What is an ETF and when does it make sense?
What an ETF is, how it tracks an index like the S&P 500, what it costs, how it differs from buying individual stocks and why leveraged ETFs are a different thing.
2 min read · Jorge Avila Meléndez
An ETF (Exchange Traded Fund) is a basket of many investments that you buy with a single order, just like a stock. Instead of picking company by company, you buy a small piece of everything in the basket.
How it works
Most ETFs track an index, a list of companies built with fixed rules. Some well-known examples:
- S&P 500: the 500 largest US companies (Apple, Microsoft, Amazon…). It is the most common benchmark for «the market».
- Nasdaq-100: the 100 largest non-financial companies on Nasdaq; heavy in technology.
- Sector or country indexes: semiconductors, health care, banks, emerging markets, Mexico…
If the index rises 10 % in a year, the ETF that tracks it rises almost the same, minus its fee. There are ETFs of bonds, gold and more complex strategies, but broad index ETFs are the simplest place to start.
What an ETF costs
Each ETF charges a yearly fee called the expense ratio, deducted little by little from its value. Large ETFs that track the S&P 500 charge less than 0.1 % a year; some thematic or active ones charge 0.5 % or more. It looks small, but with compound interest, a 1 % yearly difference over 30 years eats a significant share of the result.
ETF or individual stocks
| Broad index ETF | Individual stocks | |
|---|---|---|
| Diversification | Hundreds of companies in one purchase | You build it, little by little |
| Work | Almost none | Researching each company |
| Expected result | The market's, minus the fee | Can be better or worse than the market |
| Learning | Little about companies | A lot, winning and losing |
It is not one or the other: many people keep the core of their money in broad ETFs and a part in chosen stocks. Viernes de Invertir buys mostly individual stocks because it is an exercise to learn how to analyze companies, not a recommendation on how to invest all your money.
Careful: leveraged ETFs
Some ETFs promise two or three times the daily move of a stock or index, for example TSLL (twice Tesla) or SOXL (three times a semiconductor index). They are not a «faster» way to invest long term:
- They reset every day. When the price swings up and down a lot, the ETF loses value even if the underlying ends where it started. This is called volatility decay.
- An example: if a stock rises 10 % one day and falls 10 % the next, it ends at 99 % of its value. A 3× ETF rises 30 % and falls 30 %: it ends at 91 %.
- In sharp drops they can lose almost all their value.
On this site, when a portfolio buys a leveraged instrument it is flagged with a notice. If you use them, keep them small and know the risk; see investment risks.
What matters to get started
- An ETF is a basket: one purchase gives you a piece of many companies.
- Check which index it tracks and its yearly fee.
- Leveraged ETFs are short-term, high-risk instruments.
- More on spreading risk in diversification.