What are ETFs?
Exchange Traded Funds or ETFs have two key characteristics which are conveniently included in the name itself: they are Exchange Traded which allows easy, cheap and efficient buying and selling by an investor and they are Funds which usually means they invest in a collection of securities. ETFs address two of the main concerns faced by any investor: how to get diversified exposure to the world’s markets at a reasonable price.
Definition of ETFs
An ETF is an investment opportunity which gives you access to a diversified basket of securities at a reasonable price. This basket of securities usually mirrors common indices such as the S&P500, the Eurostoxx50, etc, and as such the ETF manager does not have any input into what goes into the basket. This lack of manager input means an ETF will usually have very low fees. ETFs are often referred to as passive investments because they simply follow an index. See also the discussion on funds which are usually active investments (the fund manager makes key investment decisions) as is your own equity portfolio if you have one, which is also an active investment.
Discover the wide range of equity funds and ETFs available on UMushroom to help you grow your investment portfolio.
How do ETFs Work?
ETFs pool money from multiple investors to purchase a diversified portfolio of securities and the performance of the fund is based on the underlying securities’ performance. These are the basics, what really goes on behind the scenes is somewhat more complex. If you’re interested here are some more details:
Let’s look at an ETF which tracks the S&P500 and has $10 billion under management. (Such a fund can be found by going to the Investments page and searching and filtering accordingly.) This fund will have spread the $10 billion across all S&P500 constituents following exactly the ‘rules’ which dictate how the S&P500 is actually put together. If you were to decide to invest $10,000 into this ETF then most likely you would simply buy the ETF units from another investor who wishes to sell. So there is no involvement from the ETF owner (the manager) at all.
But there is involvement from the manager because if there are too many sellers and too few buyers or vice versa and the price of the ETF is in danger of drifting away from the S&P500 then the manager may have to step in and fill some orders. And so the manager may be gaining or losing cash which then needs to be compensated by actually going into the stock market and increasing or reducing the actual holdings of S&P500 equities. (Having said this, there are also computers monitoring the price of such ETFs and if the prices deviate at all from the underlying indices, they will kick in and start buying or selling, having identified an arbitrage. The financial markets can be brutal.)
If you were to buy this S&P500 ETF, denominated in USD while the US stock markets are open, you can reasonably expect the fees to be below 0.10% per year. Which is excellent.
But a similar ETF denominated in Singapore dollars trading in Singapore (in other words trading when the US markets are closed) makes things more complicated. There is no realtime price for the S&P500 and there is also a currency mismatch… this additional complexity is incorporated in the fees: they will be higher. Not to speak of ETFs linked to, for example, agricultural commodity indices which can get fairly pricy.
But not to worry, this is all behind the scenes stuff. The Why is important: continue reading.
Why Are ETFs Important?
A successful investor will focus on three things: fees, diversification and time horizon. By paying too much in fees OR by not being sufficiently diversified OR by not having a sufficiently long investment horizon the investment outcome is likely to be disappointing. Of course there are those who get lucky from time to time on some very specific investment and you will hear about those lucky punches for sure. But for every lucky punch there are 10 disasters which are not broadcast at all, for obvious reasons. Who, after all, likes to brag about a total loss?
Fees, diversification, horizon: you need to get all three right. Luckily, with the help of ETFs, the first two are very easy to get right: cheap exposure to a diversified basket of equities. Not to mention exposure to a basket of bonds, bonds being an asset class which is simply not accessible through individual purchases. And on UMushroom, in selected countries, we even have some recommendations as to brokers which have reasonable brokerage fees, check out the ‘Trade with’ links.
The third, time horizon, is extremely difficult to get right though because this is where psychology kicks in. When the markets are going down, it is a depressing experience and no-one is paying attention but that is when it is time to buy. And when the markets are booming and the talk is of nothing else but buy, it is time to sell. The solution to this psychological conundrum is simple though: buy and hold. For at least five years.
While on this topic, there was a fund manager which decided some time ago to analyze all the customer accounts to see what type of customer had the best investment returns. The findings were striking, to say the least, and helpful for us all, as follows. The customers which had the second best performing fund holdings were those customers who had simply forgotten they had some fund investments at all. And the winners, the customers who had the best performing fund positions? They were the ones who had, sadly, passed away.
Those insights are there to be used: minimize the fees you pay, diversify and look away for at least five years. And if you are young, look away for much longer. Your older self will thank you for it.
Common Misconceptions About ETFs
- "All ETFs are Low-Cost": Not necessarily. Depending on the underlying basket of securities (which may be difficult to buy and sell), the geographical location as well as any currency mismatch, ETFs can become quite pricy. Keeping a close eye on the Fund Fees while searching in UMushroom will clarify this.
- "ETFs Returns are always positive": Not at all in fact. ETFs simply follow the performance of the underlying basket and so when that basket increases in value so will the ETF, and vice versa.
Conclusion
ETFs provide investors with an accessible and efficient way to invest in the stock market. By understanding these investment vehicles, individuals can make informed decisions that align with their financial goals.
FAQs About ETFs
- Q: How do I invest in ETFs?
A: Investors can purchase equity funds through brokers or financial advisors and buy ETFs on stock exchanges like individual stocks. - Q: Can I lose money in ETFs?
A: Yes, like all investments, there is a risk of loss in ETFs as a result of a negative performance of the underlying basket.
Related Terms
- Mutual Fund: A pooled investment vehicle managed by professionals.
- Index Fund: A type of mutual fund or ETF that aims to replicate the performance of a specific index.
- Sector Fund: A mutual fund or ETF that invests in a specific sector of the economy, such as technology or healthcare.
