What is an Exchange Traded Fund?



An exchange-traded fund (ETF) is a basket of securities – stocks, bonds, commodities or a combination of these – that you can buy and sell through a broker. They are as easy to buy as stocks. ETFs offer the best attributes of two popular assets: mutual funds and targeted funds.


They can create the diversification you want if you want to own a specific sector without having to buy unique individual stocks in order to accomplish this.  ETFs become your sector stock picker.  They buy the best performing stocks in a sector or group or targeted product.


An ETF provider (like iShares or VanEck or First Trust) owns the underlying assets, designs a fund to track their performance, and then sells shares in that fund to investors (you). Shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. Investors in an ETF that tracks a stock index get lump dividend payments, or reinvestments, for the stocks that make up the index.


While ETFs are designed to track the value of an underlying asset – be it a commodity like silver, wheat, cotton, or a basket of stocks such as the Nasdaq 100 – they trade at market-determined prices that usually differ from that asset.


ETFs also incur expenses in order to exist, so the longer-term returns for an ETF will vary from those of the underlying asset it’s trying to mimic.


To fully explain, if you wanted to own gold for example, you could buy physical, buy GC (gold continuous) future contracts, or GLD (the ETF) that mirrors the gold price. You may get a slightly better return if you were to hold the underlying asset itself, but it would require extreme amounts of liquidity (cash) in order to transact that trade/investment. ETFs are a vehicle of convenience more than anything and they’re also heavily traded, so in most cases, they give you good access to enter/exit.


However, you also have to understand the downside risks of ETFs. In some cases, like QQQ (the Nasdaq 100 proxy ETF), there may be shares of Apple that are rehypothecated. This means that QQQ may own shares of Apple and 50 other ETFs may own shares of Apple too. So, since ETFs are required by their laws and organization documents to liquidate underperforming stocks and rebalance daily, then there might be massive amounts of Apple shares that go for sale at the same time as these. If every one of these ETFs sells the same asset at the same time…you could have a very serious problem.


Here’s a real-life example:


(**Note: in this example we’re referring to an exchange traded note [ETN], which is slightly different than an exchange traded fund, but we won’t addresses the differences here as the outcome is the same for both an ETF or ETN).


In February of 2018, the exchange traded note that shorted volatility, known as XIV, blew up. One day when the market closed, there was a volatility event in progress that caused the rebalancing of the underlying components of XIV.  There was no way to do this based on the by laws and organization documents of the ETN. The ETN lost 93% of it’s value overnight and the ETN was closed a couple of weeks later. All shareholders of the ETN lost their investment.


Know what your holding. It is a big deal.