What is an ETF? A Simple Explanation of Exchange Traded Funds
This article is posted under General Information, Investing.
What is an ETF?
An Exchange Traded Fund (ETF) is an open-ended investment that is traded in the exchange or more commonly known as the stock market.
It is composed of a basket of securities or assets that seeks to mirror the performance of an index.
In other words, it’s an equity mutual fund that’s listed and traded in the stock market.
If you did not understand the definition above, then here’s a simple and better explanation of what Exchange Traded Funds are.
First, imagine that the stock market is a “Fresh Fruits Market” – a place where you can buy different kinds of fruits.
Just like in the stock market where you need to buy shares in multiples of the board lot, our fruit market has the same rule – and you can only buy per dozen of each fruit.
This means if you want to buy all the red fruits, particularly the apples, strawberries and cherries, then you would need to shell out P360.
But what if you don’t have P360, and instead you only have P30 in your wallet? How can you afford to buy all the red fruits?
This is where the ETF company can help. They will buy a dozen of each red fruit, and then repackage them into twelve bags, containing each fruit.
One bag is now considered as one share of the fund, and the ETF company brings the bags to the Fresh Fruits Market, and sell them there.
Since the ETF company spent P360 to make the 12 bags, each red fruits package has a theoretical value of P30 – that’s simply P360 divided by 12.
Now, you can buy all the red fruits with your P30!
The prices of shares in the stock market change everyday, which means the prices of the fruits can change everyday as well.
So let’s assume that the next day, the price of apples changed from P120 to P126 per dozen. This means that the “Red Fruits Index” or the cost of buying all the red fruits will now cost P366 instead of P360.
This change in price of the apples will certainly cause the price of the red fruits package to change accordingly.
So if you were able to buy a bag at P30 yesterday, then you can now sell your bag in the market for P30.50 and make a P0.50 profit!
And that’s basically how Exchange Traded Funds work.
Of course, this is just an oversimplified explanation, and there are many other factors and terms that you’ll need to learn to fully understand ETFs. But we’ll tackle that some other time.
For now, all you need to know is that first, just like a mutual fund, an ETF is created by a company, which we referred to above as simply the “ETF Company”.
Second, an ETF tracks the performance of an index. For our example, the price of the bags follow the “Red Fruits Index”.
In the Philippines, ETFs can choose from any of the eight indices that we have, including the Philippine Stock Exchange Composite Index.
And third, just like investing in the stock market or in an equity mutual fund, investing in ETFs is also high risk.
Exchange Traded Funds simply provide investors a new way to diversify their portfolio – because now, if you want to invest in the stock market, then you have three choices: buy individual stocks, invest in a mutual fund, or buy shares of an ETF.
That’s it! I hope you find my explanation of ETFs easy to understand.
For those who would like to do more reading, below are some related articles:
Stay tuned for my upcoming articles about ETFs, like how they differ from mutual funds, the advantages and disadvantages of investing in them and many others. Don’t miss them by subscribing to Ready To Be Rich below.
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