ETF investing has risen in popularity over the last decade, attracting attention from beginners and experts alike. In this article, we’ll look at:
Wall Street loves to use jargon to make the simple sound complex. With news coverage focusing on stocks, bonds, crypto, commodities, interest rates, and inflation, making sense of all this data becomes a task in and of itself. This can make it daunting for would-be investors to get involved in the markets and start their investing journey.
For new investors – or those looking for a quick refresher – understanding what ETFs are, is likely a good place to start.
What is an ETF or Exchange Traded Fund?
ETF stands for Exchange Traded Fund and is a financial product that offers investors a quick and easy way to diversify their portfolio. ETFs are a type of pooled investment fund that is traded on a stock exchange in the same way that shares of an individual company are. Many of the ETFs we’ll discuss in this article are passively managed ETFs – meaning they follow a stock market index like the S&P 500, the Nasdaq 100, or the ASX 200.
Term check: A stock market index or a benchmark index, simply represents a collection of different stocks or businesses. Buying an ETF that focuses on the S&P 500, for example, will give you access to those 500 companies - through one trade.
This is one of the reasons ETFs have become so popular: because they allow investors to instantly diversify their investments. This popularity has been driven by both investor demand for these products, and the growth in different and interesting ETF offerings. 2021 was a record year for ETFs globally, with investors pouring an additional USD 1 trillion into these products, taking the total amount invested in ETFs to USD 10 trillion.
What are the benefits of ETF investing?
In general terms, ETFs offer investors a quick, easy, and low cost way to diversify their current investment portfolio or start their investment journey. As markets remain volatile, let’s take a look at some of the key benefits of ETF investing in the current environment:
1. A low-cost way to invest
Passive ETFs will likely charge lower fees than actively managed ETFs or other funds, which employ teams of analysts to select and trade investments.
Paying these experts, the expectation of superior returns, and more frequent trading, all adds to the costs that organisation takes on when managing active ETFs or funds. The costs an organisation takes on when managing a passive ETF by comparison, are generally lower. Remember, a passive ETF is trying to match, not beat the index that it tracks!
Syfe stats: Across the board, the average expense ratio of an active ETF is 0.69%, according to ETF.com; while the average expense ratio of an equity index ETF - like the passive S&P 500 ETFs we have talked about in this article - is 0.18%, according to the Investment Company Institute.
Here’s what that all means in dollar terms. For an ETF with an expense ratio of 0.69%, it means that for every USD 10,000 invested, your ETF would attract USD 69 in fees, annually. Those fees – expressed as an expense ratio – would be factored into the overall net asset value of the ETF. These are deducted automatically for you by the ETF provider. Remember, always check the expense ratio!
2. Instant diversification
As we touched on above, one of the biggest benefits of ETFs is that they allow you to instantly diversify your investment portfolio – all in one trade.
Take the S&P 500 index, for example, which tracks 500 large and prominent publicly listed US-listed companies. The S&P 500 is made up of many household names, including Apple, Microsoft, and Tesla; but it is also comprised of companies you likely haven’t heard of, such as Sealed Air Corporation, Rollins Inc., and Franklin Resources Inc.
As an individual investor, if you wanted to invest in all 500 companies in the S&P 500, not only would you require a large amount of capital to make a meaningful investment, but it would take significant time, and incur significant brokerage costs. ETFs streamline that process. Instead of buying and selling every stock in the S&P 500 – you could instead consider the following ETFs:
- Vanguard S&P 500 ETF (VOO)
- SPDR S&P 500 ETF Trust (SPY)
- iShares Core S&P 500 ETF (IVV)
Those three ETFs all track the S&P 500, allowing you to gain exposure to those 500 companies, with a much smaller up-front investment – both in terms of dollars spent and time expended.
S&P 500 ETF example
Beyond simplifying the investment process, ETFs also allow investors to quickly diversify their portfolio. Generally speaking, it’s considered less risky to have exposure to 500 companies, than 2.
Here’s what we mean by that: if your portfolio was just made up of Invesco’s S&P 500 Equal Weight ETF (RSP) and 2 companies dropped 50% (and all others stayed flat), your portfolio would only go down by 0.2%. On the other hand, if you owned shares in only 2 companies and 1 of them fell by 50%, your portfolio would decline by 25% (considering the other stock stays flat).
Finally, diversification shouldn’t only be thought of as a numbers game. Ideally, investors also want to consider diversification in terms of different countries, sectors, and asset classes – like bonds or crypto. While diversification won’t guarantee that your investment or investments will go up, it will mean that you are well placed to weather periods of volatility – big or small.
3. Thematic ETF investing – access to trends and themes
Using ETFs allows you to invest in almost anything, from shares to bonds to commodities, all across a range of countries and sectors. You can even tap into specific trends and themes that are aligned with your investment objectives or personal preferences.
For example, there is a growing range of ETFs that target environmental, social and governance (ESG) issues – such as iShares ESG Aware Moderate Allocation ETF (EAOM) or the Invesco Water Resources ETF (PHO). Other ETFs offer exposure to companies or industries at the forefront of disruptive technologies – such as the Global X Robotics and Artificial Intelligence ETF (BOTZ) or the Fidelity Crypto Industry and Digital Payments ETF (FDIG).
4. Full transparency
Another key feature of ETFs is that you can easily identify what underlying investments are contained within them. This is true of both passive funds such as the S&P 500 ETFs we have discussed, and also of active ETFs.
Other types of funds, depending on their size and other factors, may be less forthcoming with the assets that they hold. The transparency of ETFs means it is easy to see if you are getting a ‘fair deal’ when you make an investment.
Generally speaking, most prominent ETFs will trade at a price very close to their Net Asset Value (NAV). This means that their price is usually in line with the value of all the investments held in the fund. An ETF might trade above or below its NAV for a number of reasons, including low demand for the ETF or concerns about one or more of an ETF’s underlying holdings.
Fact check: In saying all this, it’s important to understand that ETF returns don’t exactly match the returns of their benchmark index. This is because of the operational costs associated with an ETF, such as management fees, trade execution costs and potential foreign exchange rate movements.
For example, the Vanguard S&P 500 ETF (IVV) has a tracking error of -0.04% – which means it deviates from the S&P 500 by that percentage amount. Even with that ‘error’, ETFs remain low cost when compared to active investment fund offerings, and returns should mostly mirror that of the index which they track.
As one final note, it’s also important to understand that when you buy an ETF, you don’t directly own the underlying assets, but rather a unit in a fund that owns the investments. Each ETF will have a product disclosure statement that gives you more details about how it is invested, how much it costs, and what risks to expect. As with all things finance, it pays to read the fine print.
This article/webinar is brought to you by Syfe Australia Pty Ltd., CAR number 1295306 of Sanlam Private Wealth Pty Ltd (AFSL 337927). Disclaimer: Investing involves risk including the risk of losing your invested amount. We do not provide personalised advice or recommendations. Any information we provide is general advice and current at the time written. Please speak to your Financial or Tax adviser for personal advice. Any reference to an investment’s past or potential performance is not an indication of any specific outcome or profit. Data in article correct as of July 12, 2022.