An exchange-traded fund (ETF) is a financial investment vehicle that is traded on stock exchanges in the exact same way as stocks. An ETF holds assets such as stocks, commodities, currencies or fixed income products and trades at approximately the same price as the net value of its underlying assets (this is referred to as “net asset value or NAV”) during the trading day. Most ETFs track an index, such as the S&P 500. Not all indexes track the costs of stocks, so ETFs that buy and sell commodities will follow the index for that asset, such as the ICE Brent Index for oil.
ETFs are attractive as investments because of their low costs, tax efficiency, and stock-like features. Most importantly for Zolio users, since they can be bought and sold as stocks, they can be purchased by investors who want to make a bet on the future value of a non-equity asset, such as gold, oil, corn, or a foreign currency.
Most ETFs are an actively traded financial instrument that funciton similarly to mutual funds in that this trading activity attempts to track the returns of an index, sector, commodity or currency. ETFs began trading in the United States in 1993 and in Europe in 1999. Until 2008, ETFs were not actively-managed by portfolio managers, and were initially created merely to follow another instrument.
Because of their largely automated function, many ETFs are much lower cost than mutual funds, which makes them an attractive asset for investors looking to mimic the return behavior of a particular asset. ETFs also trade throughout a regular trading session, which provides robust liquidity, compared to mutual funds which are only liquidated after every regular trading day.
Index Funds
Most ETFs track a specific index or sector by holding securities relevant to that index or sector. An index fund attempts to mimic the returns of by generating a portfolio that owns stock that makes up an index. Some index ETFs, known as leveraged ETFs or inverse ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse of, the daily performance of the index. In other words, inverse ETFs (also known as “short” ETFs) will try to go up when an index goes down, or vice versa. Leveraged ETFs (often called double funds, 2x, 3x, and so on as relevant) will try to go up at a multiple to the index itself. A 2x index fund will try to go up twice as much as the undelrying index, for example.
There are leveraged inverse ETFs, which try to go up twice as much as an index goes down, for example. However, leveraged and inverse ETFs often fail to track the index they follow, which is why investors need to be careful when buying into these types of funds.
Index funds are not only used to make bets on a market movement: they are also used for speculation and hedging. An index fund such as the Spider Select S&P 500 Fund (NYSE: SPY) will follow the returns of the S&P 500 index and give an investor direct exposure to this large cap index. If a bet on the S&P 500 is a hedge of a larger bet (such as the appreciation of gold), an investor can buy into this ETF to hedge the other bet.
Index ETFs are also used to hedge exposure to specific market indexes. Many investors will use liquid index ETFs to hedge a portion or their entire portfolio prior to an adverse market move. Investors will also look to mitigate volatility by shorting index ETFs, and protect their portfolio of stocks that track major indexes.
Popular Index ETFs are:
- iShares Russell 2000 (NYSE:IWM) – This liquid index ETF follows a broad small cap index and provide superior liquidity for investors looking to generate exposure to the Russell Small Cap Index
- Nasdaq 100 PowerShares Trust (NYSE:QQQ) is the most liquid and well-known gauge of the Nasdaq 100. This ETF is an excellent proxy for technology stocks and is used for both speculation and hedging.
- S&P 500 iShares Spider Select (NYSE:SPY) is the most liquid of the index funds, capturing the movements of the benchmark S&P 500 Index.
- Diamonds iShares (NYSE:DIA) – The most liquid of the index ETFs the follow the Dow Industrial Index, DIA can be seen as SPY’s DJI-oriented sibling.