The Basics of ETFs: Fundamental Terms and Concepts

Exchange-traded funds (ETFs) are a type of pooled investment security. When you trade an ETF, you get a collection of stocks, bonds, and other securities that can be bought and sold during market hours, undergoing the same price changes throughout the day as stocks.

What Is an ETF?

ETFs generally offer greater exposure and could come with a lower risk by spreading your funds across a number of instruments, thereby reducing the impact of a single stock dropping in price. ETFs operate similarly to mutual funds, tracking a specific index, commodity, or sector. However, unlike mutual funds, ETFs can be purchased or sold on stock exchanges like common stocks.

The First ETF

The SPDR S&P 500 ETF (SPY) was the first ever ETF, and it tracks the Standard & Poor 500 (S&P 500) Index. It remains the largest and one of the most actively traded ETFs today. According to the latest statistics, there are currently 1,782 ETFs traded on the U.S. markets and 8,754 ETFs globally.

9 Basic ETF Terms You Should Know

1. Index

An index is a group of securities representing a market or a portion. It tracks the market or submarket’s performance and serves as a benchmark for fund managers or investors. Some examples of common indexes are the S&P 500 (also called the USA 500) and the Dow Jones industrial average.

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2. Asset Allocation

Asset allocation is an investment strategy that helps investors manage their account's risk and reward expectations. Investors spread their accounts across various instruments, such as cash, bonds, stocks, and property, allowing for different risk levels and the possibility of potential returns.

3. Diversification

Diversification takes balancing risk and returns a step further than investment allocation by deciding which stocks and bonds one should invest in and how much should be invested. With a diversified portfolio, potential profits can balance out losses if other investments do not perform well. The level of diversification depends on an investor’s appetite for risk and return.

4. Physical and Synthetic ETFs

Physical ETFs track their target index by holding the entirety or a portion of the underlying instruments. Synthetic ETFs, on the other hand, do not invest directly, but instead give access to instruments that are otherwise difficult to obtain, such as commodities.

For example, a synthetic ETF can track crude oil and thus hold oil futures contracts. As such, an investor can access the instrument without physically owning barrels of crude oil. 

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5. Beta Funds

Beta is a metric that analyzes the return on an investment relative to the broader market. The S&P 500 index usually measures it. For example, an investment with a beta of 1 means that it moves in accordance with the overall market or that a 1% rise or fall in the S&P will likely correspond to a 1% rise or fall in the investment's price.

» Discover how to use SQQQ ETFs in trading

6. Liquidity

Liquidity refers to how quickly a security or instrument can be converted to cash without affecting its market price. Generally speaking, the higher the liquidity, the more cost-efficient it will be to buy and sell that investment. In contrast, low liquidity (or illiquidity) could spell difficulty in trading and more significant transaction costs.

7. Minimum Volatility

Minimum volatility is a strategy that aims to reduce the impact of the market's ups and downs. It can help reduce the impact of changes in interest rates, rapid ups and downs in stock prices, and currency shifts. The strategy is used to give investors close-to-market potential returns and could present a lower risk.

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8. Yield

Yield refers to the return on investment. It is usually expressed as a percentage of the invested amount, such that an ETF that costs $100 and pays a $5 dividend would yield 5%.

9. High-Yield Bonds

Investors looking to increase their portfolio usually consider including high-yield bonds. A company typically issues these debt instruments with a low credit rating, and higher yields and returns are typically expected to compensate for the high level of risk involved.

The Importance of Understanding ETF Terminology

There are many different aspects to consider when it comes to investing. With so much information, researching and learning the theory is essential before you decide to start trading for real, and the terminology is the first step towards doing that.