How ETFs Really Work – And Why It Matters

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Active investors typically hold a lot of different types of securities in their brokerage accounts. From interacting with my newsletter subscribers, I know that many of them think of every investment in their brokerage account as “stocks”; however, much of what we own may not be common stock shares.

This may seem like a minor point, but it can have big implications for your returns. So today, let’s take a look at how ETFs differ from common stock shares – and I’ll throw in one of my favorite, high-yield ETFs right now, too…

Until the early 1990s, most investors invested through mutual funds. Mutual fund shares are purchased and redeemed directly with the fund’s sponsor company. For example, if you invested in a Vanguard mutual fund, you had an account directly with Vanguard and bought or sold shares through that account. Vanguard would sell or redeem mutual fund shares at the current net asset value (NAV). For mutual funds, share price and net asset value are identical.

In January 1993, State Street Global Advisors launched the first exchange-traded fund (ETF), the SPDR S&P 500 ETF (SPY). The advent of ETFs brought a significant change to the investing world. Now, 30 years after SPY launched, more than 1800 ETFs trade on the U.S. stock exchanges.

Stocks refer to common shares of individual companies. Common stock shares of corporations, REITs, and BDCs provide ownership stakes in the companies you own.

ETFs are first cousins to mutual funds. An ETF share is an investment in a portfolio of securities. You can view ETF shares as mutual fund shares that trade on the stock exchanges. An ETF sponsor will create or redeem shares for institutional investors. The creation redemption mechanism forces ETF shares to trade very close to the NAV.

The growth in the number of ETFs, plus the advent of discount brokerage accounts, which eventually drove stock commissions to zero, opened a broad universe of opportunities for trading and investing.

Early ETFs allowed investors to invest and match the returns of a specified stock index. For example, SPY lets investors match the returns of the S&P 500 stock index. To broaden their offerings, ETF sponsors found or developed hundreds of indexes on which to base their ETFs. You can use ETFs to invest in any market sector or asset type you can imagine. SPDR ETFs let you invest in the different S&P subsectors, such as information technology, energy, real estate, or consumer staples. There are international stock ETFs, commodity ETFs, and cryptocurrency ETFs.

ETFs track an underlying index, so as an investor, you should select ETFs based on the characteristics of those underlying indices.

In 2020, ETF sponsors expanded the universe to include actively managed funds. An actively managed ETF has portfolio managers that buy investments for a portfolio based on the fund’s stated investment criteria and goals. Typically, an actively managed ETF will strive to achieve better returns than a specific index. For example, the InfraCap MLP ETF (AMZA) is an actively managed fund designed to outperform the index-tracking Alerian MLP ETF (AMLP).

As you research ETFs, the first step is determining whether it is an index fund or actively managed. The next step would be to analyze the underlying index or the manager’s investment strategy. A few specialty types of ETFs, such as covered call funds, use an option selling strategy based on an underlying index or portfolio.

From my experience, index ETFs are the choice for investors or traders that want to play trends or hot sectors. Well-chosen, actively managed ETFs are best for long-term investors.

I’ll close with an actively managed fund from a beaten-down sector: real estate. Look at the Hoya Capital High Dividend Yield ETF (RIET). This fund pays monthly dividends with a 9.5% current yield.

This post originally appeared at Investors Alley.