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What is an ETF?

By  +Follow January 21, 2014 9:00AM
Tickers Mentioned:

It’s an age-old maxim that is as true today as it ever was: the majority of mutual fund managers fail to beat the market. More specifically, a mid-2012 survey by Standard & Poor’s found that 65 percent of fund managers trading large, blue-chip stocks failed to beat the S&P 500. In fact, the S&P Composite 1500 beat 89.4 percent of mutual funds over the year preceding the study. Oof.

But is that fair to the fund managers? Annualized returns for the S&P 500 are right around 10 percent on average, a rate almost any investor would have to be pretty happy with. Since its inception, the lowest average annual return for the index over any one 25-year period is 9.28 percent. Again, the lowest. The best annualized return over any 25-year period was 17.25 percent, and the median was 12.98 percent.

Whether or not this qualifies as an indictment of stock-picking as a whole remains up for debate, but anyone looking at the above numbers might come to a rational conclusion: why keep paying fund managers so they can try and fail to beat these benchmarks? What if you could just buy shares in the S&P 500 itself? Wouldn’t you rather just do that?

And the answer to that question came in the form of the Exchange-Traded Funds (ETF) designed to match the performance of an index, thus circumventing the question of outperforming “the market” altogether. Because, after all, if you can’t beat ‘em, join ‘em.

What Are ETFs?

Simply put, an ETF is a portfolio of stocks (or other assets, but more on that later) that are managed by a financial company, or issuer. That company then sells shares of the portfolio to the general public. Which is almost exactly what a mutual fund is.

The key difference in an ETF is that the company managing the portfolio, rather than attempting to maximize returns by selecting those stocks the managers like the most, is trying to replicate the movement of a specified target index. This is notable because it’s actually remarkably easy to do, unlike hand-picking a portfolio that beats the market.

So, for the SPDR S&P 500 ETF ($SPY), by far the most-traded ETF, the goal is to match the movement of the S&P 500. The managers carefully maintain a portfolio that has the same proportions of those 500 stocks as the index, and the results are a fund that tracks the S&P 500 to within tenths of a percentage point.

The same is true for the SPDR Dow Jones Industrial Average ETF ($DIA) and the, you guessed it, Dow Jones Industrial Average. And the Nasdaq Composite Index Tracking Stock (ONEQ) and the Nasdaq Composite. And, at this point, pretty much any other index you can think of and the ETF someone maintains to track it.

Does It Work?

And how do they usually do? Well, given the difference in scale, it’s virtually impossible to perfectly replicate returns, but the people designing ETFs have it down to enough of a science that they come darn close.

From early 2004 to early 2014, the S&P 500 rose 64.76 percent while the SPY gained 64.03 percent. And, from early 1994 to 2014, 20 years that span nearly the entire life of SPY, the index has returned 296.26 percent to the fund’s 294.23 percent. While not perfect, few investors are willing to quibble over those fractions of a percent each year.

The ETF Industry

ETFs have exploded in popularity since their introduction, with over 1,200 different products controlling more than $1 trillion in assets. With so many different options, one can make any number of very broad or very specific bets on a variety of different market conditions using ETFs. There are commodity ETFs to track commodity prices, bond ETFs that track the returns of baskets of bonds, and ETFs focused on very specific industries, like the Robo-Stox Global Robotics & Automation Index ETF ($ROBO), which specifically follows robotics stocks.

The industry for ETF issuers, those companies that take responsibility for creating and maintaining the funds, has also taken off and includes most of the traditional actors in the finance world. However, the most prominent issuer is probably State Street Corporation (STT) , which issues the ever-popular SPDR funds that cover most of the S&P’s sector-specific indices among others. Other major issuers include iShares (a subsidiary of BlackRock (BLK), Guggenheim Funds, Global X Funds, and the Vanguard Group.

Most Popular ETFs

The ETFs that trade the most shares on an average day illustrate the range of uses investors and traders alike have found for the instruments.

Certainly, many of the top 10 most-traded funds represent those offering a chance to make broad, relatively low-risk bets on large indices, like the SPY, the SPDR Financial Select Sector SPDR ($XLF), the iShares Russell 2000 Index ETF ($IWM), which tracks the Russell 2000 Index, and the PowerShares QQQ ($QQQ), which tracks the Nasdaq-100 Index.

However, some of the other high-volume ETFs represent a much more speculative, high-risk approach. The iShares MSCI Emerging Markets Index ETF (EEM) represents an investment in foreign, emerging market equities most would usually avoid in a risk-off environment, and the Market Vectors Gold Miners ETF ($GDX) is made up of gold mining stocks that tend to display wide moves in value in relation to the price of gold. And the iPath S&P 500 VIX Short-Term Futures ETN (VXX) tracks the volatile and little-understood VIX index.

ETFs: A Part of Most Balanced Portfolios

Ultimately, ETFs are a valuable investment and trading vehicle that are flexible and useful. Virtually any investor could most likely compliment their portfolio by understanding and utilizing them, provided that one’s familiar with what they are and how they best fit into a broader investment strategy.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.

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Results for SPY
27 Nov 14 18:37:09
RT @seeitmarket: Lots of new research, insights, and charts posted: http://t.co/ED9ukbUBcw | $SPY $QQQ $GLD $CL_F $F $CMG $STUDY
Chris Kochiya
27 Nov 14 18:35:04
$SPY --More support than resistance at current level, to me. May not "jump" higher, but may "inch" higher into year end.
PennyStock Zone
27 Nov 14 18:34:55
Is this stock analyst lucky or what? http://t.co/nGpJsAI10D #stocks #trading $SPY $STUDY $LNKD $LIVE #pennystocks
Kevin Brent Cook
27 Nov 14 18:21:09
"@bluebeechartAlerts: $SPY $MDY Stocks show strength http://t.co/Nv9Q8bdekr" Nice table! We bought $SCHM last month to capitalize on trend!
S&P Fractal
27 Nov 14 18:13:10
New $SPY alerts have recently been posted. Check them out now. http://t.co/gOixl7UWMz
Raziq Berrecloth
27 Nov 14 18:00:26
Today started to focus back to individual stocks instead of the indices. $SPY $QQQ $CYBR
Keith Santiago
27 Nov 14 17:47:34
Similarity between SP2013, Dow 1963/75 #stockmarket #trading #spx $spx $spy $nyse #cboe #euro #ftse $vix
27 Nov 14 17:46:50
Our Penny Stock Pick On $STTK Is Up 128.57% In 2 Days! Major Update: http://t.co/oR27rFfh2v $LEN $SPM $SPY
Emerentius Fuentes
27 Nov 14 17:40:25
RT @_thebigbadwolf_: $SPY Are U Holding 4 next week? #SPX #stocks #stockmarket #cac #dax #ftse
27 Nov 14 17:39:21
$SPY "Leveraged Rydex bull/bear asset ratio in“extreme optimism”for more than a year.Currently at new all time high" http://t.co/Ie7dxOkMrV
Aldrich Drake
27 Nov 14 17:37:53
Today started to focus back to individual stocks instead of the indices. $SPY $QQQ $CYBR
27 Nov 14 17:35:51
$T Reversed on Monday, 5% dividend in Jan, $36.00 short term target $1.00 upside. $SPY http://t.co/vJyIBI1UPc
Котовa Злата
27 Nov 14 17:33:53
RT @stock_champ: Looks like the bulls are in control now. $SPY $$
27 Nov 14 17:33:02
$TSX held up relatvly well today despite crude oil drop. Sign of strength? Much will depend on US open tomrw IMO #stocks $uso $spy #Canada
WallStreet Dope
27 Nov 14 17:32:44
Enjoying #Thanksgiving... Can't help but glance at #Bond prices and noticing the Yield is 2.23 #Recession is coming... $USO $SPY #Deflation
27 Nov 14 17:32:38
Anything contrarian I've ever done that was ultimately validated was initially shunned by others as uncool questioning the status quo. $SPY
TP Strategic Partner
27 Nov 14 17:25:21
$SPY If Saudi wants to increase demand for fuel, it is essential that they invest in World highwaay infrastructure. The traffic has to move.
TP Strategic Partner
27 Nov 14 17:21:52
$SPY Why is the Oil price dropping? To stimulate Gasoline Auto sales in Europe, China, U.S., Brazil.
Mwajuma Schultz
27 Nov 14 17:20:39
good luck today guys, i'm net short, and going to watch my son play soccer. enjoy the weekend. $SPY
Business Ventures
27 Nov 14 17:16:33
Top story: Lach14 - $SPY The OPEC meeting drops WTI below $70 $USO, $XLE, $XO… http://t.co/FfyqMQSJ2t, see more http://t.co/tg2jBvNZhg
27 Nov 14 17:10:23
$SPY Mid Cap Stocks show strength http://t.co/xtdMh2CKRy
27 Nov 14 17:04:57
Commented on: "Futures little-changed ahead of big day of data" http://t.co/ovX6CH5Ir2 $SPY $QQQ $DIA $SH
27 Nov 14 16:59:17
RT @ppprophet: Don't Let Greed Blind You, $SPX $DIA #stocks #stockmarket #trading #daytrading $vix $spy $tvix $vxx #cac #dax #ftse http://…
27 Nov 14 16:59:02
$SPY Large Cap Stocks showing strenght http://t.co/reCTg3xi5N
Griseldis Kyllford
27 Nov 14 16:56:31
SLV Rebound/Reversal in making great progress right now. Looking for it too keep heading higher. $GLD $SPY $QQ
27 Nov 14 16:54:32
$SPX 8 hour chart from 9/6 @ EWF http://t.co/h5ApAXJ2C1 #ElliottWave $SPY $DIA $QQQ #Trend #Cycles http://t.co/4Rkl3TJOXL
27 Nov 14 16:49:26
Crude at 68.59 down 5 points. http://t.co/8z1GNui4Nz $spy $fb $twtr $lnkd
TP Strategic Partner
27 Nov 14 16:48:30
$SPY All it takes for the Saudis to raise the price= An agreement with Russia to set the price at $127..00 Period.
Van Castle
27 Nov 14 16:47:07
RT @andrewnyquist: New Post - "S&P 500 Technical Update: Stocks At Key Resistance" http://t.co/XICo1uTjT0 $SPY $SPX $STUDY
TP Strategic Partner
27 Nov 14 16:46:34
$SPY Logic shows us a market of tiered pricing in Oil, Coal. The danger is the marginal 3% of production doesn't move a price 33%. Dngerous
Cari Short
27 Nov 14 16:39:48
Knew would be inactive beginning of '14 but my 12 risk stocks, 16.73% $SPY outperformance
Devlin Branch
27 Nov 14 16:34:15
hsmDOtzW2f Life as a trader is easier if you dont try to intellectualize the movement of prices $SPY $I
Bill B
27 Nov 14 16:32:58
$SPY hrly range I posted last wk providing support this week. SPY set up for a b/o, but w/o a rest, will likely fail. http://t.co/htZRuyz8QC
Lucinda Newborn
27 Nov 14 16:32:30
Should've added some more puts yesterday. $spy puts doing really well today.
Jay W. Jensen
27 Nov 14 16:32:05
RT @andrewnyquist: New Post - "S&P 500 Technical Update: Stocks At Key Resistance" http://t.co/XICo1uTjT0 $SPY $SPX $STUDY
Gurinder Langrick
27 Nov 14 16:29:59
Microcaps rocking today. $IWC up 1.5% versus 0.5% for $SPY.
Melaney Hailston
27 Nov 14 16:25:11
Markets looking heavy near term. Watching for pullback this week $DIA $SPY $QQQ $IWM
Pacienca Macparlan
27 Nov 14 16:14:51
Francestein: The Next European Shoe to Drop $SPY $DIA $VIX $QQQ #STOCKS #STOCKMARKET
27 Nov 14 16:10:59
And You Thought QE Was Over? http://t.co/MCZqWypq61 $SPY
Forex Status
27 Nov 14 16:04:04
$SPX 500, no signs of a bubble here: http://t.co/Vl9r6ZQIkj $ES_F $SPY
27 Nov 14 16:01:41
RT @OptiontradinIQ: Gift Ideas For Stock Traders http://t.co/tKW39bgnZd $SPY $SPX #options #trading
Options TradingIQ
27 Nov 14 16:00:31
Gift Ideas For Stock Traders http://t.co/tKW39bgnZd $SPY $SPX #options #trading
27 Nov 14 16:00:04
Steve Nurse
27 Nov 14 15:58:18
As soon as you can live off the grid, you should $FSLR $SCTY $VWS $DIA $SPY $QQQ http://t.co/mVdnKawNiN
Jake Catskill
27 Nov 14 15:53:44
$USO getting whacked après OPEC meeting. $XLE $OIH $SPY.
Пыжалов Владислав
27 Nov 14 15:52:55
RT @SocialStockRep: New pick coming soon! Stocks I am trading and watching now include: $hlf $iep $spy #stocks #pennystocks
Get R Dun
27 Nov 14 15:29:35
RT @sanglucci: Chopper city again. Scalp away folks. Social media has a slight bid wait for washouts on your calls before going in. $SPY
Who wants to know?
27 Nov 14 15:20:00
RT @sanglucci: Chopper city again. Scalp away folks. Social media has a slight bid wait for washouts on your calls before going in. $SPY
27 Nov 14 15:19:00
$SPX expectations and key price points http://t.co/z2CGthxT8S $SPY #SandP #S&P500 #stocks #options
Hager Garcia
27 Nov 14 15:18:54
3 Bad Reasons For Mutual Funds http://t.co/ROmO4Ze6J7 $SPY $VOO $FB $TWTR
By  +Follow January 21, 2014 9:00AM



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