So there I was, chilling at Victory Square in the beautiful city of Timisoara, Romania with a colleague of mine, when he asked me to explain what an ETF is. (I lent him my copy of Sam Beckbessinger’s Manage Your Money Like A F*cken Grownup to read on the plane.)
My colleague is a health nut, so I decided to use a health-related analogy to explain.
The health-conscious amongst us have different ways of structuring our diets. You could be vegan, vegetarian, pescatarian, high-carb or low-carb, each with its own criteria of what to eat and what not to eat. In the world investing, this is called methodology. The type of diet you need to follow could be likened to the type of investment exposure you would like.
To buy food, you’ll go to the supermarket. In the investment world, the supermarket would be the stock exchange (also referred to as the market).
Your shopping basket could be filled with a wide variety of items, or a few items, based on the criteria of a specific diet. Each of the different items in the basket is priced individually. To keep track of the total cost of the entire basket, we consider the average price of the foods in the basket. This average is called an index.
Let’s imagine for a moment that you can only buy one product per trip to the supermarket. For example, you can only buy bananas. You can, however, buy as many as you want, but you can’t buy bananas and apples and kale during the same trip. You would have to make three trips to get those three. In investing, these “trips” are the transactions. Just as you would have to spend money on petrol or a taxi to get to the supermarket, you would have to pay a broker or financial services provider to perform transactions.
However, you can also buy a hamper with all three items in one trip, saving you time and money. Now the people who put the hamper together also charge a fee. In the world of ETFs, they’re called ETF providers and the hamper is the ETF. The fee they charge is called a total expense ratio (TER) or total investment cost (TIC).
In the basket, you might find three bananas, two apples, eight carrots and half a watermelon. This quantity is called weighting. Most people would simply use popularity as a means to decide how much of each to buy. This popularity is called market cap. The market cap is calculated by multiplying the number of shares available in the market by the share price.
The food items in the basket are the different shares/companies in the market. You get the same benefits (dividends, capital gain, etc.) from buying the entire basket as you would buying the companies in the basket individually. However, buying the entire basket means you do so at a fraction of the cost because you pay fewer transaction fees. And in the investment world, fees matter.
Njabulo Nsibande is a Just One Lap user-turned-contributor. His “Cash Club” blog details his experiences balancing the financial obligations of a young parent with his investment aspirations.
Njabulo is a founding member of an investment club. In this blog he shares his experiences trying to work out the intricacies of collective investment in the true sense of the word.
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Find him on Twitter: @njabulo_goje.
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