What is an ETF?

Posted by Andrew Gordon on March 28
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ETF stands for Exchange Traded Fund. This can be broken down into two parts. The first part is “Exchange Traded” and the second part is “Fund”. Let’s start with what a fund is.

Fund

To understand what a fund is we need to know what shares and bonds are. This video explains what a share is, and this video explains what a bond is. Shares and stocks are essentially the same thing and the words are used interchangeably in the finance industry. Now that we know what shares and bonds are, we can learn what a fund is by watching this video.

One of the most popular types of investment funds is a mutual fund. This allows many investors to pool their money together and let a fund manager invest in many stocks and bonds for them all. All the investors contributing to the fund get to benefit from diversification. Before mutual funds it would have been hard for the average investor to achieve such levels of diversification as they would have had to buy all the stocks and bonds themselves for their portfolio.

The first mutual fund dates back to a Dutch merchant in the 1770s.  However, the first modern mutual fund as we know it today appeared in Boston in the 1920s and was called the Massachusetts Investor’s Trust.

The first index fund, which is a type of mutual fund that aims to track a market index such as the FTSE 100 dates back to the 1970s. It is these index funds that laid the ground work for ETFs.

Whilst mutual funds were revolutionary when they first launched and have evolved since then, they still do have some downfalls which can include being typically quite expensive and not always transparent as to what they hold. Another main disadvantage is that they can normally only be bought or sold once a day and hence can only be bought or sold for one price a day.

 

Exchange Traded

This means that the security can be traded on an exchange, but to understand this fully we must understand what an exchange is. An exchange is a place where buyers and sellers can come together to “exchange” goods with each other.

In the context of a stock exchange, it is a place where people can buy and sell stocks. The most well-known stock exchange now is the NYSE (New York Stock Exchange) which was created at the end of the 18th century. The NYSE, however, was not the first of its kind, stock exchanges date back as far as the 16th century in Europe.

Stock exchanges used to be physical places where buyers and sellers would come together to shout their prices and orders in an open outcry format, but from the late 1960s they started becoming increasingly electronic. Nowadays nearly every stock exchange in the world is electronic so rather than being physical pits they are now on computer servers. When a stock is listed on an exchange it means that while the exchange is open, investors can get live prices of what they can buy or sell the stock for and then make a decision if they want to make a trade to buy or sell.

 

How do the two come together?

As discussed above stocks can be bought and sold at any time during the trading day on the stock exchange. ETFs work in the exact same way. Their prices are updated constantly throughout the day and can be bought on stock exchanges, hence the “Exchange Traded” part of their name. But rather than buying a share of a company, it is a share of a fund that tracks an index that you are buying, hence the “Fund” part of the name. Put the two together and we get “Exchange Traded Fund”.

ETFs are typically much cheaper and more transparent than mutual funds and can be bought and sold throughout the trading day. The first successful ETF was the S&P 500 Trust ETF created by State Street Global Investors in 1993, and it is still one of the most popularly traded ETFs today.

 

Example of an ETF we use at Moola

One ETF we use at Moola is the iShares FTSE 100 UCITS ETF. In this example iShares is the ETF provider and the index the ETF tracks is the FTSE 100 index. The FTSE 100 index consists of stocks of the top 100 publicly traded companies in the UK as measured by market capitalization (how big they are). So, when you buy a share of the FTSE 100 UCITS ETF what you are buying is a fraction of a share of each of the companies in the FTSE 100.

You can buy or sell this ETF on the London Stock Exchange any weekday between 8.00am and 4.30pm. You can also buy it on other stock exchanges in Europe.

To find out more about why we use ETFs at Moola click here.

 

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Written by Andrew Gordon

Andrew is the Head of Algorithmic Trading at Moola. He previously worked on the ETF Trading Desk for three and half years at Susquehanna International Group, a global quantitative trading firm. Andrew has a degree in Finance from Queen’s University Belfast.

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