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What are ETFs and should you invest in them?

07 Aug 2022

Exchange traded funds (ETFs) are essentially investment funds which are listed and traded like a stock

ETF cover

What you'll learn:

  • What are ETFs?
  • What are the different types of ETFs?
  • What's the difference between a passive and active ETF?
  • What are some examples of popular ETFs?
  • What are the advantages and disadvantages of ETFs?
  • What should you consider before buying a ETF?

TL;DR

  • Exchange traded funds are essentially investment funds which are listed and traded like a stock.
  • They are a great way to invest in a basket of securities.
  • Most ETFs are designed to mirror the performance returns of an underlying major index.
  • You can consider investing in ETFs if you’re looking for a well-diversified investment.

What are ETFs?

You might be wondering… what exactly is an ETF?

An exchange-traded fund, or ETF, is an investment that trades like a stock.

Like other types of funds, ETFs pools money from different investors into a basket of different investments. This includes stocks, bonds, REITs, and others.

By allocating the fund’s money across different securities, ETFs can provide investors with diversification.

As you can see, investing in an ETF can help you balance your risk.

What are the different types of ETFs?

In the same way that there are different types of mutual funds, there are also different types of ETFs with their own objectives.

Some ETFs invest in a combination of selected stocks and bonds, while others are designed to replicate the performance of a stock index like the S&P500. 

There are also ETFs that track the performance of a particular market sector, such as technology.

Naturally, different ETFs offer different amounts of diversification.

ETFs that focus on a specific sector, for example, typically offer less diversification than those tracking the performance of an index.

Not all ETFs are created equal!

What's the difference between a passive and active ETF?

Broadly speaking, there are two kinds of ETFs - passive and active ETFs.

Passive ETFs

Passive ETFs will usually track an index such as the Dow Jones Industrial Average.

The portfolio is simply updated on a quarterly basis to reflect any changes in the underlying index.

These ETFs provide an affordable and fuss-free way of getting exposure to a broad based index of stocks.

Active ETFs

Active ETFs involve a fund manager who is actively managing a basket of securities

As ETF shares are traded on a stock exchange, they usually incur commissions and other related fees.

This is usually for investors who are less than contented with average returns in the market.

Unfortunately, not all fund managers are able to beat the market…

What are some examples of popular ETFs?

There are many popular ETFs which vary from equity ETFs, bond ETFs, balanced ETFs, commodity ETFs, real estate ETFs, and so on.

But instead of boring you, we thought to pick three passive ETFs for the everyday investor to check out.

#1 - US market-cap index ETFs

First is the Vanguard S&P500 ETF (VOO) which gives investors broad exposure to publicly listed companies in the US.

This kind of ETF uses a passive investment approach that tracks the top 500 performing companies in the US.

#2 - International ETFs

Second is the Vanguard FTSE All-World UCITS ETF (VWRA) which aims to mimic the performance of the FTSE All-World index.

It is made up of large and mid-cap companies from developed and emerging countries.

#3 - Sector/Thematic ETFs

Third is the Vanguard Health Care ETF (VHT) which tracks the performance of stocks in the healthcare sector.

It consists of stocks of healthcare companies that provide medical or healthcare-related products and services.

And no, we are not sponsored by Vanguard.

What are the advantages and disadvantages of ETFs?

Advantages

We think ETFs are great for investors for a number of reasons.

First, they take the stress out of investing in single stocks. Investing in ETFs allows the everyday investor to achieve market returns over time without having to do individual stock picking.

This means not having to worry about which stocks to buy, making it easier for you to get started in investing. Investing in ETFs mean that you don’t need to research on individual companies which can be daunting for most.

Second, ETFs essentially provide you with market exposure to a wide range of stocks, bonds, REITs, and other assets at a minimal cost.

The low commission fees can be attributed to the passive nature of such ETFs which do not require a fund manager.

You will also be able to get investment exposure to a particular market using one single instrument (as opposed to buying individual stocks).

Third, ETFs are very easily traded on a stock exchange. They are much more liquid than mutual funds as they are much easier to buy and sell with an online broker.

Disadvantages

But there are also some drawbacks when it comes to buying ETFs.

First, you have to remember that most ETFs are simply created to track and not beat the index. Investors who are looking to achieve higher than market returns will feel disappointed by this.

Second, investing in an ETF still exposes you to market risk. If you have an ETF with exposure to the US market and the US experiences a market downturn, your investment will be directly affected. 

For this reason, it’s never a good idea to invest only in one particular market or sector. If you are exposed solely to the US market, you might also want to invest in ETFs with exposure to European and Asian markets.

Lastly, some ETFs may have high expense ratios. These are usually found in investment themes which invest in alternative investments or ones where the fund manager is actively trading almost everyday.

These ETFs can charge an expense ratio of over 3.00%. Most passively managed ETFs, however, will charge a reasonable 0.05% or less. 

Regardless, it's always to check what's the expense ratio for the ETF you are considering. 

What should you consider before buying a ETF?

As always, you should consider what your investment objectives are before putting your money into any investment asset.

If you’re looking to give your portfolio some broad based market exposure, ETFs are a great way to increase diversification.

For beginners, we definitely recommend investing in ETFs instead of trying to pick individual stocks. They’re also a good option for those who want to get started on investing.

Now suppose you want to invest your money into an ETF, you would also need to take a look at which ETF can best suit your needs.

This involves looking at the historical performance, tracking error, and expense ratio amongst others.

After researching through different ETFs and picking your desired choice, you’re all good to go!

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