Exchange-Traded Fund (ETF)

What are ETFs? Well, first…this is the random financial term you want to be asked in the Financial Term Spelling Bee. And second, you should know that ETF stands for Exchange-Traded Fund.

ETFs are kissing cousins of Index funds, with one key subtle but important difference. ETFs don’t change, at least generally speaking. An index fund might reflect the transportation industry and have so much exposure to Ford, GM, United Airlines, Tesla, etc. But it’s required to have, say, 65% of its exposure to companies based in the United States. In its charter, every month, it has to re-balance that exposure.

So if the auto companies do very poorly in a given month, the index fund has to rebalance by buying more shares of those auto companies to make up the difference...given that they’ve performed poorly relative to airlines, trucking companies, railroads, jet-powered segways, and so on. But in ETFs, the fund is basically set once. And the shares just freely...float.

If, over a decade, the auto companies do really well, then in an ETF they will just have a dominant influence on the overall performance of the fund. The management company doesn’t have to buy and sell shares regularly to fulfill the legal promises it agreed to at the outset of the fund in the way an index fund rebalances shares.

So...what does that mean? Well, it means that ETFs may “drift” in given directions. For example, a generic technology ETF might have had a total of 5% exposure to internet stocks in 1997. But Amazon, eBay, Yahoo, Netflix, and AOL performed massively better than the broader technology market...which did well…but just not OMG.com well.

So that 5% weighting 20 years later might be more like 50% or more of that particular ETF. One other key aspect of an ETF is that it’s traded like a stock, i.e. in one block. There’s a bid and an ask price; the bids are all added up and shares in the fund can be bought at any time throughout the day...although the market sets the price on an ETF just like it does on a stock.

Ok, so now you’re all ready for the Financial Term Spelling Bee. They might also ask you to spell IPO, so...you might want to write that one on your arm.

So yeah, ETFs are just a bunch of stocks in one investment that are linked to an index (like the Dow or the S&P 500). When an ETF is set up, someone buys up stocks in the companies listed in a specific index in the same amount as the index itself. Your ETF is based on the FUN* index that's made up of stocks in ten candy and video game companies? Great, your ETF will have stocks in those ten companies. Here's where things get interesting: the thing about an ETF is that no changes are made to the fund as the index changes. Over time, some companies might fold or be replaced on the index. Some companies might tank. No matter. Your ETF will remain pretty much true to the index on the day your fund was created—no big changes.

By the way, ETFs may look like mutual funds (they are a collection of stocks, after all), but they trade like stocks on the markets.