← Money Lessons with Andrew Temte, PhD, CFA
Money Lessons with Andrew Temte, PhD, CFA
The ETF: Trade It Like a Stock, Hold It Like an Index Fund
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Owning a broad index ETF is one of the soundest ways to build wealth over time. But only if you let it behave like the index fund that it really is on the inside. Buy it like a long term investor and hold it like a long term investor. The fact that you can trade it like a stock all day every day does not mean that you should. Hi, I'm Andy Tempte and welcome to Money Lessons. Join me every Saturday morning for bite sized lessons that are designed to improve financial literacy around the world. Today is July 3rd, 2026. We're releasing the show a day early so that everybody can enjoy the semi quincentennial of the United States of America. Anyway, last week we asked what the the market really is and we met the indexes that measure it. The Dow, the S&P 500 and the NASDAQ 100. We also saw that when you buy a fund built to track one of those indexes, the fund must hold whatever the index holds and buy whatever it adds. At the end, I promise to show you the vehicle most people use to do exactly that and wear that automatic. Behind the scenes buying and selling really lives. That vehicle that we're going to talk about is the exchange Traded fund or the ETF. So let's start with where ETFs come from. On January 22, 1993, a firm called State street launched the very first ETF on the American Stock Exchange. They named it the Spider, or the Spider for short. And it's built to do one thing, track the S&P 500 index that we spent last week getting to know one purchase and you owned a sliver of all 500 companies from that one fund. The idea grew into the primary way, or a primary way, that Americans own stocks. Today, more than $15 trillion now sits inside ETFs, a pool of money equal to roughly a fifth fifth of the entire US Stock market. Now that may sound exactly like the index mutual fund that Jack Bogle gave ordinary investors back in 1976. A single mutual fund that holds every stock in an index so that your money is spread across all of them all at once. The idea inside index mutual funds and ETFs is the same. Both hold a basket of stocks that mirrors an index index. What's different is how you buy and sell these particular investment vehicles. So let's start with a mutual fund and how it works. First, when you put money in, you are buying directly from the fund itself. You place your order and you get a price calculated once after the market closes, which Is the total value of everything the fund owns divided by its number of shares outstanding. Everyone who buys or sells that day gets the same end of day price, one price once a day, that carries a hidden cost of its own. When you place the order, you do not yet know the price. The market keeps moving until the close, and only then is your price set. You commit to buy or sell before you know what what the price is that you'll pay or receive. Now, an ETF is a little bit different, and it works the way that a single stock does. Its shares trade all day long on an exchange. And here's the key part. You are usually not buying from the fund at all. You're buying from another investor who wants to sell. In the secondary market, where existing shares change hands between buyers and sellers, the price moves all day, second by second, just like a stock's. And because you're trading with another investor, there's a small cost that most people never notice that the index mutual fund doesn't bear. Back on March 14, we met the bid ask Spread the gap between the highest price a buyer will pay and the lowest price a seller will accept. When you buy an etf, you pay the slightly higher asking price. And when you sell an etf, you receive the slightly lower bid. For the big, heavily traded ETFs. That gap is tiny, often a penny, but it is there, and it is the price of being able to trade the moment you want to. So there's one more cost. An index mutual fund and the ETF share it, and it is called the expense ratio, a small yearly fee that the fund charges for running itself as a slice of what you've invested. For a plain index ETF and index mutual fund, the fee is tiny, often a fraction of 1% per year. The question though, is, is ETF or an index mutual fund cheaper? The two are really about even. Both cost only pennies a year on every $100 invested. But across the industry, the average mutual fund actually edges out the average index ETF by just a hair. That low cost in either form is a big part of why these funds have spread so far. Now to the question that I left you with last week. If an ETF's shares trade between investors all day long, where does the actual buying of the underlying stocks happen? The answer is a standing arrangement between the fund and a handful of large financial firms called authorized participants. Think of authorized participants as the wholesalers of the ETF world. When demand for an ETF runs high and more shares are needed, an authorized participant goes out and buys the entire basket of stocks. The index calls for all 500 in the right proportions and hands that back basket back to the fund. In exchange, the fund hands back a large block of brand new ETF shares, which the firm then sells to the rest of us. This is called creation. The process also runs in reverse. The firm can return a block of ETF shares to the fund and receive the basket of real stocks back. That is called redemption. So this is the machinery that does the index buying and selling. When millions of people pour money into AN S&P 500 ETF, authorized participants create new ETF shares. And to do that, they must buy the 500 underlying individual stocks. This creation and redemption process does one more thing. It keeps the ETF's price tied to the real value of the underlying stocks that make up the fund. Suppose that heavy buying pushes an ETF's price above the value of the basket of stocks it represents. An authorized participant can buy the basket at its lower true cost, swap it for new ETF shares, and sell those ETF shares at the higher price, pocketing the difference. That selling pushes the ETF's price back down toward the value of its holdings. If the ETF ever trades below the value of the basket, the firm does the reverse. This is arbitrage, buying low in one place and selling high in another. No agency or rule forces it. It is simply traders chasing a profit. It is through arbitrage activity that traders keep the price you pay for an ETF close to the worth of the stocks it holds. Now, what does all this mean for you? So the ETF is a genuinely powerful tool. A whole index bought in a single trade for a tiny yearly cost that you can buy or sell at any moment. The market is open. But that last feature, the freedom to trade it instantly all day long, is the one I want you to be careful with. An index mutual fund, in contrast, only lets you trade once a day at the closing price. And that limit is almost a gift. It's a regulator. It makes it hard to do anything rash. An ETF removes that constraint. The very same fund that is meant to be a calm, long term holding that you buy and keep now sits in your trading app with a price that flickers in your face all day, inviting you to react, to sell on a frightening morning or to pile in on an exciting one. What you own inside is the same, but the temptation to trade around it is new. So here's the discipline. Owning a broad index ETF is one of the soundest ways to build wealth over time, but only if you let it behave like the index fund that it really is on the inside. Buy it like a long term investor and hold it like a long term investor. The fact that you can trade it like a stock all day every day does not mean that you should. You can buy nearly all of this, your ETF shares, your individual stocks through a commission free app, the kind that we met back in our November 29th episode where each trade costs you nothing. Apps like Robinhood next week. A question that has sat unanswered since that episode is if the trading is free, how does Robinhood, how does the brokerage behind the app make its money? The answer has a name and it's called Payment for Order Flow. And it reveals who really is on the other side of that free trade that you just made. Remember, nothing in this life is free. So until next week, I wish you grace, dignity and compassion. My name is Andy Tempte and this is Money Lessons. You can find the show on all the major streaming servers, services as well as out on YouTube. Please like subscribe, rate and most importantly, share this public educational good with your friends, your family, your colleagues and maybe a neighbor. The show is produced by Nick Tempte and we will see you next time on Money Lessons.