What Is an ETF? | Finances

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Life and Finances, in Medicine.

What Is This About?

If you are beginning to invest, you will quickly encounter three letters: ETF, which stands for exchange-traded fund. An ETF is essentially a basket of investments that you can buy and sell. Instead of purchasing shares of a single company, an ETF allows you to own pieces of dozens, hundreds, or even thousands of companies at the same time. ETFs are one of the simplest ways to build a diversified portfolio, which is widely used to manage the risk of your investment.

Imagine holding a bunch of balloons with your arms closed. Some may move up while others may move down. Individual company stocks move in the same way. By holding an ETF, just like holding balloons with your arms closed, you can balance out some of this individual volatility, this upward and downward movement. The goal, nonetheless, is for the overall effect to be an upward movement (valuation) of your ETF. Diversification, however, does not eliminate risk. If the overall market or a particular type of stock goes down, the ETF can also lose value.

Why Should Medical Professionals Care?

How Does an ETF Work?

Instead of deciding whether to buy Apple, Microsoft, Amazon, or hundreds of other companies individually, you can buy one fund that owns many of them. That is essentially what many ETFs do. One very common example is an ETF tracking the S&P 500. If you buy this ETF, you own a tiny piece of 500 very large companies in the United States, chosen based on specific criteria. ETFs generally trade in the stock market throughout the day, just like individual stocks. Their prices change while the market is open. This is different from traditional mutual funds, for example, which are priced once a day, at the end of the trading day.

Passive vs. Active ETFs

Many ETFs are, for the most part, passively managed. I am a big fan of passive management. It is very useful, especially when you are a busy doctor. A passive ETF tracks the performance of a specific index, instead of relying on a manager or financial advisor continuously deciding which stocks to buy and sell. Larry Swedroe, in his book Enrich Your Future: The Keys to Successful Investing, explains in detail how financially efficient passive investment is.

There are also actively managed ETFs, nonetheless, where a portfolio manager selects investments based on your fund's investment strategy.

What Types of ETFs Are Available?

Broad-market ETFs: May hold hundreds or thousands of companies.
Market-cap ETFs: Focus on large-, mid-, or small-market-capitalization companies.
International ETFs: Invest outside the United States.
Sector ETFs: Concentrate on specific industries such as healthcare, technology, or energy.
Dividend ETFs: Focus on companies that pay dividends.
Bond ETFs: Hold government, municipal, or corporate bonds.
Other types: Commodity, currency, and other specialized ETFs also exist. They may carry additional risks.

The Bottom Line

An ETF is just a container. What matters is what is inside the container. ETFs may include hundreds or thousands of companies, providing diversification. But an ETF concentrated or specialized in a specific sector may behave very differently.

If you are a beginner, don't start by searching for the “best” ETF. Start by learning how to evaluate an ETF. Look at what it owns, how diversified it is, its expense ratio (we will shortly have an article about this), and how it fits in your portfolio.

If you decide to invest in an ETF, start with an amount you can invest consistently without disrupting your daily expenses, your debt payment, or your emergency savings. You do not need a complicated portfolio to begin. You need a sound plan, nonetheless. And the discipline to keep investing.

Key Takeaways

✓ You don't need to own all major company stocks individually. You can avoid plenty of headaches by using ETFs wisely.
✓ Before you choose an ETF, you need to understand what you own and why you own it.
✓ ETFs can be actively and passively managed. I personally chose the latter over the former.

“You need to understand the nature of the risks of an investment before you commit to it.”

Larry Swedroe

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