ETF Talk — Terminology 101
During the past several months, I have provided my ETF Talk readers with features aimed at identifying new funds, key sectors and important trends. I also like to go back to the basics once in awhile with something that I call ETF 101. The name comes from the 101 number often given to an introductory course at a college or university for virtually any subject.
The idea is to provide a bit of instruction about ETF terminology and investing. I know that ETFs are new to many of you and I want to make investing in them as simple as possible. ETFs offer diversification and cost-effectiveness that is unmatched by most other investments, including mutual funds. For that reason, I want to explain key terms this week that will help ETF investors of all experience levels.
As regular readers of this feature know, one of my top goals as an ETF enthusiast is to simplify what may seem like complex investment terms to produce confident and well-informed ETF investors. For that very reason, I chose to define eight ETF terms this week that every ETF investor should know. Among the eight key terms are ultra, short, volume, and sector — common investment vocabulary that you may have heard about but not understand fully. Remember that I encourage my readers to send me their ETF questions. If you have one that you want me to answer in an upcoming issue, please click here.
The following is a list of eight useful ETF terms, along with their definitions:
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Leverage — This term is used to describe when an investor borrows capital to increase his or her potential returns. The use of leverage also raises the risk, so these kinds of funds require caution. In ETF speak, leverage usually refers to a fund designed to move twice as fast as its underlying index. Leverage can be used either on the long side, or the short side.
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Ultra — This class of ETFs uses leverage to double the exposure to a particular benchmark index. For that reason, these kinds of funds also double the risk and the potential reward.
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Short — In normal stock investing, this is the practice of an investor selling a borrowed security for the short term in hopes that it will fall in value before it is repurchased later for a reduced price. In ETF speak, short refers to a fund designed to move higher when its underlying index moves lower.
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Commodity — An asset class featuring natural resources or agricultural goods that can be bought or sold through specially designed ETFs. For example, a commodity ETF may focus on a single kind of good and hold it in physical storage. A commodity ETF also may invest in futures contracts. One example of a commodity ETF is PowerShares DB Agriculture (DBA), which tracks the performance of the Deutsche Bank Liquid Commodity Index. That index consists of futures contracts on agricultural commodities, such as corn, wheat and sugar.
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Index — A statistical measure of change in a market. In the case of financial markets, an index is an imaginary portfolio of securities representing a particular market or a portion of it. Two major market indexes are the Dow Jones Wilshire 5000 and the iShares MSCI EAFE Index (EFA).
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Volume — The number of shares or contracts traded in a security or an entire market during a given period of time. I tend not to recommend ETFs that do not have a daily trading volume of at least 100,000 shares.
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Sector — A group of securities that are in the same industry or market.
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Expense Ratio — A measure of what it costs an investment company to operate a given fund. The expense ratio is determined by an annual calculation that divides a fund’s operating expenses by the average dollar value of its assets under management.
I hope you agree that none of these terms are overly complicated. You now should have an improved grasp of key ETF asset classes and terms. Once you understand the kinds of ETFs that are available, you can better determine how best to use them to your advantage.
Jim Woods is a 30-plus-year veteran of the markets with varied experience as a broker, hedge fund trader, financial writer, author and newsletter editor.
His books include co-authoring, “Billion Dollar Green: Profit from the Eco Revolution,” and “The Wealth Shield: How to Invest and Protect Your Money from Another Stock Market Crash, Financial Crisis or Global Economic Collapse.” He’s also ghostwritten many books and articles, as well as edited content for some of the investment industry’s biggest luminaries. Read more about Jim Woods.
