay $10 to buy the ETF and $1.6 yearly to own the ETF.
Why do we pay MER? Well, the institution that holds the ETF will have to buy/sell shares of the underlining stocks in order to maintain it well balanced and we will have to cover a fraction of the fees they pay in order to do this.
ETF vs Stocks. Which one should I own?
This is a subject on it’s own and we will do a full post about it. But for those of you who are looking for a short answer:
Passive Investor: If you are an investor who doesn’t have the time to do research and follow news everyday, then by all means by an ETF and you will have instantly a well diversified stock. As long as said ETF is not a niche ETF (Banks ETF).
Active Investor: If you are an investor that is doing constant research on the market and trends and you are well informed about each sector of the stock market, then buy the Stock that you have done research on it
We hope that you’ve found this post informative, please stay tuned because we will dig more on this subject.