This is the part of the newsletter where I try to provide some useful knowledge to people who are not yet so familiar with financial terms and concepts.

Since I have often mentioned ETFs and wrote about the S&P 500 index above, it is a good time to look at what exactly an ETF means and how it can be used by investors to diversify risk, while still taking part in the stock market.

The abbreviation “ETF” stands for Exchange Traded Fund.

In a nutshell, an ETF is a basket of several securities. It can be purchased and traded just like an individual stock, but it includes several securities and therefore offers the benefit of diversification.

Most ETFs are structured in a way, to track some equity index (such as the S&P 500). But they can also include other assets, such as bonds or commodities and track all sorts of investment strategies. Examples are:

• Stock Index ETFs (e.g. the SPDR ETF is tracking the S&P 500.)
• Industry ETFs
• Country/Region ETFs
• Commodity ETFs
• Bond ETFs
• Currency ETFs
• Even leverage ETFs (seeking to return more from gains of the underlying assets, but also incur more risk doing so).
• Or Inverse ETFs (betting on the underlying assets to decline).

Active Vs. Passive Investment

ETFs are often compared to Mutual Funds, which is another investment vehicle used for diversification. The difference is, that an ETF usually comes as a passive investment vehicle, which is structured to operate according to a certain predetermined strategy, whereas a Mutual Fund is mostly operated by active money managers.

According to modern portfolio theory and Fama’s EMH (Efficient Market Hypothesis), it is basically impossible for an investor to outperform the market by speculating on individual assets – except for pure luck.

I don’t agree with the EMH theory for multiple reasons, but just statistically speaking, it has been true that — on average — active investors have failed to beat the market. Therefore, following the S&P 500 index seems to be a good way to invest in the stock market. However, an individual investor usually can’t buy and continually rebalance the stocks to track the index. This problem is solved by mutual funds and ETFs.

Over the past 20 years, ETFs have seen rampant growth, while actively managed funds have been declining:

This trend has led to the amount of assets held by ETFs, surpassing that of actively managed capital. Last year marks the first time, that passively managed index funds have overtaken actively managed funds’. Passive funds now account for about 16% of the total U.S. stock market.

The reason for this trend is that ETFs:

• Can charge ultra-low fees.
• Are more liquid and can be traded daily.
• They are transparent in what exactly is tracked.
• Have tax advantages.
• Most importantly, on average active managers have not been able to outperform the market.

Thus, simply investing in the market and sticking to it has generally had the most successful outcome.

However, the past does not determine the future and there are also some specific risks associated with investing in ETFs. The proliferation of index funds, for instance, creates a situation where stocks that are included in an index gain in value just because of their inclusion and not because of actual fundamentals. Taking the position that the stock market is in a bubble, this would mean that there is probably also way more air in the stocks which are included in the major ETFs. Once the bubble bursts, the air could come out quickly and the ‘ETF-balloons” could deflate more substantially than the broad market.

Related article:

The S&P 500 Stock Market Index as a Key Market Indicator