What are ETF’s and How Can I Make Money with Them?

As you explore different investment opportunities you are bound to come across something referred to as an “ETF” or “Exchange-Traded Funds”. Typically a more conservative investment, it can be a fantastic way to get the benefits of investing in the market without as much risk of losing all your money. There are some trade-offs when it comes to investing in an ETF but let’s discuss more about why you would want to invest in one and what exactly you are investing in.

Why Choose an ETF

First, let’s discuss the difference between investing in an ETF and investing in a normal stock. At a high level, when you buy a stock, you are purchasing a small part of ownership in that company. When you purchase an ETF, you are buying a small portion of many different companies. There are many different ETFs and each one is structured a little differently but essentially when you buy an ETF you are purchasing a small portion of every company the ETF is involved with. Where an ETF is beneficial is instead of having to make individual purchases
for each company you may want to invest in, you can find the right ETF for you and only purchase it but take advantage of many different companies at the same time!

So what kinds of ETFs are out there? There are so many different ones out there and some are still being created today. Some ETFs invest in energy companies, others invest in the automotive industry, some invest in real estate, and some include every company in the S&P 500. Every ETF will have a list of companies they own along with what percentage of the ETF consists of that company. It’s normal to see many different companies that only makeup 1 or 2% of an ETF.

Here is another way that an ETF could be a good investment option. Let’s say you believe that solar energy is going to be huge in the next 5 years. With normal stocks, you would have to research every solar company and figure out which one you wanted to “bet” on to take advantage of any growth over the next few years. With ETFs, you could invest in all of them equally and not worry about picking the “wrong” one. Companies can be in a field that experiences growth and still go bankrupt, so ETFs help minimize those risks. If 1 company in an ETF goes bankrupt, it is unlikely to drop the overall price of an ETF (since it probably only consists of 1 or 2% of the entire fund). You must also consider the flip side of that statement though when talking about growth. If only 1 company in an ETF increases in value, you are unlikely to see a huge jump in the overall value of the ETF you are invested in.

How are ETFs Created

Let’s talk about how an ETF is created so we can discuss the “Price to Book” value or P/B. When an individual or organization decides to create an ETF, they purchase the underlying stock and put it into a fund. That fund then gets approved and becomes an ETF. This is an
oversimplification, but we’ll use it for illustrative purposes. So if this entity wanted to invest in the automotive industry, they may buy millions of dollars worth of all the big automakers (Ford, Toyota, Tesla, GM, etc.). Once they have purchased these stocks, they create an ETF under the ticker symbol “AUTO”. Now investors can purchase shares of “AUTO” for the price the fund is worth divided by the number of outstanding shares (Ex: if the fund has $1,000,000 worth of shares and there are 10,000 shares issued then each share would cost $100). Now once these shares are purchased, they can be bought and sold on the market like any other stock and the price can go up or down based on demand. Where it gets interesting is each share should only be worth the value of the assets divided by the number of outstanding shares, but this isn’t always the case. Price to book value tells us how much an ETF is trading at compared to its actual value. If an ETF is trading in the negative, then shares are less than what they are worth. If they are in the positive, then shares are overvalued.

Should I Invest?

So what should you look out for when investing in an ETF? You should always check on fees and commissions and ensure you aren’t paying too much. Most ETFs are passively managed so fees should be on the lower side compared to actively managed funds. Another thing is to look at the mix of companies and the percentage of ownership of each. Some ETFs have different percentages for each company and others try to keep them all equal (this is important because if an ETF has a higher level of ownership in one company, the fund is more likely to go up or down based on that company). You should also look at whether the ETF pays a dividend or not.

There are many great ETFs out there and we would encourage you to research them as they can be great additions to any investment portfolio. Some examples would be VOO (probably one of the most popular ETFs that invest in the entire S&P 500), NOBL (contains companies that are “Dividend Aristocrats” or companies that have increased their dividend payments every year for at least 25 years), CARZ (as opposed to the fictitious example “AUTO” used above, CARZ is an actual automotive ETF), USA (a more technology-heavy ETF that aims to pay about a 10% dividend every year) and SPY (An ETF similar to VOO that matches the S&P 500). Just like any investment, however, there is always a risk that you could lose value so please make sure you do your research before investing in any ETF.