Exchange Traded Funds
Exchange Traded Funds have been around for some time but it is in the last five years or so that they have become quite popular, in particular with DIY investors. So what exactly is an ETF?
Think of an ETF as a managed fund. Only this managed fund can be bought and sold just like a regular stock on the share market. There’s no sign up process. No minimum investment amount. You have full freedom to buy and sell as you please.
It’s easy, and that’s one reason why many people love ETF’s. There are several other reasons why people like them. In this article we’re going to take a look at what is an ETF, why people like them and how they work.
No stock picking required
Many people are interested in investing but don’t have the confidence to choose which stocks to include in their portfolio. Or it could be that you just don’t have the time to research individual companies. Others will want to get started in investing but they don’t want to fork out for a financial advisor.
A good thing about ETF’s is that they take the stock picking out of investing. You are essentially buying a basket of stocks all in one go. All you have to do is choose which exchange traded fund you want to go with.
Why is diversification important in investing?
The more stocks you hold the more diversified you are. The more diversified you are the less your portfolio will be impacted by a particular negative event. That’s the theory anyway.
According to portfolio theory you need to hold at least around 20 stocks to reach peak diversification. After this point the marginal benefit become less and less with each stock you buy.
Right so portfolio theory says you should buy at least 20 different companies. The beauty of an ETF is that you can take care of diversification in one fell swoop because the underlying fund will often hold well over 20 companies. You’re diversified from the get go.
What type of ETF should you buy?
ETF’s are supposed to take the hassle out of investing. And nowadays there are so many different types of ETF’s available and new ones are being created all the time. It can still get confusing if you don’t know what you’re looking for.
In the following sections we look at some of the different types of ETF’s how they can be useful.
What is an Index Fund?
The vanilla option of ETF investing is index funds. Index funds are what are considered to be a passive fund. A passive fund is a fund where the fund manager has no discretion over which companies to buy on your behalf as part of the ETF. They simple buy whichever companies are represented in the relevant index for that ETF.
Index funds track a particular index. For example if you own an ASX200 ETF, what you are buying is a little piece of every company that is part of the ASX200 index. That is the top 200 listed companies in Australia.
Easy access to markets
ETF’s provide easy access to asset classes that may not be so easy to get access to if it wasn’t for the ETF. For example most amateur investors know how to buy a stock in a company. But what if you wanted to want to buy a government bond? That gets a bit trickier. But with an ETF it’s easy.
All you have to do is go onto one of the ETF provider websites and see what is available. You can buy a single bond ETF that holds a selection of government bonds without you having to go out and buy the Australian Government 10 year bond, and the 3 year bond, and a state government bond…You get the idea. ETF’s make it easy.
Exchange Traded Funds are also a great way to invest in real estate without having to actually buy any property.
Do any ETF’s hold Bitcoin?
There will be people who are interested in getting into crypto but just aren’t sure where and how to start. It can be confusing. You’ve got cold wallets, hot wallets, staking, crypto exchanges collapsing, exchanges being hacked. It’s kind of like the wild west and it’s no wonder a lot of people are worried about the risks.
ETF’s can offer a solution to people who would like to dip their toes into the crypto markets. It’s an evolving space but more ETF’s are being launched that either focus on companies that work on the underlying blockchain technology or the cryptocurrency tokens themselves.
How to buy ETF’s that focus on a particular sector or theme?
Exchange traded funds make it easy to invest in particular sectors or themes within the markets. For example you can buy ETF’s that focus solely on healthcare, big tech, infrastructure, property and more.
You can also use ETF’s as a tool to build out your portfolio in way that aligns with your investing goals. So if you want a portfolio that supports your lifestyle – that is you want income – then you can invest in ETF’s that focus on high dividend stocks. Or if you are looking for long term growth there are ETF’s that focus on that as well.
Access to international investment markets
By buying individual shares of companies that are listed on the ASX, you will be mostly buying companies that carry out business in Australia. And there’s nothing wrong with that. But it’s also worth noting that Australia makes up only 1.7% of the world economy. So by only investing in Australian companies you are missing out on 98.3% of the action.
What you can do now is invest in ASX listed ETF’s that focus on different parts of the world economy. For example you can buy US based NYSE index funds, the FTSE in the UK or even emerging market economies. ETF’s have really opened up international markets to retail investors.
Cost effective investing
With popularity comes scalability. Over recent years the management fees that are charged on ETF’s have been on a downward trend as the established providers scale up their operations and more people are investing. The cost of providing the ETF product is spread across more investors so they are able to charge less in way of a management fee and still remain profitable.
Potential risks of ETF’s
ETF’s offer many perks but they also do have their critics. One of the reasons some investors don’t like ETF’s is that buy buying into them you are following the herd in some respects. For some of the more sophisticated investors this can be seen as a risk.
Another potential issue is that some stocks that find their way into an index fund such as the top 200 companies will then automatically get a boost as investors are now forced to buy that company just because it happens to be part of the index now. This can lead to overvaluations.
A more remote risk is that by using a fund manager you technically don’t have custody of the share itself at the individual company level. Whereas if you bought the individual stocks directly you would be cutting out the middle man – being the ETF provider – and removing any third party risk. Although it has to be said that it would be pretty unlikely for any of the established ETF providers to go bust and not return your capital.
How do you get started investing in ETF’s?
As said earlier you can buy an ETF in the exact same way that you buy an individual share. All you need is broker platform where you can buy and trade shares on the ASX. All of the major banks offer platforms that do this. There are also several smaller platforms available.
Then you can go onto the websites of the various ETF providers and have a look around at what is on offer, carry out your research, and then execute the trade.
Some of the main ETF providers in Australia include, in no particular order:
Thanks for reading.
