Financial Freedom 101

An ETF is short for exchange-traded funds.  It is an investment fund traded on stock exchanges, much like stocks.  ETFs are used to group sectors of industry and create less risk for investors.  Let’s look at an example.

The best example is to look at the ETF for the S&P 500.  This is known as the SPY.  The SPY is a combination of the top 500 companies in America.  As seen below in the figure you can see what companies make up the SPY.

This shows that Microsoft makes up 6.08% of the S&P 500, and Intel Corporation makes up .96% of the SPY. You can see this from the “Weight” column. This list goes on and on till the 500th company. That is why the S&P 500 and the SPY are considered a strong display of how the economy is doing.

Another example is the United States, Oil Fund. This is one of the many ETFs for the oil industry. Here is how an ETF is created. A third party buys hundreds of millions of shares in each American Oil company and then creates X number of shares for investors to buy. Say this ticker symbol is OIL. Now you purchase shares in OIL, you will own shares in the oil industry. Instead of buying a company like Occidental Petroleum Corporation (OXY), which is only one company inside the oil industry. Buying one company is more risk than buying OIL stock. If OXY does poorly, you will lose money. But if one company in OIL does bad, your losses will be much less since you own the overall oil industry and not the one company that does badly.

Now there are two main ETFs. They are Diversified ETFs and Industry ETFs.

Diversified ETFs

A diversified ETF is something like the S&P 500. There are many sectors involved in it. There are technology companies, retail companies, banks, supermarkets, home repair companies, and many more. This is extremely diverse. That is why the S&P 500 is regarded as showing the current economic trends.

Industry ETFs

A specific ETF is something like the United States Oil Fund (Ticker symbol: USO). There are also real estate ETFs such as the Vanguard Real Estate ETF (VNQ), or the tech dominate ETF such as the PowerShares (QQQ). You can also buy the Vanguard Energy ETF (VDE).

Vanguard is a company that creates ETFs for specific industries in the US economy. That will be a post for another day.

Inverse ETFs

Inverse ETFs allow investors to make money when the market or the underlying index declines, without selling anything short. Inverse ETFs’ use of derivatives—like futures contracts—allows investors to make a bet that the market will decrease. If the market falls, the ETF rises by the same percentage it fell. They are not long term investments, but they are an excellent way to hedge against a bear market and save yourself some money in a recession.

Bond ETFs

Bond ETFs are a type of exchange-traded fund that exclusively invests in bonds. Bond ETFs offered an excellent alternative for individual investors looking for ease of trading and increased price transparency and want to practice indexing or active bond trading. Bond ETFs pay out interest through a monthly dividend, while any capital gains are paid out through an annual dividend. For tax purposes, these dividends are treated as either income or capital gains.

Wrap Up

ETFs is a stock that consists of multiple companies. Instead of buying five different tech companies, you can just buy the stock QQQ or the SPY. This lowers your risk significantly. ETFs can be regarded as safe investments. You own a piece of the whole industry. Buying the Oil ETF means you own a share in the oil industry. Oil isn’t going anywhere, so its a very safe bet. The same goes for buying the S&P 500, yes you will experience the lows and the highs of the market, but the bull market always prevails. I have personally owned the ETF of the S&P 500 (Ticker symbol: SPY). I don’t have the money to buy such large shares, so someone down the line made the SPY so investors with smaller portfolios can enjoy the gains of the S&P 500.