Lesson 5

ETFs: how to invest in hundreds of companies easily

To buy one share each of Microsoft, Apple and Amazon, you need more than 1000 dollars. How much do you think it would take to invest in the top 500 companies in the U.S.? If you want to buy each stock individually, you’re looking at several thousand dollars at least. But there’s a way you can do it with just a few hundred: invest into a fund or ETF.

Here’s what you will learn:

  • How funds and ETFs work
  • What investing into an ETF means
  • The different types of ETFs

How funds are organized.

ETF stands for Exchange Traded Fund. It is a basket of dozens or even hundreds of securities collected on a certain basis - from one industry or a single country. Most often the fund simply duplicates one of the world indices, for example the S&P 500, an index made up of the 500 largest U.S. companies by market cap. The management company buys the shares of all the companies in the index, collects them into a fund, and then offers a share in that fund.

This means buying one share of the fund means you’re investing — indirectly — in several companies at once. For example, the FXIT fund includes more than 80 shares of US technology companies, including such IT giants as Apple, Microsoft, Facebook, Visa, Intel, etc. Instead of buying the shares of all those companies separately, you can buy a share of the fund, and get the same return.

The price of the fund is directly correlated with the price of the index it tracks, or the companies in it. So if the S&P 500 rises 2%, the fund will rise around 2%.

Why not exactly 2%? There’s a few reasons. One is that the company might charge a management fee on the fund, which is calculated directly into the return. But the company might also lend out the shares to short sellers, collecting fees from them, which it invests back into the fund to offer the investors a better return. The fund might also have a tracking error, if the stocks in it are adjusted manually, there might be a delay between the fund and the index, which leads to the returns diverging slightly. Lots of ETFs are passively managed, which means the managers keep their hands off the fund. That usually leads to lower fees and commissions for the investor.

Making dividends ‍

So what about all those benefits of owning stocks, like voting rights and dividends. Do ETFs give investors those as well?

Partly. On the dividend side, ETFs pay out the full amount of the dividends that the companies’ they track issue. However, the ETF can decide whether to pay that amount in cash or in additional investment into the ETF. Either way, the benefit is passed along to the investor.

As for voting rights, that’s where things get a little trickier. While the ETFs may own company shares, the ETF investors only hold shares in the fund, which means no voting rights for all the companies in the index.

However, many of the companies that offer ETFs publish voting guidelines. For example, Blackrock, one of the world’s largest investment firms and offerer of ETFs, has a detailed guideline on how they vote at company shareholder meetings. If you’re concerned about how your investment will impact a company, you can look around and find an ETF where the issuer votes how you would.

Different types of ETFs

Funds are usually divided into equity (stock), bond, commodity (such as gold funds), and mixed, which include several types of assets at once. This is also true of ETFs.

Once you go a level below the funds that track a whole index, an almost infinite variety of sub ETFs becomes available. Management firms will take an index, like the S&P 500, and then choose all the companies in it that meet a specific criteria, and offer those in a separate ETF.

For example, the SPDR Information Technology ETF only picks the companies from the S&P500 that are part of the information technology sector, a Global Industry Classification Standard category. If you invest in this ETF, you’re investing in all of the information technology companies in the S&P500, and nothing else. That means if that sector outperforms the rest of the index, your returns are greater. If it underperforms, so does your investment.

You can find a type of ETF for almost any category. Whether it’s screening by sector, company size, percentage of female leadership, or anything else, chances are there’s an ETF that tracks it.

Because these kinds of ETFs have a narrower focus than a whole index does, they tend to be more volatile. An ETF that only invests in companies in the energy sector will be more affected by up- and downturns in that sector than a general index might. The management firms also tend to charge higher management fees for these ETFs, because they’re selected and maintained by human managers.

Alright, it’s that time again. Let’s see how much you picked up this chapter.

What's next?

It's time for a quiz!

You now understand the basics. Let’s test your knowledge, and then go a bit deeper.
Your result

It's time for a quiz!

You now understand the basics. Let’s test your knowledge, and then go a bit deeper.
Lesson 6

How to build a portfolio

Lesson 6

How to build a portfolio

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