What is an ETF?

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It’s hard to imagine an investing world without ETFs these days. More than $4 trillion is invested in funds that track U.S. indices alone, and that’s despite this kind of investing only really existing since about 1990. 

Most newcomers to investing start with an ETF, as they generally have the lowest fees and generally lower-risk than other investment strategies. 

But what are ETFs? If you’re completely new to the world of investing, it can be worth it to really understand what you’re buying into when you invest into an ETF. 

Tracking the Index

An ETF is an exchange-traded fund. That means it’s a pool of money from different investors, with its own shares, which can be openly traded on an exchange. Unlike other products with shares however, investors don’t make money depending on who’s buying or selling the ETF shares. Instead, the fund tracks an index — another collection of shares. Some track a well-known index, like the S&P 500, which is made up of the 500 largest U.S. stocks. But there are almost as many indices as there are stocks. 

ETFs track their index by buying its shares for the investors. So if your ETF is tracking the S&P 500, it likely owns shares of every single of those 500 companies. As the price of those companies’ stocks increase and decrease, so does the index, and therefore the value of the ETF share price. But instead of having had to buy every one of those shares, an investor can get the same benefit by buying the ETF. 

It’s important to note that ETFs closely, but not perfectly track their index. This is because the funds are buying and selling the shares in order to mimic the movement of the index. Large ETFs will have nearly identical performances to the indices they track, but it can vary depending on the fund. 

Making dividends 

So what about all those benefits of owning stocks, like voting rights and dividends. Do ETFs give investors those as well? Partly. On the dividend side, ETFs pay out the full amount of the dividends that the companies’ they track issue. However, the ETF can decide whether to pay that amount in cash or in additional investment into the ETF. Either way, the benefit is passed along to the investor. 

As for voting rights, that’s where things get a little trickier. While the ETFs may own company shares, the ETF investors only hold shares in the fund, which means no voting rights for all the companies in the index. However, many of the companies that offer ETFs publish voting guidelines. For example, Blackrock, one of the world’s largest investment firms and offerer of ETFs, has a detailed guideline on how they vote at company shareholder meetings. If you’re concerned about how your investment will impact a company, you can look around and find an ETF where the issuer votes how you would.