How Exchange-Traded Funds Work - dummies

By Russell Wild

Just as a deed shows that you have ownership of a house, a share of an exchange-traded fund (ETF) represents ownership (most typically) in a basket of company stocks.

To buy or sell an ETF, you place an order with a broker, generally (and preferably, for cost reasons) online, although you can also place an order by phone. The price of an ETF changes throughout the trading day, which is to say from 9:30 a.m. to 4:00 p.m. New York City time, going up or going down with the market value of the securities it holds.

Sometimes there can be a little sway — times when the price of an ETF doesn’t exactly track the value of the securities it holds — but that situation is rarely serious, at least not with ETFs from the better purveyors.

Originally, ETFs were developed to mirror various indexes:

  • The SPDR S&P 500 (ticker SPY) represents stocks from the S&P (Standard & Poor’s) 500, an index of the 500 largest companies in the United States.

  • The DIAMONDS Trust Series 1 (ticker DIA) represents the 30 underlying stocks of the Dow Jones Industrial Average index.

  • The NASDAQ-100 Trust Series 1, which was renamed the PowerShares QQQ Trust Series 1 (ticker QQQ), represents the 100 stocks of the NASDAQ-100 index.

The component companies in an ETF’s portfolio usually represent a certain index or segment of the market, such as large U.S. value stocks, small growth stocks, or microcap stocks.

Sometimes, the stock market is broken up into industry sectors, such as technology, industrials, and consumer discretionary. ETFs exist that mirror each sector.

Regardless of what securities an ETF represents, and regardless of what index those securities are a part of, your fortunes as an ETF holder are tied, either directly or in some leveraged fashion, to the value of the underlying securities.

If the price of Exxon Mobil Corporation stock, U.S. Treasury bonds, gold bullion, or British Pound futures goes up, so does the value of your ETF. If the price of gold tumbles, your portfolio (if you hold a gold ETF) may lose some glitter.

If GE stock pays a dividend, you are due a certain amount of that dividend — unless you happen to have bought into a leveraged or inverse ETF.

Some ETFs allow for leveraging, so that if the underlying security rises in value, your ETF shares rise doubly or triply. If the security falls in value, well, you lose according to the same multiple.

Other ETFs allow you not only to leverage but also to reverse leverage, so that you stand to make money if the underlying security falls in value (and of course lose if the underlying security increases in value).