What is an ETF?

A basket instead of one company

Buying one company’s shares means your money rides on that one business. If it does badly, you do badly. Buying twenty companies one by one spreads the risk, but it takes a lot of money, a lot of orders and a lot of attention.

A fund solves this. It collects money from many investors, puts it in one pool, and buys a basket of investments with it — dozens, hundreds or thousands of companies. Each investor owns a slice of the pool, in proportion to what they put in.

What an ETF is

An ETF, short for exchange-traded fund, is a fund whose slices — called units, or simply shares of the fund — are bought and sold on a stock exchange. You buy one through your broker the same way you buy a share of a company: you place an order, it is filled at the market price, and the units appear in your account. Their price moves throughout the trading day.

That is the difference from an older kind of fund, the mutual fund. You buy a mutual fund’s units from the fund company and sell them back to it, usually once a day, at one price worked out after the market closes. Both hold a basket; an ETF simply trades like a share.

What you actually own

When you buy an ETF, you do not become a shareholder of the companies inside it. You own units of the fund, and the fund owns the companies’ shares. The value of each unit follows the value of everything the fund holds, divided by the number of units.

If the companies in the basket pay dividends, the fund receives them. Depending on the fund, it pays them on to you or adds them back into the fund. The fund — not you — votes at the companies’ meetings.

Running a fund costs money, and the fund takes it as a yearly fee from its assets, called the expense ratio. You never see a bill; the fee is why the next lesson exists.

Index funds and active funds

Funds come in two broad kinds, by how they decide what to hold.

• An index fund copies. An index is a list of companies chosen by fixed rules — the S&P 500, for example, follows 500 of the largest US companies. An index fund holds the same companies in the same proportions, and changes only when the index changes. Its return is the index’s return, minus its costs.
• An active fund chooses. Managers research companies and decide what to buy and sell, trying to do better than an index. Because people are paid to do that work, active funds usually charge more. Whether a manager will do better is never known in advance.

Most ETFs are index funds, though not all. The fund’s own documents say which kind it is and which index, if any, it follows.

Spreading your money in one purchase

The main thing a broad fund gives you is diversification in one purchase. With many companies in the basket, each one is a small part of the whole, so one company’s trouble moves the total only a little.

How much each holding counts is its weight. Not every fund is equal-weighted: many index funds weight companies by their size, so the largest few can make up a big part of the fund.

The figure shows one such basket. Push up the largest holding’s weight: the fund keeps the same name and the same number of holdings, yet more and more of your money rides on one asset. Looking at a fund’s largest weights tells you more than counting its holdings.

The risks a basket does not remove

A fund spreads the risk of single companies. It does not remove risk.

A fund’s name is a label, not a guarantee. What protects you is what the fund actually holds, in what proportions, and at what cost.

In short

An ETF is a basket of investments that trades on an exchange like a single share. You own units of the fund, the fund owns the companies, and one purchase can spread your money across many of them. An index fund copies an index; an active fund pays someone to pick. Either way, the basket goes down when its contents do — and a narrow basket is only as safe as the one thing it holds.