Exchange-traded funds (ETF) are one of the fastest-growing financial products and are a popular form of passive investing as they combine the best attributes of stocks and mutual funds. ETF’s assume that you are not trying to beat the market and are great for people without time or expertise to do it themselves due to their cost efficiency and diversification.
An ETF is a basket of individual holdings (e.g. stocks, bonds or commodities) that aims to track an index and are traded on an exchange. When you buy an ETF, you are purchasing the underlying shares of all assets per their weights in the index (the 'weight' is derived from a company’s market capitalisation). For instance, an ETF tracking the S&P 500 will buy all the stocks in that index according to their index weights. These 500 companies make up about 80% of the total value of the US stock market.
“Don’t look for the needle in the haystack. Just buy the haystack!”
– John Bogle (Vanguard Group and credited with creating the first index fund).
ETF investment managers do not try to outperform the index; they try to match the performance in a reliable and cost-efficient manner. Many investors argue that low-cost tracker funds such as ETFs will outperform active investments over the long-term, mainly due to the high fees charged by active investment managers (see more in the article linked).
The benefits of ETF’s?
- Diversification - maintaining a well-diversified portfolio is an essential part of a successful investment plan, and ETF’s can be an ideal way to achieve this. For example, if you have funds invested in the S&P 500, your investment has a wider spread over the range of products and industries.
- Ultra-low fees - as ETFs track a target benchmark or index rather than focusing on looking for winners, you can avoid continually buying and selling shares or bonds and will have less oversight from fund managers. As a result, they have extremely low expense ratios compared to actively-managed funds, and lower expenses often translate to higher returns over time.
- Simplicity - an ETF offers an easy way to invest in a chosen market as it merely seeks to track an index. There is no need to select and monitor individual managers or choose between investment firms.
- Transparency - different from mutual funds which post their holdings monthly or quarterly, you can check ETF holdings any time you like.
- Accessibility - ETF’s allow any investor with lower amounts of money to access the same investments as private portfolio clients (the "rich"). They also give access to international investments that can otherwise be difficult.
- Liquidity - ETFs have high liquidity (ability to convert to cash in a short amount of time) as they are bought and sold on an exchange, and, likely, there will always be a buyer.
All in all, ETFs are cost-efficient, diversified, flexible, and easy-to-understand investment instrument, making them ideal for wealth creation. In the next article, I will explain how ETF’s work, how you can invest in them by providing some different options of companies that specialise in ETF’s.
Information provided by goBuoyant is general in nature and does not take into consideration your personal financial situation. It is for educational purposes only and does not constitute formal financial advice. Remember, the value of any investment can go down as well as up.
Comments