One common question among investors is “What exactly do I own when I buy an ETF?”
To be technical about it, when you buy an ETF you own “an undivided interest in a pool of securities.” To which the average investor may reply, “What the heck does that mean?” To put it in simpler terms, you own a piece of whatever securities the ETF portfolio holds in its portfolio. And while you cannot break out the individual pieces, you do get to participate in the fluctuations of the value of the overall portfolio.
The easiest way to understand this concept is via an example.
Schwab offers a range of ETFs under two broad categories: Fundamental Index® ETFs and Market Cap ETFs. For this example, we’ll take a look at the Schwab US Large-Cap ETF (ticker SCHX), which is a Market-Cap ETF. The fund provides exposure to large-cap U.S. companies. It seeks investment results that track the performance, before fees and expenses, of the Dow Jones U.S. Large-Cap Total Stock Market Index.
Bar chart for ticker SCHX
By buying shares of SCHX, you gain exposure to a diversified portfolio comprised of Large-Cap stocks. The value of your investment will rise or fall in line with movements of the Dow Jones U.S. Large-Cap Total Stock Market Index. The Dow Jones U.S. Large-Cap Total Stock Market Index made up of approximately the largest 750 U.S. stocks. Each stock represents a certain weighting in the overall portfolio.
For example, shares of Apple might make up over 2.5% of the entire portfolio and shares of Microsoft might make up 2% of the portfolio and so forth. These percentages will fluctuate over time as share prices for each individual stock rise and fall, and if and when changes are made to the holdings that comprise the index itself.
One potential advantage to owning an ETF such as SCHX that tracks a particular index versus a standard actively managed mutual fund is that the portfolio of securities held by the ETF will only change when the underlying index is changed. On the other hand, the portfolio for an actively managed mutual fund can change from day-to-day.
In other words, you may have a better idea of exactly what it is you are buying with an ETF that tracks an index. As with standard mutual funds, index ETFs typically also offer the potential benefit of broad diversification. For example, ticker SCHX may hold up to 750 different stocks. If you really want to know “what’s under the hood,” in most cases you can find a detailed listing of the securities held by a particular ETF and their respective weights on the fund sponsor’s website.
But the bottom line—and the key thing to remember—is that when you buy an ETF you are buying the right to participate in the price movements in the underlying portfolio.
So you now know what you own when you buy an ETF but we still haven’t covered what may be the most important aspect: Why buy ETFs?