Hey, what's up everyone? We've got just a quick educational video for you today. Someone asked in our community discord about ETFs and how they make money, which I thought was actually a very interesting question, a great one to also do a short video on.
Because, you know, we often talk about how useful ETFs are, especially to more passive-minded investors that want a simple, maybe even safer way of diversifying their portfolio without having to invest in so many different individual stocks. And having to do all that extra work but what i feel doesn't get talked about nearly as often is how these etfs actually make their money after all they're not like a traditional brick and mortar business that is selling some type of physical product or performing various you know services at some type of profit margin that's uh something that the discord member actually mentioned is that you know we don't go into etfs looking at financial statements and trying to see how they're performing and how that might impact us as shareholders in terms of like a business It's literally just an investment of other investments that we hope to make a profit on. So it is kind of a little strange in that sense.
And I can totally understand why someone might wonder how all of this actually works. Like who's the company behind these ETFs? How do they benefit from the ETFs?
Where do they get the money to buy all the holdings within the ETF? And what affects the actual price of that ETF, either going up or down? And how do you as an investor? actually make money from it too?
How does it trickle down to us, you know, individual retail investors? Well, I'm going to do my best to break all of this down for you in a simple, easy to understand way. So I hope you enjoy it, but let's go ahead and just jump straight into it.
Let's talk about ETFs. Now, first off really quick, what is an ETF in the first place? An exchange traded fund?
Well, it's really just a basket of many other securities like stocks or bonds. which can sometimes be even in the hundreds or even thousands of different individual stocks held within a single ETF. It's kind of crazy, right?
And so the ETF itself is issued usually by a large financial institution, something like Vanguard or even BlackRock, who also manage the ETFs themselves, investing in and out of certain stocks, usually within a certain index or a type of field that pertains to that index. So for example, it might be like an ETF focused on internet technology stocks or energy or finance or even foreign stocks too. Okay, so where do these asset managers like BlackRock get all the money to invest in all of these stocks through the ETF?
Well, there's actually a couple of different ways that involves multiple entities. But the simplest way to explain this for anyone that is kind of a beginner here that wants it just an easy way to understand all this is that Really, when an ETF is created and listed in the open market, it's done so through collaboration with APs, what are authorized partners, which are large financial institutions that basically back the ETF. They provide the capital needed to buy all the underlying stocks within the ETF, and then in exchange, they're able to sell ETF shares in the open market to recoup that money. Then as time goes on, if a lot of investors are buying the ETF too and demand starts to rise maybe even higher than the underlying value of the stocks, what we call the net asset value of an ETF or the NAV, well, the APs will come back in and run a similar process again, buying more stocks to raise the NAV and issuing new ETF shares to balance it all out.
Now, I know some of that may sound a bit confusing, but the main point is that basically investors like you and me are what contributes to an ETF being able to add more stocks to the pool. The more that we buy an ETF, the higher the demand goes, the higher the price goes for that ETF, and the more new ETF shares that they can basically create and sell, which gives them money to buy more stocks within the ETF and grow it even larger. And that's kind of the simplified, that's probably the simplest way that I could explain how all of that works.
Now, Of course, that's mostly just the money that is being used to buy stocks for the ETF. But what about profits here? How do the ETF issuers actually make a profit from the ETFs that they're managing and issuing? Well, the largest and most obvious way is that they collect fees for managing those ETFs. This is what is known as the expense ratio, actually.
Whenever you look at an ETF and you look to purchase an ETF, well, there's going to be a yearly... percentage of the ETF price that is going to be taken out of your investment and it's going to be given to the issuer. Now, don't freak out.
It's usually a very small percentage. It's like less than half a percent on average. But if you have a huge amount of money invested in ETFs, you will obviously start to notice those fees over time it'll kind of snowball and get larger and therefore you should typically try to get as low of an expense ratio as possible although higher quality etfs that are known for performing well tend to have higher fees so it is also a bit of you get what you pay for in that scenario too so it's a bit bit of a balancing act and by the way there are other ways that etf issuers can make money too like by lending out the stocks within the ETF to other market participants like short sellers for example, where in return they receive collateral or fees and they might even collect transactional fees too from all the buying and selling that they do because there's a lot of ways to monetize that as well.
But again by far the biggest way that they make a profit here is going to be from those direct management fees that they get to collect on the ETF for for managing them for controlling them. keeping an eye on them and all that all that that entails okay so that's how these issuers make their money but what about you the investor how do you make a profit from your ETF investments well there's actually a couple different ways now the first is probably the most obvious that being the actual price of the ETF like if you buy an ETF share for $100 but then it rises up to $200 so you decide to sell it well you just made a hundred percent profit on your investment because it doubled in price and you sold it. And of course, what influences the ETF price is the performance of the individual stocks within the ETF, which can drive up both the ETF total value as well as the demand for it. Again, this is what is known as that net asset value that we talked about earlier.
It's the total sum of all the assets within the ETF. And so if those assets or let's just say stocks are performing very well and they're going up in price, well, then that NAV, net asset value, it's going to rise too because of it. And thus the ETF will be worth more and it'll also have higher demand for it because it's performing well. Another way investors can profit off of ETFs though is through dividends.
That's right. Many ETFs pay out dividends too because of the individual dividend paying stocks that they may hold within the ETF. And so that's another way to do it. The ETF manager in this scenario will collect all of those dividends individually from the basket of stocks that is in the ETF. And then they'll redistribute those dividends to all the shareholders, usually on a quarterly payment kind of basis.
And by the way, there can even be some situations where the ETF reinvests those dividends back into the underlying stocks to to buy even more of them, thus raising the NAV value as well to further benefit the shareholders as well. Now. Also, it doesn't have to just be stock dividends.
Some ETFs actually invest in bonds or other fixed income securities where they're able to earn money through the interest payments that these bonds generate. And then that interest income is often distributed back to the shareholders after all of that, providing another steady stream of cash flow there as well. Okay, so in conclusion, we discussed how ETFs work and how they make their money for both the issuer as well as the individual shareholders of it.
And again, ETFs can also just be a great way of diversifying your portfolio with a wide range of assets that is managed and controlled for you while also reducing your risk compared to having to invest in just one single stock or a bunch of individual stocks. And this can greatly benefit both beginners as well as higher wealth individuals that want a safer way to perhaps invest their money. Or really also even someone that just wants Exposure to a specific area that they're not very knowledgeable enough on to you know Pick and choose individual stocks an ETF can be a great solution in that scenario, too Anyway, I hope that you enjoyed this video Let me know if you'd actually like to see a top 5 ETFs video or something similar to that in the future because I would love to make That type of video for you if there's enough demand for it so let me know down in the comment section if you'd like to see that and Make sure you subscribe for more stock market related videos in the future Hope you're all doing well my friends. I'll catch you in the next one. Take care everybody.
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