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What the heck does ETF stand for? An explainer

Paddy Hirsch's Whiteboard blog and video series

Anyone can invest in exchange-traded funds. That's the beauty of them: they're dead simple in concept and dead easy to use.

But they're also like matches: they're so simple that a toddler can use them, and there's a real risk of getting burned.

I'm not saying that retail investors who buy ETFs are toddlers – although, let's be honest, most of us could use some supervision or advice when we make investment decisions – but I do think many investors are lulled into a false sense of security by the apparent simplicity of the ETF model.

Part of the problem is that ETFs look a lot like one of the most easily understood investments out there: the company share.

Just like a company share, an ETF is listed on an exchange; just like a company share, the ETF rises and falls depending on investors view of the fund; and just like a company share, you can trade in and out of an ETF any time.

But just because they look easy to understand, doesn't mean they are. ETFs are often a lot more complicated than company shares. For one thing, as Forbes columnist Rick Ferri points out, there are several kinds of ETFs. Depending on how your ETF is structured, you may be taking on a lot more risk than you think you are, and you may be treated differently by the taxman.

And ETFs can go into some dangerous territory.

One of the great lures of ETF investing to retail investors is our ability to gain exposure to a market that would otherwise be closed to us, or at least difficult to access. ETFs allow us to make bets on commodities like gold and palladium without having to buy the actual product or leave the comfort of our den.

They also allow us to wager on the health of corporations via the credit derivatives market. That's right, the kind of wildly complicated investment that helped drag the financial system to its knees is now open to you and I via the magic of ETFs.

Most normal people have no idea how a credit default swap works. So, for most of us, investing in an ETF of CDS is highly risky. It's true that most people won't invest in this kind of fund – the letters CDS will probably have the same effect on retail investors as a sign that says "Warning! Land mines!" – but the same rules apply for all ETFs: if you don't understand the stuff that's in the fund, you'd be wise not to buy the shares.

After all, if you have no idea what you're investing in, you're a whole lot more likely to get burned.

About the author

Paddy Hirsch is a Senior Editor at Marketplace and the creator and host of the Marketplace Whiteboard. Follow Paddy on Twitter @paddyhirsch and on facebook at www.facebook.com/paddyhirsch101

Paddy Hirsch's Whiteboard blog and video series

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