What is an ETF?

You've probably encountered clickbait headlines like "3 Dividend ETFs You Should Own for the Recession" or "ETF that Will Skyrocket with AI." ETFs, or exchange-traded funds, have been prevalent for over 30 years. While initially a controversial investment option, they have now become a mainstay in investment portfolios despite many investors not fully understanding what they are investing in.

An ETF is a fund traded on an exchange consisting of a basket of stocks, usually representing a specific sector or industry. Take SPY as an example - it tracks the S&P 500, meaning that owning a share of SPY gives you partial shares in all the companies that constitute the S&P 500. Currently, the top five holdings in an S&P ETF include giants like Microsoft, Apple, Amazon, Nvidia, and Google. Owning an S&P ETF, therefore, makes you a partial investor in these companies, as well as 495 others.

Unlike mutual funds, ETFs are not actively managed. Instead, their stock holdings adjust automatically based on changes in the companies' weights within the S&P 500. So if Google's value surpasses Microsoft's value, moving from the 5th largest holding to the 1st, the ETF will automatically adjust its holdings to reflect this change. Mutual funds, on the other hand, rely on a fund manager to make these decisions.

Historically, mutual funds have demonstrated lower returns compared to ETFs over their lifespans. In fact, a 2022 study by S&P Dow Jones Indices revealed that not a single mutual fund outperformed its benchmark index. This, combined with higher capital gains taxes due to active management and higher fees than those associated with ETFs, makes the case for choosing mutual funds over ETFs a challenging one. ETFs were created to offer investors the best possible returns, which they have consistently delivered.

The success of ETFs and other passive investment vehicles has been remarkable since their inception. Passive investments now comprise 37% of the US stock market. However, this has led to a lack of price discovery, evident in the top 5 companies of the S&P 500, representing 25% of the index's weight. As stocks increase in value, ETFs are compelled to purchase more, creating a cascading effect. While this has contributed to a reduction in market volatility over time, it has also resulted in sharper volatility during significant market swings.

Some critics argue that this investment approach dampens market dynamics. Nevertheless, the increased returns and lower fees provided to individual retail investors represent a net gain. Generally, no one aims to be average, but when mutual funds consistently fall below their benchmarks, embracing the benchmark and enjoying the average returns of its constituent companies is a considerable victory.

This is not investment advice. Image: https://freetrade.io/etfs/what-is-an-etf