What is an ETF? Definition

What is an ETF? Definition

ETFs are very popular and useful investment vehicles that offer affordable diversification and professional portfolio management. An ETF is a basket of securities that is designed to ‘mimic’ the performance of an index, sector, or category of securities.

For example, the ETF with ticker SPY is designed to track the performance of the S&P 500, and the company that creates the ETF (in this case Barclays iShares) builds the ETF simply by purchasing the 500 stocks in the S&P 500. Investors can purchase shares of the ETF as a means of gaining instant access to all 500 stocks in the S&P 500, thus tracking its performance.

The main difference between ETFs and mutual funds are that ETFs are not actively managed, they trade intra-day (whereas mutual fund trades settle at the end of the day), and they do not have a goal of outperforming the benchmark. Day traders can use ETFs just as efficiently as stocks or other highly liquid instruments.

By using margin trading to acquire larger positions with leverage, some ETFs can offer 2x or 3x exposure to major indices, which makes them a popular tool for hedging as well as speculating. When you buy an index ETF, you track the performance of a certain market sector, country, industry, or any other coherent basket of securities, without having to individually purchase the stock of multiple companies.

This can be very attractive to investors because there may only be one transaction for which they’ll pay fees, as opposed to multiple trades. ETFs are also "tax-friendly" because you are in charge of the Capital Gains, since you pay taxes only after you sell the ETF (this is not the case for Mutual Funds).

This is partially because of the structure which enables them to trade intra-day: they use a custodian entity to distribute “creation units” in the fund, acting as a buffer from the tax liability of gains.

The abundance of ETFs issued in the last five years allows you to create a tailor-made portfolio with very low expenses. If you had purchased individual stocks, your expenses would have been much higher due to transaction costs associated with so many trades.

How do I buy an ETF?
What kinds of ETFs exist?