What are ETFs and how can I invest in or trade them?
You know what the S&P 500 index is. It is an index that tracks the performance of a basket of 500 of the largest US companies. It is a number that can be used to know whether the US stock market was mostly up, down or unchanged. The weight given to each company in the index is not even but rather determined based on the free float market capitalization so that large companies have a correspondingly large influence on the index.
Let's assume that you have some money and you wanted to invest it in large US companies but you don't want to "put all your eggs on one basket" so to speak, so you decide that in order to diversify you want to create a portfolio for yourself and that this portfolio has to have the same performance as the S&P 500 index. Since you know how the index is constructed you can replicate it and create such a portfolio for yourself. You would need to take the money that you intend to invest and divy it up in 500 portions according to the weight given to each of the companies in the S&P 500. Then you can start buying each of the 500 companies with the money that has been allocated to each so that at the end you have a portfolio with 500 companies inside it that moves with the S&P 500 since you have all of its components.
As some companies become larger you would need to buy more of them and sell the ones that are getting proportionally smaller in terms of free float market capitalization (this is called rebalancing and is done to keep the right proportion of companies within the index). Even not considering the constant rebalancing of your "indexed" portfolio you can see how cumbersome it is to have to buy 500 different stocks (and the proportionally correct number of shares) just to replicate the performance of an index.
Wouldn't it be great if you could buy only one stock that would move exactly like the S&P 500 moves so that you don't have to buy all of its components?
Well, as you can guess, Wall Street has already thought of that and has created a product that does just that. ETF which stands for Exchange Traded Funds are exactly what the name indicates, they are funds that are traded on an exchange, just like a stock.
The idea here is that an ETF moves in exactly the same way as the index or basket of securities that it replicates. In our example, instead of buying 500 stocks and paying commisions for 500 transactions (and 500 more when you decide to sell) you would buy and sell only one product that essentially behaves like a stock (the actual construction of an ETF is rather complex but you don't need to understand that, only what you can do with it and how to do it).
So if you think that buying the S&P 500 is a good idea, then just go and look for the ETF that tracks the S&P 500 in this case it's called the SPDR (Standard & Poor's Depositary Receipts), or in trading lingo: the Spider (ticker: SPY) and buy it like you would a stock. One transaction, one commission and it will have the same performance as that of the S&P 500 so instant diversification across all sectors in the US all in a single transaction.
There are many ETFs of which SPDRs are probably the most liquid and the most well-known but the ETF universe is quite large now to the point where some of the most traded vehicles on a daily basis nowadays are actually ETFs. There are ETFs that you can get to replicate the performance of indices, sectors, foreign indices, bond performances, commodities and even ETFs that replicate the inverse of the performance of some other product (similar to selling short).
In the case where the securities underlying the ETF actually pay a dividend normally the ETF will pay it as well. The only thing with this is that since there are many companies in the ETFs all of them with different dividend payout dates normally the ETF itself will determine a dividend payout date consolidating all of those on a single distribution date. For example SPDRs (tracking the S&P 500 index) pay out a quarterly dividend but Diamonds Trust Series 1, normally referred to as Diamonds (ticker: DIA), which is the ETF that tracks the Dow Jones Industrial Average, have monthly Distributions.
In subsequent articles we will look at ETFs in more depth and see actual practical information about how to incorporate them to your investing and trading strategies.