Part 1

What is an ETF?

Don’t look for the needle in the haystack. Just buy the haystack!”

– John C. Bogle

The Exchange Traded Fund or ETF has been one of the more disruptive financial innovations in the last few decades. It has materially altered markets, investment strategies, and what options are available as investments. These instruments bring low-cost access to a wide variety of companies, currencies, and commodities.

They provide investors flexibility and multiple avenues for beating the market without the massive investment of time associated with active management. Just yesterday, Black Rock cracked $3 tn of ETF assets. That’s right, ETFs are that big. In a word, one of the significant benefits these funds offer is a higher level of diversification than was previously available at the single-security level. Yet, these instruments change just as a stock would.

What is an ETF?

Source: Ishares

You can enter the ticker in your brokerage and get exposure to the entire S&P 500 Energy Sector or Technology sector. Not only that, you can gain exposure to multiple risk dimensions. Suddenly, you own an Emerging Market ETF, a small-cap ETF, and a Semi-Conductor Equipment ETF.

The distinguished Mr. Bogle makes a solid point, but even his point is now a bit dated. The idea of sacrificing the good of specialization is no longer wholly relevant for ETFs. The specialization has increased so much with both assets invested and the number of ETFs exploding. Not only can you mimic assets, you can get leveraged ETFs, say you want 3x the return of the S&P 500 in either direction?

Well, you can get it. Whether or not the correlations will be worth the money is a different question altogether. One crucial metric by which to judge the efficacy and usefulness of an ETF is to gauge its correlation to the underlying asset.

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For example, in April 2020, when crude oil went negative, holders of the United States Oil fund were in for a rude surprise! We’ll give you some metrics and easy tools to compare ETFs to understand the relative value, volumes, and idiosyncratic risks. As the case of the United States Oil fund proves, it’s not always as simple as advertised.

Exchange-Traded Fund is a mouthful. They’ve been in existence for a few decades, but their prominence, as well as the prominence of passive investing, has risen in recent years. Generally, Exchange Traded Funds are passive vehicles whose primary goal is to as closely as possible mimic the pricing behavior or an underlying index, sector, industry, or group of related companies.

The passive nature of these funds allows them to have lower fees than actively managed mutual funds, and another significant benefit is for assets that have access issues, like, say, owning physical gold, can be easily financialized and turned into a ticker you can buy to get exposure. In a broad sense, ETFs have dramatically democratized access to a wide variety of assets sliced across multiple dimensions that were wholly unavailable to retail investors in the past.

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