Investing Basics: ETFs

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Narrator: An exchange-traded fund, or ETF, is an investment fund that trades like a stock. ETFs, like other types of funds, pool together money from investors into a basket of different investments, including stocks, bonds, and other securities.

By spreading the fund's money into different securities, ETFs can generally provide investors with diversification, which can help manage risk.

And because ETF shares are traded on a stock exchange, they're bought and sold like stocks and may incur commissions. It's also worth noting that an ETF's market price may differ from the total combined value of its holdings, known as its net asset value, or NAV. These discrepancies are due to the way ETFs trade and track the value of their component investments and are typically minor.

Just like there are a variety of mutual funds, there are a variety of ETFs, each with its own stated objective. Some ETFs invest in stocks; others may invest in bonds or other assets. Some may seek to replicate the performance of a broad market index like the Dow Jones Industrial Average^® or S&P 500^®.

Other ETFs may track the performance of a particular sector or industry like information technology or pharmaceuticals. The level of diversification an ETF provides depends on the index it tracks. For example, ETFs that track a specific stock sector would offer less diversification than one designed to replicate a broad market index.

Let's look at an example of investing in an ETF. Suppose an investor wants to make a diversified investment that is designed to mirror the performance of a major stock index like the S&P 500. After researching different ETFs and finding one that meets their objective, they purchase shares of it just like they would an individual stock.

Now that they own shares, the investor has exposure to each of the fund's basket of investments while only having to purchase one ETF. This can save an investor research and analysis time.

So how can investors potentially profit from an ETF? Similar to a stock, they can earn a return two ways: a rising underlying asset price and dividends. Typically, if the value of the ETF's investments increases, so does its price. If an investor purchased a hypothetical ETF at $40, and a year later it was selling for $50, the investor could profit $10 per share by selling the position. Of course, if the ETF's price dropped, the investor would've lost money if the position was sold at the lower price.

Because most ETFs are traded on a stock exchange, they can be bought and sold throughout the day. However, not all ETFs are widely traded, which can cause difficulty when trying to fill orders.

Separate from changes in price, an investor can potentially earn income if the ETF pays a dividend, which is a payout of part of the fund's earnings and capital gains. One of the ways to tell whether a fund pays dividends is to look at what's called its dividend yield.

On-screen text: Dividend divided by ETF price equals dividend yield.

Narrator: This yield is the amount that a fund pays out compared to the current market price of a share. Just keep in mind, dividend yield is not the only way to measure an ETF's performance. You'll also want to consider the ETF's standardized performance as well.

Another factor to consider when evaluating ETFs is the expense ratio. This is a fee charged annually by the fund to cover its management costs. High expense ratios can eat into profits.

There is a wide variety of ETFs that invest in assets like corporate bonds, domestic and international stocks, commodities, and currencies, among many other investments. While these assets and the ETFs that track them carry unique risks, ETFs offer investors a practical way to analyze and potentially find opportunities in a number of markets.

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