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What's an ETF?

In past articles, I’ve discussed the two most common kinds of investments made around the stock market, index funds, and equities. Today, I'll be discussing another popular kind of asset you can invest in.

The ETF, or exchange-traded fund, is a stock-like asset that's price is based on several other assets. It derives its value from a series of, say, stocks or bonds. I say “stock-like” because it can be bought and sold like a stock, over an exchange (hence the name).

A common example is an index-based ETF. This is a security you can purchase instead of buying an index fund. Both an ETF that tracks an index and an index fund do the same thing, they both allow you to invest in an index without purchasing every single stock in said index. ETFs don't only track indexes, but also entire sectors and industries. There are bond ETFs, treasury ETFs, commodity ETFs, to name a few.

For example, you can invest in a clean energy ETF (ICLN), or an airline ETF (JETS). This allows you to invest in an entire section of the stock market without actually owning each stock that makes up that sector.

So, instead of owning American Airlines, United Airlines, Delta, and Southwest, you can simply own JETS. This way, you get exposure to the entire industry without owning each stock.

What are the benefits of this? Well, one of the biggest upsides is the fact that you can invest in an entire sector for a fraction of the price. Without ETFs, you'd have to buy every single stock that made up the sector, which is extremely expensive. In the case of an ETF, an institution (like a fund), will actually purchase all of the stocks in a specific sector and create a new security, the ETF, which has its price based on the performance of all those stocks. This takes away the massive expense of owning a ton of stocks, leaving you to buy one single share of the ETF for a much lower price.

Another benefit of an ETF is the fact that you have exposure to a ton of stocks without actually owning each of them. This decreases your potential downside while still allowing you to enjoy the growth of the sector and its individual stocks. Even if one of the stocks in a sector declines in price, it only makes up a small portion of the ETF, so the overall ETF price isn't affected too much meaning you take a lesser loss. However, this means that if a specific stock in a sector goes up drastically, the ETF won’t have that same increase, minimizing your profits. This is the risk-return tradeoff.

In short, the purpose of an ETF is to allow investors to invest in a sector, industry, or other group of assets without actually owning all of the components in that sector/industry. It's a great way to minimize your downside while gaining exposure to an entire industry.

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