A Brief Introduction to Exchange Traded Funds

An Exchange Traded Fund, (ETF) is a relatively new investment vehicle that has disrupted the stock market status quo of mutual funds.  Talking about mutual funds is beyond the scope of this guide, but they were essentially the only option for the average-joe investor before the advent of ETFs.  Let’s get an overview on what ETFs are.

An ETF Overview

An info-graphic that shows the benefits of investing in an ETF: Diversity, low fees, liquidity, and tax control

The benefits of investing in an ETF

What’s an ETF?

In all simplicity, an ETF is “a cheap way to distribute your risk”.  When it comes to the world of investing, high returns generally come with high risk.  However, there are ways to reduce your risk without significantly lowering your returns. An ETF is one way to do this.  Physically speaking, an ETF is backed by the stocks that the ETF managers invests in.  It’s like how the US dollar use to follow the gold standard (A long time ago, you could take a US dollar to the government and exchange it for gold.  Nowadays, the US dollar is backed by faith & trust).  Likewise, you can take shares of an ETF and exchange them directly for the underlying stocks that the ETF holds.  The value of the ETF is directly tied the stocks that make it up.  To better understand this concept, lets take a look at how ETFs are made.

How are ETFs made?

An info-graphic showing how ETFs are produced: by pooling together a group of stocks and issuing new stocks backed by the group of stocks.

Let’s say that you have 3 shares of company A, 3 shares of company B, and 3 shares of company C (9 shares total).  You can then create an ETF.  Let’s say that you issue 3 shares of your ETF.  Because the value of your ETF is directly tied to the stocks that make it up, each share of your ETF is equivalent to 1 share of company A plus 1 share of company B plus 1 share of company C.  Essentially, that’s how ETFs are made, except on a much larger scale.

ETF Characteristics

Back in the overview graphic, we talked about some basic characteristics of ETFs.  Lets go into more detail and thoroughly explain each characteristic and why they are important.

Diversification

We already know that ETFs are diverse because they are composed of multiple stocks.  But, why is that important?  Let’s find out through a little game.

The importance of diversification

Investing in a single stock or company is risky because any downturn in that single stock/company will cause significant loss to you.  To better understand this, lets simplify purchasing a company to a coin toss.  The coin toss will have the following characteristics:

  • The cost to flip a the coin will be $4 (purchasing a stock)
  • A tails will yield $0 (stock goes broke)
  • A heads will yield $10 (stock goes up)

An illustration showing a coin flip bet that cost $4 to play and has a reward of $10

Let’s analyze the coin toss to see if its a good bet.  We have a 50% of winning or losing (assuming that we are flipping a fair coin).  Thus, the expected value of this bet is 0.5*10 (the probability of winning times the value of winning) + 0.5*0 (the probability of losing times the value of losing) is $5.  Because the expected value, $5, is greater than the $4 it cost to flip, the coin toss is a good bet.  However, it may not necessarily make sense to take this bet.  After all, you still have a 50% of losing your entire investment ($4).  To better understand this, take a look at the graph below:

A graph comparing the probability of winning a certain amount of money in one coin flip

Now, let’s increase the scale a little.  Instead of $4, you have $400 to invest in this bet.  If you were to put it all on one coin toss (which is similar to investing everything into one company), you would have a 50% to lose $400, and a 50% to gain $600.  However, what if you chose to do 100 $4 coin tosses?  What would your graph look like then?  Well, after doing quite a bit of math, I can show you:

A graph comparing the probability of winning a certain amount of money after 100 coin flips.

The most likely outcome is that you get 50 tails and 50 heads, resulting in a gain of $100.  However, you won’t necessarily get this outcome as it has a little less than 8% chance of occurring.  However, one thing to note is that the probability of you losing money (that is ending the coin flips with less money than you started with, $400) is less than 2%.  This is way lower than the previous bet, where the probability of you losing money was 50%.  Essentially, ETFs work like our coin flip example.  You can replace each coin flip with a stock.  With many stocks under your ETF, your distribution of risk results in a significantly lower chance of losing money compared to purchasing a single stock (or taking a single coin flip).

Liquid – trades like a stock

ETFs are liquid because they can be easily converted into cash.  You can sell your ETFs during business hours on almost any stock exchange.  Here’s an example of doing so in a brokerage account with a single click:

A snapshot showing how to sell an ETF share.

Selling an ETF share

However, its important to note that some ETFs are more liquid than others.  The liquidity of an ETF is determined by how many people actively trade it each day along with its bid-ask spread.  Generally speaking, the higher the volume of an ETF, the more liquid it is.

Low fees

The costs associated with buying an ETF can be as low as zero on commission free funds, and go as high as $15 a trade on expensive brokerage accounts.  There’s another expense associated with purchasing an ETF called an expense ratio – however you do not pay this fee directly yourself.  I’ll explain expense ratios more in depth later in this post.

Tax Control

In order to discuss the tax control that ETFs give you as an investor, we need to first discuss how you are taxed on capital gains.  Basically, whenever you sell something for more than you bought it, you get taxed.  When you sell something for less than you bought, you get a tax deduction.  ETFs managers typically do not buy and sell underlying stocks very often.  This allows you to have control over when to take a capital gain or loss.

Analyzing ETFs

Before we dive deep into ETF analysis, let’s get an overview of a few basic elements that ETFs share in common.

An infograph

Expense Ratio

An expense ratio is a fee that managers of an ETF charge to cover their expenses.  You don’t pay this fee directly – instead the managers of the ETF will sell their underlying assets to raise enough cash to pay for their expense ratio.  The higher the expense ratio, the more money the managers will need to take from the fund.  Although you don’t pay expense ratio’s directly, they do impact you by lowering the value of your ETF.  To better understand this, let’s explain it with a real life example.  Now, I’m going to use PGX as the ETF for my examples.  I don’t recommend buying it (I’ve actually lost money on this ETF), but it’ll serve its purpose.

Real Life Expense Ratio Example

Below is a picture of PGX’s expense ratio, (typically you want to pay attention to net expense ratio, as this is what you’ll eventually be paying).

A table containing information about PGX, a preferred stock ETF.

I currently hold $1798.25 worth of PGX.

An image detailing exactly how much PGX I currently own, $1798.25 worth.

Because the expense ratio is 0.5%, the managers of PGX essentially sell about (0.005*1798.25) $8.99 worth of my shares each year as a fee for managing my money.  As a result, ETFs with higher expense ratios will end up costing you a lot of money in the long run.  As a general rule of thumb, it is a good idea to avoid ETFs with high expense ratios.

Yield

The yield of an ETF is essentially how much money it will pay you divided by its current market price.  Most ETFs will display this value as a percentage.  You can think of yield like an interest rate – the higher it is the more money you’ll earn.  However, you’ve got to be careful when simply chasing high yields.  Most of the time, extremely high yields are not sustainable (most ETFs cannot afford to keep paying out high dividends forever) so you should be suspicious if you see anything extremely high (7%+).  Let’s take a look at PGX’s yield.

Real Life Yield Example

As you can see below, PGX pays a dividend of about 7 pennies every month, and its price is $14.56 per share.

The monthy dividend yield for PGXA table containing the price of PGX as of 2/02/2017

Thus, by doing some math, we can calculate its dividend yield.  Every year, PGX will pay us (0.07*12) a $0.84 dividend.  Dividing that by the price of PGX gives us (0.84/14.56) a dividend yield of about 5.77%.  Basically, if we invested $100 into PGX, we would earn about $5.77 by the end of the year.  Now, this just an approximation, because the dividend & price of PGX fluctuate throughout the year.  However, this isn’t exactly what we earn, because our expense ratios lurk in the shadows of our ETFs.

As for myself, I’m currently earning (123*0.84) about $103.32 per year with PGX.

Effective Dividend Yield

However, the dividend yield displayed isn’t what we keep in the end.  Remember that we indirectly pay our fund managers through expense ratios.  I calculated before that I paid about $8.99 in expense ratio fees each year.  Subtracting that with what I earn from dividends (103.32 – 8.99) leaves me with about $94.33 in my pocket at the end of year.  Using this number, my effective dividend yield is actually closer to (94.33/1798.25) 5.25%.  For a shortcut to calculating this, just take the distribution ratio (interest rate the fund pays you) and subtract the net expense ratio.

Spread

The spread is the difference between how much sellers want to sell their stocks for and what buyers want to buy the stock for.  For example, if a seller is willing to sell a share for $15, but a buyer is only willing to purchase that share for $14, the spread is $1, ($15-$14).  Having a large spread is usually a bad thing because you are going to get the lower end of the stick whenever you want to make a transaction.  When you want to buy, you are going to be forced to pay the sellers price, and when you want to sell, you’ll be forced to sell for the buyers price.  It’s like dealing with a stubborn sibling who refuses to negotiate.

A cartoon showing a fight between two people who cannot come to an agreement.

Liquidity is a combination of spread and volume

The main reason that you should care about the spread / volume of your ETF is because it determines whether you can purchase/sell your shares at a fair price!  If your ETF has high volume and low spread, there’s a good chance you’ll be able to sell/buy at market price.  If your ETF has low volume and high spread, the price that you will be able to sell/buy at will be the short end of the stick!

PGX has huge volume (millions of shares are traded each day) and a spread size of pennies.  As a result, I’m able to purchase or sell shares of PGX for market value extremely easily.  If PGX didn’t have a high volume or a low spread, I wouldn’t be able to easily sell or purchase it for a fair price.

Distribution Frequency

Distribution frequency is how often a stock pays out a dividend.  PGX pays out a dividend every month, so its distribution frequency is monthly.  The vast majority of shares pay out distributions quarterly, or every 3 months.  The most common distribution frequencies are:

  • Annually (once a year)
  • Biannual (twice a year)
  • Quarterly (four times a year)
  • Monthly (12 times a year)

The best distribution frequency is monthly because it allows your money to compound faster.  What this means is that your money grows faster if you get paid sooner.   To illustrate this point, lets examine the growth of $10,000 earning 5% interest in accounts paid annually and monthly.  You can find the data for this graph here.

a graph comparing the annual and monthly distributions for accounts containing 10K earning 5% interest

The account that has $10K growing monthly earns more interest than the account that earns interest annually.  After a 5 year period, the results are as follows:

Time (Months) Annual Monthly
60 12762.8 12833.58679

Over a 5 year period, the monthly account earns $70.78 more than the annual account.  This happens because the monthly account allows its interest to earn interest faster than the annual account.  As a result, you generally want your distributions to be as frequent as possible.

Underlying Structure + Assets

There are 5 different structures that ETFs can use.  They are Open-end funds, Unit Investment Trusts (UITs), Grantor trusts, Exchange-traded notes (ETNs), and Partnerships.  Let’s get a brief overview of each type of structure:

An info-graphic detailing the 5 different ETF structures, Open end funds, Unit investment trusts, Grantor Trusts, Exchange traded notes, and partnerships

ETF structures are important because they affect your legal protections and how you will ultimately be taxed on your earnings.

Open-end Funds

The most common ETFs are Open-end funds, which typically hold stocks and bonds.  They are called open-end because they allow trading between their shares and underlying assets.  Authorized participants are allowed to trade the ETF shares for their underlying assets.  This helps keep the ETFs price in check.  However, this structure has difficulty holding alternative assets such as commodities and currencies.

Unit Investment Trusts

UITs are similar to open end funds in that they typically hold stocks and bonds.  However, the main difference is that there isn’t anyone in charge of the UIT – there is no management.  It simply invests in a bunch of securities and then pays out dividends to shareholders every quarter.  This typically means that UITs have less fees than most other structures.

Grantor Trusts

Grantor trusts differ from Open-end funds and UITs in that they are especially well suited to hold commodities and currencies (basically alternative investments).  They are commonly used for ETFs that hold precious metals such as gold or silver.

Exchange Traded Notes

ETNs are made out of unsecured debt.  The managers of the ETN hold notes, or obligations to pay back money.  The ETN makes money by collecting interest on their notes.

Partnerships

Partnerships are a special structure that allows for no taxation on profits.  This means that the Partnership has more money to pay out to you, the investor.  The downside to this is that partnerships usually require extremely complicated K-1 tax forms.  By investing in a partnership you trade simplicity for profit.

Discount / Premium

An ETF is trading at a discount when the market value is less than its underlying assets.  Likewise, the ETF is trading at a premium when the market price is more than the value of its underlying assets.  Typically, whenever a large discount / premium occurs, secret authorized participants exploit the difference by doing one of the following:

  • Purchasing shares of the ETFs and trading them for their underlying assets (when the ETF is trading at a discount)
  • Purchasing shares of the underlying assets and trading them for the ETF (when the ETF is trading at a premium)

They are essentially merchants, buying low and selling high.  However, because of these authorized participants, the discount / premium for ETFs rarely gets out of control which helps to maintain a stable market value for ETFs.

Ultimately whenever you are purchasing an ETF at a discount, you are purchasing it for less than its “fair market value” and vice-versa when purchasing an ETF at a premium.  However, it’s not always wise to purchase ETFs trading at huge discounts – there may be a good reason investors are running away!

How to get started

The best way to get started with investing in ETFs is to open a trading account at some financial institution. If you’d like a checklist to help you quickstart your investing, enter your name & email below!

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