What is an ETF? A Simple Explanation of Exchange Traded Funds

Posted by under General Information, Investing . Updated: September 20, 2016

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.

fresh-fruits-market

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.

red-fruit-index

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.

etf-creation

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!

etf-market

The prices of shares in the stock market change everyday, which means the prices of the fruits can change everyday as well.

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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!

price-change

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.

Learning Beyond Exchange Traded Funds

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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10 Responses to “What is an ETF? A Simple Explanation of Exchange Traded Funds”


  1. Ricky Rumbaoa says:

    Wow! Ang galing ng explanation. Isa kayong alamat Sir Fitz! Thanks for enlightening me about ETFs. I cant wait for ETFs to come out! Excoited!

  2. Great explanation Sir Fitz! 🙂

  3. haydn says:

    So, when you will buy an ETF, you will have to choose from any eight of the indices we have, such as property, services, holdings, etc…, is that what it means?

  4. Kiko says:

    Nice! very simple yet clear.

    Sir do you have article that compares online stock brokers line COL and BPI trade?

  5. Fitz says:

    @haydn

    An ETF Company will list an ETF in the stock market with its own “stock code”. The ETF Company must announce what index they will track (follow).

    This means, two or more ETF Companies can follow the same index.

    As an analogy to our example above, let’s say Company A will launch “RF1” which follows the Red Fruits Index by putting in one piece of each red fruit in the “package”.

    Meanwhile, Company B will launch “TCF” which also follows the Red Fruits Index, but they’ll put one apple, one strawberry and two cherries in the “package”.

    I hope I was clear with the explanation.

    @Kiko

    No I don’t have an article about that yet. Good suggestion. I’ll see if I can research on BPI Trade so I can compare (I’m with COL).

  6. […] explained what and how ETFs work here just in case you want to know […]

  7. sandy mae says:

    Thank you sir for enlightening my brain cells! Hehe. I’m not good in this field of mathematics or finance but I’m learning surely and slowly with the help of your article.

  8. […] ETF’s are a good alternative to Index Funds because they carry the same risk and long-term growth potential. If you want to learn more how ETF’s work, then you can read this simple explanation that I wrote before. […]

  9. Charles Salvacion says:

    Hi Sir Fitz,

    Available ba ang ETF kay COL Financial?

    Thanks!

  10. Fitz says:

    Hi Charles. Yes, currently, FMETF is the only one that’s available in the country, and you can buy shares through COL Financial (or any other stock broker).

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