Investing can be daunting at times. What’s the best-performing stock right now? Which one has done best over time? Which stock is going to the “moon”? It’s… not an exact science and it’s hard to know. And for the masses, it’s generally better to just invest in an index according to many financial experts. According to Warren Buffet in his 2013 shareholder letter, Buffett recommended that most investors should put their money in a low-cost S&P 500 index fund. He even noted that his will instructs that 90% of the cash inherited by his family be invested in such a fund.
This is where ETFs come in handy. In this ETF primer for beginners, I’ll give you a quick rundown on what ETFs are, key things to watch for when investing in ETFs, and the pros and cons of investing in ETFs.
What is an ETF (exchange-traded fund)?
If you’re interested in the true legal/regulation definition according to the SEC, feel free to check out their website.
However, in a nutshell, you can think of an ETF as a basket of stocks and as an investor, you’re able to buy a piece of that total basket. Some baskets (“ETFs”) track an index like the S&P 500 and others are more industry or commodity-focused (like gold). If you’re looking to be exposed (invested) in a specific industry, you can probably find an ETF for it.
What are the different types of ETFs?
There are many many many different types of ETFs out there but here’s a list of just a few.
- Index Funds: Index funds are investment vehicles that aim to replicate the performance of a specific market index, such as the S&P 500. These funds offer diversification by including a broad range of assets within the index, making them suitable for investors of all experience levels. Index funds are known for their low fees and are considered a passive investment strategy.
- Industry-Specific: Industry-specific ETFs focus on a particular sector or industry, allowing investors to gain exposure to companies within that specific economic segment. This type of ETF is ideal for investors who want targeted exposure to sectors like technology, healthcare, or energy, providing a way to capitalize on the potential growth of a specific industry.
- Security-Specific: Security-specific ETFs are tailored to invest in specific types of securities, such as stocks or bonds. Equity-focused ETFs invest in stocks, offering ownership in a basket of companies, while bond ETFs focus on fixed-income securities. Investors can choose these funds based on their risk tolerance, investment objectives, and preferences for either capital appreciation or income.
- Leveraged Funds: Leveraged funds use financial derivatives to amplify the returns of the underlying assets, typically aiming for double or triple the performance. While these funds offer the potential for higher returns, they also come with increased risk and volatility. Investors considering leveraged funds should conduct thorough research and be aware of the potential for magnified losses.
- Dividend Funds: Dividend funds are designed for income-seeking investors. These ETFs invest in companies with a history of paying consistent dividends. Investors benefit from regular dividend payouts, providing a steady income stream. Dividend funds are suitable for those looking for a combination of potential capital appreciation and regular income from their investments.
- Commodity Funds: Commodity funds invest in physical commodities like gold, silver, oil, or agricultural products. These funds provide a way for investors to gain exposure to the commodities market without directly owning and storing physical goods. Commodity ETFs can be a hedge against inflation and provide diversification beyond traditional asset classes like stocks and bonds.
- Actively Managed Funds: Actively managed ETFs involve fund managers making investment decisions to outperform the market or a specific benchmark. These funds often have higher fees compared to passively managed options, as they require ongoing research and management. Investors considering actively managed funds should assess the track record and expertise of the fund managers before making investment decisions.
What are the risks of investing in ETFs?
Just like investing in any marketable security, there is market risk. The value of your share will only be worth the amount that someone else is willing to buy. Investing is a zero-sum game.
- Market Risk: Just like investing in any marketable security, there is market risk. The value of your share will only be worth the amount that someone else is willing to buy. Investing is a zero-sum game. ETFs are subject to market fluctuations. If the overall market performs poorly, the value of the ETF may decline.
- Tracking Error Risk: The performance of an ETF may not perfectly mimic the performance of its underlying index. This discrepancy, known as tracking error, can occur due to factors like fees, transaction costs, and the fund manager’s strategy.
- Liquidity Risk: While many ETFs are highly liquid, some may have lower trading volumes, which could result in wider bid-ask spreads and increased trading costs.
- Sector and Concentration Risk: Some ETFs focus on specific sectors or industries. If those sectors or industries perform poorly, the ETF may be more adversely affected than a more diversified investment.
- Credit Risk (for Bond ETFs): Bond ETFs are subject to credit risk if they invest in bonds with lower credit ratings. If the issuers of these bonds default, it can negatively impact the value of the ETF.
- Dividend Risk: Dividend-focused ETFs may be affected by changes in the dividend policies of the underlying stocks. If companies within the index reduce or eliminate dividends, it can impact the ETF’s yield.
- Regulatory and Tax Risks: Changes in regulations or tax laws can impact the performance of ETFs. For example, changes in capital gains tax rates may affect the after-tax returns for investors.
- Closure Risk: ETFs can be closed if they fail to attract sufficient assets. In such cases, investors may need to sell their shares, potentially realizing capital gains or losses.
- Currency Risk (for International ETFs): If an ETF invests in assets denominated in a foreign currency, changes in exchange rates can impact the fund’s returns when translated back into the investor’s home currency.
- Counterparty Risk (for Synthetic ETFs): Some ETFs use derivatives to replicate the performance of an index. If the counterparty (the entity on the other side of the derivative contract) fails to meet its obligations, it can result in losses for the ETF.
Investors should carefully consider these risks and conduct thorough research before investing in any ETF. It’s also important to note that the specific risks can vary depending on the type of ETF, such as equity ETFs, bond ETFs, commodity ETFs, or leveraged/inverse ETFs. Diversification and a clear understanding of the investment strategy are crucial in managing these risks. Consulting with a financial advisor can provide personalized guidance based on individual investment goals and risk tolerance.
How can you evaluate ETFs?
- With index funds, this is fairly easy. Just find the underlying index you’re trying to track and compare the performance side by side. It should be the same since the entire point of an index fund is to track an index.
- For an actively managed fund, the usual objective of the fund is to try to beat the underlying benchmark. If the performance is subpar, you may want to consider if the expense ratio you’re paying is worth the underperformance.
- A funds track record can tell you a lot. If an ETF has a fairly long record of outperformance, it can indicate what the future may hold, especially if the historical performance has been with a manager with a stellar track record. Of course, the historical record is no guarantee of future results.
- The fund company will often post their objective and how they’re investing their funds. Does the fund’s objective meet your own? If not, it may not be best for you to buy into it. For example, if you’re heading into retirement and looking for a fund to invest in. If you’re looking to your funds to generate income, do you think it’s appropriate to go for a fund that is 80% invested into growth stocks with high volatility and low dividends or distribution payouts? Probably not.
Things to look out for with ETFs
Expense ratios: Although they seem small, expense ratios can eat away at your total return over time.
Turnover ratio: This helps you determine if this is a more actively managed or passively managed fund.
Liquidity: Watch the total amount of volume traded. Thinly traded (low volume count) securities can lead to large spreads (the difference between the bid and the ask). This may lead to undesirable selling prices if you try to get out at the wrong time.
Issuer Reputation: Not all fund companies are the same. If you’ve ever had a bad doctor or mechanic, you are probably familiar with the concept that there are bad and good professionals in their field. It’s the very same for ETFs so be sure to check who the issuer is and what their credibility or reputation is in the industry.
Performance History: If you’re buying into a fund for a specific purpose. For example, if you’re buying into a fund that’s expected to track the NASDAQ but you’re seeing major differences in the NASDAQ’s vs the fund’s year-over-year performance, would you expect that this fund will match the NASDAQ’s performance in the future? Although there’s no guarantee in stock market investing (even with treasuries), if a company has a long-term track record of underperforming, it’s probably a fair sign that it’s going to continue on this trend unless there’s some sort of change within the fund company like a management adjustment.
What are the pros and cons of investing in ETFs?
Pros
- Diversification: There are many schools of thought regarding building your portfolio but a general rule of thumb is that diversification is a benefit because it helps you spread your risk. Instead of putting all your funds in a single or a few stocks, you can invest in an ETF and gain exposure to hundreds of stocks.
- Exchange-traded: Investors can buy, sell short, and use margin to make trades. Because exchange-traded securities are based on supply and demand, the price of the NAV and the fair market value could vastly differ. Usually, the ETFs are recalculated every 15 seconds and then again after the regular market session closes. However, prices tend to go up when demand is high (and supply decreases) and prices decrease in the vice versa situation.
- Professionally managed: Having the benefit of a manager who can observe and react to market events saves you the trouble of having to check in on your investment. With the right manager, you can get as close to a passive investment as there is.
- Low Cost: Most ETFs come with lower costs compared to mutual funds when it comes to the expense ratio (or what you pay the manager).
- Transparency: Actively managed ETFs have to show their holdings daily per the SEC and you can always check the filed documents for periodic snapshots of holdings over time.
- Accessibility: ETFs allow you to get access to industries or companies you might not usually have access to. For example, if you don’t have $500 to go into the latest tech stock, you can buy a piece of the index it is in. You usually won’t have as much total growth (because you essentially buy a small portion of the stock) but an ETF can be a stepping stone until you have enough funds to buy a share down the line.
Cons
- Management fees (expenses): With professionals’ aid in managing your funds, there is usually an expectation of fees, and ETFs are no exception. These fees are part of the metric named, “expense ratio” and high management fees can seriously eat away at your total returns. Just like how compounding can work in your favor, compounding fees over time can work against you.
- Lack of control over investments in the fund: Since ETFs usually track an underlying benchmark or index and are run by a fund manager, if you have preferences over which investments you want to be in, you may be exposed to securities that you may not entirely want.
- Risk: Please see the list above.
ETFs vs. Mutual Funds
If you’ve ever heard or read about mutual funds, you may ask what the difference between an ETF and a mutual fund is. Well, there are a few key differences that you may find useful in this article.
Wrap Up
Exchange-Traded Funds (ETFs) stand as versatile and valuable assets in any investor’s toolkit. Their simplicity, diversification benefits, and low costs make them an attractive option for both seasoned investors and those new to the market. By seamlessly fitting into your portfolio, ETFs offer an efficient way to access a wide range of assets, providing the potential for growth and stability. Whether you’re a long-term investor or seeking to balance risk, you can consider incorporating ETFs to enhance the overall strength and resilience of your investment strategy.
Disclaimer: ETFs are not for everyone. I am not a financial advisor or a tax professional, and this should not be considered financial advice. This is simply meant to be educational content. Please always do your research as everyone’s situation is different.