How Exchange Traded Funds (ETFs) Work – Dance Group Metaphor
According to the U.S. Securities and Exchange Commission (SEC), Exchange-traded funds, or ETFs, offer investors a way to pool their money in a fund that makes investments in stocks, bonds, or other assets and, in return, to receive an interest in that investment pool.
What's the heck does THAT mean, you say?
When teaching forex in my book “Invest Diva’s guide to making money in Forex,” I used the dancing couple analogy. Basically, since currencies are always traded in pairs, we imagine that any specific currency pair is an international dancing couple that is jumping up and down the forex dance floor (AKA trading chart) based on fundamental, technical and market sentiment factors.
When it comes to ETFs, we can use a similar metaphor but this time instead of an international couple, we have a group of peeps with similar interests dancing on the the dance floor... or in a pool... something like, an orgy you may say? A very group with a VERY specific interest!
In the ETF world, these “interests” are basically the different asset classes, such as stocks and bonds that you can choose from to form an ETF basket. So instead of a folk dance group, group salsa, or Scot dance group, you can choose your ETF basket by sector, commodity, investment style, geographic area, and more. Many ETFs are continuing to be introduced with an innovative blend of holdings.
While in the forex world “opposite attraction” is a key factor in choosing a currency pair to trade, (you'd want to trade a weak currency against a strong currency) , it’s all about teamwork when it comes to ETFs.
In other words, ETFs are funds that track indexes like the NASDAQ-100 Index, also known as the Nasdaq dance group, S&P 500 dance group, and Dow Jones dance group. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don't try to outperform their corresponding index, but simply replicate its performance. They don't try to beat the market, they try to be the market so all assets can dance together in harmony!
There is a chance you have heard about another type of instrument that is kinda similar to ETFs; The good'ole Mutual Funds. ETFs are similar to mutual funds because both instruments bundle together securities in order to offer investors diversified portfolios. Typically over 100, or even up to 3,000 different securities can make up a fund. Yet, the two investment types are marked by significant differences that I'll cover in the next lesson.