ETFs(Exchange Traded Funds)📈📊are the middle product in stock trading. Above them are Indexes and below them are equities.
ETFs follow Indexes but act more like equity.
First, what is an Equity Index?
An equity index is a bunch of stocks with a common theme either representing a certain industry, market etc. ⠀⠀
To purchase stocks in an equity index you will need to purchase hundreds of stocks and buying each stock in the equity index will incur separate broker commision charges for each. ⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀⠀
Equity indexes are also hard to track or price as stock prices of the different companies can move in different directions at the same time. This makes it very hard to also trade the equity fund as the stocks move in different directions.
What is an ETF?
This led to the creation of the ETF which essentially is an index based investment that follows a particular commodity, bonds, or a basket of assets like an index fund. So if the correlating index goes up, the ETF will go up to.
This method means the investor does not have to own all the underlying stocks as the ETF does and divides them into shares so investors can still trade them indirectly by buying an ETF which follows a particular market.
ETFs simply follow the correlating index and mimics their performance. The goal isn't to outperform the index but rather mimic it.(There are some exceptions to this with leveraged and inverse ETFs). ⠀⠀
What separates ETFs from Indexes and equities?
ETFs are a portfolio of companies, so their stocks cannot be traded independently unlike equities or indexes. When you buy an ETF, you essentially buy shares in a portfolio of companies.ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. You can buy an ETF through the stock exchange or via a broker.
ETFs are basically an easy and cheap way to get exposure to a sector that would be very difficult to access.
Example of an ETF in practice.
If you wanted to invest in gold you would have to buy physical gold or melt down the gold you currently have and then sell it when the price is right. This will take much time and there is no guarantee there would be a buyer waiting to buy your physical gold from you.
You could instead simply invest in shares of the GLD ticker which is an ETF that follows the market price of Gold. This will be much cheaper and take less effort.
If you wanted to buy an index such as the DOW JONES as you predict the whole DOW JONES market will go up you could either by shares(or a share) of each of the 30 companies that makes up the DOW JONES or you could buy shares of an ETF that follows the DOW JONES such as the DIA.
You will still get exposed to the DOW JONES but at a much cheaper price and less stress.