W.T.F. Is An ETF?

Introduction

There is this book I finished earlier this year, which is called “Thinking In Bets by Annie Duke,” One of the things that stood out to me was the absolutism of people’s communication, even when they cannot say with total certainty what the next moment holds. Annie discusses how people, when communicating, lean into certainties of speech and get completely discombobulated when the future they thought they would receive in total certainty does not unfold in the manner that was hoped. It is either all or nothing. This has nothing to do with one's confidence in one's abilities; it is the consideration of as many data points and pieces of information that one has to draw from, and the fact is that one could be in the territory of known unknowns. As such, Annie Duke puts forward that we could add qualifiers to our certainty to allow for the possibility of being wrong and be aware of the very possible smaller percentage. That is to say that if we have an 80% certainty of an event occurring, we should state it that way: hope for the 80% but mitigate for the very real 20%. Her example of this was the fact that in the 2016 U.S. election, the polls showed Hilary Clinton to win by 65% and Trump winning by 35%, but the news station’s reputation was beaten as on Trump's victory, the media and their readers took that 65% as an absolute certainty and did not prepare for the very presence of the 35% Trump win.

That preamble was necessary to give a good foundation as to the logic of index funds. Your equities and commodities investment need not be a zero-sum game. You don’t necessarily need to have returns of upward of 50% if the risk is losing the entire value of your portfolio. Rather than taking one single bet on one single company, you should rather take numerous little bets on an entire asset class.

In fact, this is perfect for those who want to explore long-term investing and wealth preservation to weather these volatile times. A visual analogy of ETFs and index funds more broadly would be the comparison of betting/investing the entirety of one’s savings into one single company and betting/investing the entirety of said savings into all the companies within the basket. Yes, you could strike gold on a single company such as Nvidia of 2016/2019/2022 and make a thousand percent gains, but you could have also struck out by picking a company like BlackBerry, very much all or nothing.

With the current market volatility, your portfolio would most certainly have swayed a little too close to your top risk tolerance. As such you, like me are looking to mitigate your risks by diversifying your portfolio in order to de-risk it through a multitude of ways such as choosing to stay more cash-liquid or invest in government or corporate bonds.  You may have heard of what I am about to discuss in detail, it comes in many forms and has evolved over the years as a financial instrument. I think this would be the best time for me to discuss this form of investment called Exchange Traded Funds, which although similar to other index funds and mutual funds, there is a need to explore the particulars of this SPFV this is because, for the day trader and the long term investor, it has outperformed the best and brightest active fund managers as it simply mimics the market and the barrier to entry is much lower.

In plain English for those who aren’t finance wiz, rather than Simon (an imaginary person made for the purpose of the example) picking $500 worth of individual tech/finance/agriculture, etc. stocks to add to his portfolio, he buys one $500 ETF and leaves that do the work of tracking the shares that fit his industry exposure and risk tolerance. Think of index funds as a basket of equities, commodities, or other financial instruments that get you a better average because the catastrophic fall of one stock is averaged/hedged by the stratospheric rise of another stock.. It is what the great Warren Buffet categorizes as “The Do Nothing Rationale,” he believes in it so greatly that Buffett himself, in his will, is providing for his wife an index fund above an actively managed one.

An ETF [Exchange Traded Fund] is an investment fund that holds multiple underlying assets and can be bought and sold on an exchange, much like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of stocks. The fact that the underlying asset bundle itself trades as equity or like a stock is the major difference between an ETF and other types of index funds, such as a mutual fund that trades once per day

Index Funds

I think it would be right not to assume that it is widely known but to give a clear explanation of an index/tracker fund. As its name suggests, it tracks a particular investment market, such as a stock market index. The most popular one is the Standard & Poor’s 500 Index (The S&P 500), and there is also the Financial Times Stock Exchange 100 index (FTSE 100) these funds deliver broad exposure to the stock markets at a very low cost because there are no fund managers to pick stocks or make big investment calls. One thing of note about index funds is the fact that the stock/equity choices are variably “weighted,” which means the number of shares of Nvidia in Vanguard’s VOO is different from the number of Nvidia shares in the Vanguard 500 Index Fund Admiral Shares and the percentage by which each index is divided. Ergo, index fund one can have 300 Nvidia shares, but Nvidia is just 15% of the entire fund, and index fund two can have 20 Nvidia shares, but Nvidia is over 60% of the total index

For broad indexes like the S&P 500, it would be impractical or expensive to put in the right proportions on your own. Index funds do the work for you by holding a representative sample of the securities. S&P 500 index funds, the most popular and oldest such funds in the U.S., mimic the moves of the stocks in the S&P 500, which covers about 80% of all U.S. equities by market cap.

Besides the S&P 500, other major indexes followed by such funds include the Nasdaq Composite Index, made up of 3,000 stocks listed on the Nasdaq exchange; the Bloomberg U.S. Aggregate Bond Index, which follows the total U.S. dollar-denominated bond market; and the Dow Jones Industrial Average, consisting of 30 large-cap companies chosen by the editors of the Wall Street Journal.

Benefits of Index Funds

• Lower costs: Index funds typically have lower expense ratios because they are passively managed.

• Market representation: Index funds aim to mirror the performance of a specific index, offering broad market exposure. This is worthwhile for those looking for a diversified investment that tracks overall market trends.

• Transparency: Since they replicate a market index, the holdings of an index fund are well-known and available on almost any investing platform.

• Historical performance: Over the long term, many index funds have outperformed actively managed funds, especially after accounting for fees and expenses.

• Tax efficiency: Lower turnover rates in index funds usually result in fewer capital gains distributions, making them more tax-efficient than actively managed funds.

Differences between ETFs and Indexes

• Trading: One major difference between ETFs and index funds is the way they trade. ETFs trade on exchanges, meaning investors can buy and sell them like stocks during normal trading hours. Index funds, however, must be purchased and traded at the end of the trading day.

• Pricing: An ETF's price can fluctuate throughout the day as it trades like a stock. Investors can also buy shares of ETFs long or sell them short, which can impact the value of these equities. Index mutual funds are priced once a day after the market closes, when their net asset value, calculated by taking a fund's assets and then subtracting its liabilities, is calculated. Using this approach, a mutual fund's assets are determined by adding the value of the different securities in its portfolio.

• Tax efficiency: Investing in ETFs instead of index mutual funds can generate greater tax efficiency. Investors who hold these funds only pay taxes when they sell these securities. Investors who own mutual fund shares are liable for paying some capital gains taxes when these funds sell assets and realize a gain in the process.

• Accessibility: ETFs and mutual funds can offer differing levels of accessibility. More specifically, gaining exposure to an ETF requires purchasing only one share, while buying most mutual funds involves an investment of at least $500. In other words, investors can potentially gain exposure to an ETF with a smaller initial capital outlay than a mutual fund.

The Mechanics Of An ETF

There are two types of structures to a ETF, which are the Physical and the Synthetic.

Physical ETF

A physical ETF mimics the index by holding the same investments that make up the index that it is to track. The methods a physical ETF tracks an index is via full replication and partial replication. Full replication occurs when the ETF buys all of the assets in the index such as all the stocks in the FTSE 100 with an Ian to replicate identically the holdings of the index. Partial Replication (optimization or sampling) occurs when the ETF buys the main components of the index but not the index in its entirety. This is useful if the spread of the index is global, or the companies in the index are illiquid or the ETF is small.

An example (ETC) of the physical index could be seen in a physical exchange-traded commodity whereby the underlying commodity is gold. As such, the ETC would hold and own the gold, albeit through a custodian.

Synthetic ETF

A Synthetic ETF involves the ETF provider entering into a contract with a financial partner often called a counterparty. In essence, the ETF provider has an agreement with their counterparty to, if requested provide the basket of assets.

If the stock price of a company is affected by a myriad of external events but bolstered by its internal events, such as its fundamentals (Balance Sheets, P/E ratios, cash flow statements, etc.) Then, its value is hinged on the premise that its fundamentals put it in the right spot to be a good deal and eventually rise. In the same vein, the intrinsic value of an ETF is not just its price but the value of the cumulative assets bundled and not the fundamentals of any one asset is my summation. Furthermore, in the same way, a company can and often does pay dividends per share for owning a share of their company in the same way, if the underlying asset has stocks that issue dividends, the ETF itself will pay the owner a dividend.

Tracking Error

This is one of the key considerations when looking at a tracker fund, along with financial security and charges. The tracking error is the deviation of a tracker fund from the index it is tracking.

Tracking differences, or performance variation, between the fund and index, is caused by charges - an index makes no allowance for charges  and also by the fact that the holdings in the tracker fund may not be identical to the index it is tracking.

Synthetic ETFs normally have the lowest tracking errors - the tracking error of a synthetic ETF is only caused by the costs associated with the underlying swap agreements. Fully replicated ETFs are the next most efficient trackers of an index and, as you may expect, partially replicated ETFs tend to have the largest deviation from their index.

Types of ETFs

• Passive ETFs: Passive ETFs aim to replicate the performance of a broader index—either a diversified index such as the S&P 500 or a more targeted sector or trend.

• Actively managed ETFs: Do not target an index; portfolio managers make decisions about which securities to buy and sell. Actively managed ETFs have benefits over passive ETFs but charge higher fees.

• Bond ETFs: Used to provide regular income to investors. Distribution depends on the performance of underlying bonds which may include government, corporate, and state and local bonds, usually called municipal bonds. Unlike their underlying instruments, bond ETFs do not have a maturity date.

• Industry or sector ETFs: A basket of stocks that track a single industry or sector like automotive or energy. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with growth potential. BlackRock's iShares U.S. Technology ETF (IYW), for example, tracks the Russell 1000 Technology RIC 22.5/45 Capped Index.

• Commodity ETFs: Invest in commodities like crude oil or gold. Commodity ETFs can diversify a portfolio. Holding shares in a commodity ETF is cheaper than physical possession of the commodity.

• Currency ETFs: Track the performance of currency pairs. Currency ETFs can be used to speculate on the exchange rates of currencies based on political and economic developments in a country. Some use them to diversify a portfolio while importers and exporters use them to hedge against volatility in currency markets.

• Bitcoin ETFs: The spot Bitcoin ETF was approved by the SEC in 2024. These ETFs expose investors to bitcoin's price moves in their regular brokerage accounts by purchasing and holding bitcoin as the underlying asset. Bitcoin futures ETFs, approved in 2021, use futures contracts traded on the Chicago Mercantile Exchange and track the price movements of bitcoin futures contracts.

• Ethereum ETFs: Spot ether ETFs provide a way to invest in ether, the currency native to the Ethereum blockchain, without directly owning the cryptocurrency. In May 2024, the SEC permitted Nasdaq, the Chicago Board Options Exchange, and the NYSE to list ETFs holding ether. And in July 2024, the SEC officially approved nine spot ether ETFs to begin trading on U.S. exchanges.

• Inverse ETFs: Earn gains from stock declines without having to short stocks. An inverse ETF uses derivatives to short a stock. Inverse ETFs are exchange-traded notes (ETNs) and not true ETFs. An ETN is a bond that trades like a stock and is backed by an issuer such as a bank.

• Leveraged ETFs: A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. If the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF would lose 2%). These products use debt and derivatives, such as options or futures contracts, to leverage their returns.

The ETF Is Born

Parallel to the development of index funds, advances were made in trading technology and financial engineering. In the 1980s, stock index futures and options were introduced, allowing investors to hedge or speculate based on the anticipated future values of stock indexes.

In 1990, investors on the Toronto Stock Exchange could begin buying shares in the Toronto 35 Index Participation Units (TIPs 35). This warehouse, receipt-based instrument tracked the TSE-35 Index, essentially a Canadian ETF. Three years later, State Street Global Investors launched the S&P 500 Trust ETF (the SPDR or "spider" for short, SPY), the first American ETF. It remains the largest fund in the world, with over $500 billion in assets. Although the first American ETF launched in 1993, it took 15 more years for the first actively managed ETF to reach the market. From one fund in 1993, the market grew to 102 by 2002 and almost 1,000 by the end of 2009. Barclays entered the ETF business in 1996, and Vanguard began offering ETFs in 2001. As of 2024, there were over 12,000 ETFs available worldwide, with about 600 different fund management companies providing them.

ETFs on the Rise

If the launch of mutual funds available to the public was initially known as a folly, at least it received public notice, which can't be said of the launch of ETFs in 1993. Trading remained relatively low throughout the 1990s despite the massive growth of the dot-com era. By 2000, ETFs had assets that were barely 1% of those of mutual funds.

But this would begin to change, not least because many in the investing community saw ETFs—traded on U.S. exchanges like any stock—as a way to provide access through regulator brokerage accounts to off-exchange assets. Previously, you would have to find a specialized broker to help you, say, trade in the commodities markets. You could now trade in gold indirectly by purchasing shares that represented fractional ownership of an ETF that held it in its portfolio.

In the 2000s, there was a vast expansion of ETFs into new asset classes and strategies, transforming them from a niche product into a fundamental tool for both retail and institutional investors. The decade began with ETFs primarily focused on broad market indexes. In 2001, the iShares MSCI EAFE ETF (EFA) began trading, providing exposure to international stocks (excluding the U.S. and the Republic of Korea) and making it far easier to diversify across the globe with a single purchase of shares. Around the same time, bond ETFs gained popularity—it's still the second-most traded type of ETFs after equities—with the introduction of the iShares Barclays Aggregate Bond ETF in 2002. In 2004, the SPDR Gold Shares (GLD) ETF gave exchange-traded access to commodities for the first time. A year later, currencies were included when the Euro Currency Trust (FXE) ETF debuted, offering investors the ability to hedge or speculate on changes in foreign exchange (forex) rates.

ETFs were also becoming funds with strategies far more advanced than passive investing. Investors had new sophisticated tools to magnify their returns or profit from market declines. For example, in 2006, ProShares launched its first leveraged and inverse ETFs, offering two times or negative two times the daily returns of market indexes. These tools were particularly appealing during the volatile market conditions leading up to and following the 2008 financial crisis.

The rapid growth of the ETF industry also brought regulatory attention. In 2008, the U.S. Securities and Exchange Commission (SEC) began a rigorous review of them, especially those using derivatives and complex strategies. Despite SEC concerns at the time, the flexibility and range of ETFs continued to attract a broad base of investors. By the end of the decade, the number of ETFs had grown exponentially, and the assets under management (AUM) for U.S. ETFs surged toward the $1 trillion mark.

Most Popular ETFs

If you’re staring at your brokerage app, unsure where to begin, start with a well-rated S&P 500 ETF. It’s like buying the market’s greatest hits album. Not every track will be a banger, but the average performance will beat most solo acts. Below are some popular ETFs. Some ETFs track an index of stocks, thus creating a broad portfolio, while others target specific industries.

• SPDR S&P 500 (SPY): The oldest and most widely known ETF tracks the S&P 500.

• iShares Russell 2000 (IWM): An ETF that tracks the Russell 2000 small-cap index.

• Invesco QQQ (QQQ): Known as "cubes," tracks the tech-heavy Nasdaq 100 Index.

• SPDR Dow Jones Industrial Average (DIA): Known as "diamonds," tracks the 30 stocks of the Dow Jones Industrial Average.

• Sector ETFs: ETFs that track individual industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).

• Commodity ETFs: These ETFs track commodities, including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).

• Country ETFs: Funds that track the primary stock indexes in foreign countries but are traded in the U.S. in dollars. Examples include China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Others track foreign markets across multiple countries, such as emerging market economies (EEM) and developed market economies (EFA).

Conclusion

So, W.T.F. is an ETF? It’s a tool. A simplifier. A modern-day basket of bets, dressed up in ticker symbols and traded like stocks. It’s what happens when the poker table Annie Duke talks about meets the practicality of diversification and the humility to admit—maybe, just maybe—you don’t know which horse will win the race, but you can still bet on the whole damn field.

Whether you’re trying to survive volatility or ride momentum, ETFs offer a middle ground. They let you play offense and defense at the same time. They let you participate in markets with precision or with breadth. And most of all, they remind you that investing isn’t about being right all the time—it’s about being right enough, often enough, while managing your downsides like a disciplined degenerate.

So next time you hear someone throw out the term “ETF” in a conversation—at a brunch table, in an earnings call, or in some TikTok explainer with bad background music—you’ll know they’re talking about a structure that wraps diversification, accessibility, and strategy into one clean product. And now, so will you.

The game has changed. Your portfolio should too.

Disclaimer: I must state that the information contained on this website and the resources available for download through this website are not intended as, and shall not be understood or construed as, financial advice. I am not an accountant or financial advisor, nor am I holding myself out to be, and the information contained on this website is not a substitute for financial advice from a professional who is aware of the facts and circumstances of your individual situation. I have done my best to ensure that the information provided on this website and the resources available for download are accurate and provide valuable information. Regardless of anything to the contrary, nothing available on or through this website should be understood as a recommendation that you should not consult with a financial professional to address your particular situation. Read It And Eat News Corp expressly recommends that you seek advice from a professional. Neither the Company nor any of its employees or owners shall be held liable or responsible for any errors or omissions on this website or for any damage you may suffer as a result of failing to seek competent financial advice from a professional who is familiar with your situation.

I am a Barrister and Solicitor of The Supreme Court of the Federal Republic of Nigeria with a Master’s Degree in Law, who is 6ft 5in, 130kg+ on a good day and well-versed in the art of hand-to-hand combat for self-defensive purposes. I am also in no way, shape or form vying or marketing a particular ETF, all stocks, shares and tips are not to be considered as investment advice.