ETFs: Exchange Traded (made) Fun(ds)

If you’ve done research on how to start investing, you may have come across the term “indexing.” Indexing is essentially a form of passive investing where the investor does not directly choose individual stocks, bonds and other equities that compose his/her portfolio. Instead, they purchase shares of companies’ stock that are in line with different financial indexes. Typically, someone will invest in the components of the S&P 500 or the FTSE 100 because these indexes represent the economy of their respective countries (the U.S. and the U.K.). As a result, these indexes are well balanced, have minimal volatility, and in turn grow as the market grows. If the investor does not have enough time to research different companies’ financials, indexes provided an easy and relatively time effective way of incurring a return on one’s investment.

When a person indexes their money they will essentially have a return of about eight percent per year, since the market grows an average of eight percent per year. As of March 8th, 2017 the S&P 500 is valued at $2,362.98, up from $1,969 on the same date one year earlier. This represents a 19.39 percent increase year-over-year. While this return is large, what happens if you don’t have anywhere near $2,300, let alone $1,900 dollars to buy all the components of the S&P 500? You could purchase a percentage of the stocks within the S&P 500, but based on what stocks you pick, the market cap, and other factors, the volatility of your Jefferson Bible-Index (the Jefferson Bible was an edit of the Bible completed by Thomas Jefferson. He essentially cut out a large portion of the New Testament) could be higher than the original index.

So are poor millennials interested in indexing their extra income unable to reap the growths of the market? Not quite. Luckily there is something called exchange traded funds, or ETFs for short. An ETF is a financial instrument similar to that of a money market mutual fund. Here, an ETF represents a diversified basket of stocks within the market. Not just anyone can create an ETF. An authorized participant, typically an investment bank, purchases the underlying assets, then divides the total value of the portfolio into the amount of shares that they want to sell. The shares of the ETF are then purchasable on an exchange.

ETFs aren’t necessarily a new instrument in finance. ETFs have been around since 1993 and were originally used by institutional investors in order to perform more sophisticated levels of trading. They were quickly adopted by regular investors and financial planners. In 2015, ETF assets reached $2.1 trillion. It is no doubt that ETFs have become a big player in the market.

ETFs, while having a diversified composition, trade like normal shares. Investors can purchase as much as they would like and the value changes on the minute. This means that ETFs are also subject to buying and selling pressure. Therefore, if the component assets were to increase in value, the overall value of the ETF would also increase. This would then be magnified if people became greedy and began to buy the stock causing the price to increase further. In the opposite direction, if the underlying assets were to decrease in value and investors became fearful and sold their shares, this would further decrease the price.

One notable example of an index-based ETF is SPDR (SPY). SPY is one of the cheaper S&P index ETFs. A person can typically purchase a share of SPY for around the tenth of the price of the S&P. This makes them relatively accessible to new investors with little money and experience. Here, SPY will more or less fluctuate with the market. There will be some minor changes due to the buying and selling pressures as mentioned earlier. Nonetheless, SPY represents a simple buy for millennials interested in investing, but not knowledgeable enough yet to compose their own portfolio to beat the market.

Not only can you purchase indexes as ETFs, but you can also purchase commodities like gold in their ETF versions. This is important because commodities like gold are pricy. Gold currently trades for around $1,200 per ounce. However, with ETFs, lower income individuals like students can purchase gold in the market. A share of iShares’ Gold Trust ETF (IAU) on March 8th 2017 closed at $11.64. This is far cheaper than purchasing actual gold and has a much lower barrier to entry than investing before ETFs.

ETFs, in conjunction with free trading apps like Robinhood, allow new investors to learn about the market and finance without sinking in a lot of time and money. ETFs are relatively cheap when compared to their component assets and can prove to be a useful learning tool for students in college, and a simple investment strategy for those who want to see their money grow, without the knowledge or expertise needed to build and diversify one.

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