In recent articles we have presented investment basics covering information on types of investments, risk, volatility, returns, costs and other important elements.
Continuing this theme of demystifying the world of investing, helping you to make good investment decisions, and understand the advice we provide, in this article we are going to discuss a type of investment that is often talked about and less often understood - ETFs or Exchange Traded Funds.
What are ETFs?
Exchange traded funds are a relatively new investment structure that have been around for a little over 30 years. They are in a sense a hybrid between a stock listed on a stock exchange, and a managed fund. To understand that you need to understand these terms.
A share (also called a stock or equity) is a piece of a publicly listed company that you can own and trade (buy or sell) on a stock exchange.
A managed fund is an investment that will follow a theme, or a risk profile, and provides a low cost way to invest across a broad range of markets without have to make the many decisions on which particular items to hold. When you invest you do so in units in the fund. You can usually see their top 10 holdings but the decision to invest is primarily decided on their expected return, volatility, cost, liquidity, reputation, and access. The fund managers charge a fee to operate the fund.
We said that an ETF is a hybrid of a managed fund and a share. Like shares, it is listed and traded on a stock exchange. This makes it accessible. Consistent with a managed fund, it holds a diversified portfolio of assets. This combination means it is usually (but not always) cheaper than a fund. When you invest you buy the share in the ETF.
ETFs can be passive, active, thematic or specialist. Passive ETFs gain a lot of attention and are also called index trackers.
Index trackers can be low cost because they don’t need to make any investment decisions driven by research and analysis. They just replicate what the index of a market does.
Slight diversion: what is an index? This is what we see reported in financial news when it is presented whether a stock market has gone up or down. An index is a representative sample of shares listed on a particular stock exchange, or across stock exchanges. The MSCI World index is an index that tracks shares across stock exchanges around the world. The CAC40 index follows the largest 40 companies on French stock exchanges, the Stoxx300 is the largest 300 companies listed on stock exchanges in Europe, and the S&P500 is an index that tracks the largest 500 companies on US stock markets.
An ETF that is an index tracker will follow an index. There are some particularities for how they do that which become important, and we can discuss these more technical details with you directly if you are interested.
What are the alternatives?
Alternatives to ETFs are direct assets, like picking shares, bonds and other assets yourself, or investing in managed funds.
Why are ETFs good to use?
The main advantages of ETFs are:
Cost - They are usually lower cost than investing in a managed fund, the more commonly used diversified alternative.
Liquid - This means you can usually access and close your investment quickly. As they are traded on stock exchanges, as long as that market is open, you can trade on that market. The requisite for this is ‘depth’. This is an investment term which means there is sufficient demand for that asset, which in the case of most ETFs is usually the case.
Diversification - This means with even a smaller amount of money you can spread your risk across a number of assets. This is much harder to do if you are buying shares directly.
What are the drawbacks? And when are they not appropriate?
What goes up must come down. When you invest in a passive index, your investment follows the market whatever it does. That is fine when markets are rising, but if markets fall, your index fund will obediently follow it as it falls as well with no changes. It might be that index ETFs are better in some stages of market cycles than others depending on your specific needs.
Concentration and distortion. This is an often overlooked issue. The composition of an index ETF does not comprise the best performing assets, it is made up of the largest. With increasing popularity of index funds and ETF, more money flows into these types of investments and therefore into the assets that make up the index. This means they get even bigger. The distortion follows. An index is not made up of equal components. For example when you invest in the S&P500 index, you are not getting 1/500th of each company, you are investing, like the index itself, proportionately to the relative size of the underlying companies. At the moment the top 10 companies are around 36% of the index meaning you only invest 64% of your funds across 490 remaining companies. This concentration risk at the top of the index can magnify losses in times of market downturns. The popularity of this type of investing can be its downfall and it is a useful reminder not to follow the path just because others are doing it. You need to make sure how you manage your money is appropriate for your specific situation.
No adaptation to market changes. By their nature they are passive, they follow the index irrespective of what the market is doing. That may be appropriate for some investors, but if you need a more active approach that can adapt to changing markets, economic news, politics and investment cycles, you will need a more dynamic and active approach.
In summary ETFs are a useful investment but like any investment they are just another way of investing, are not a panacea and will work for some people some of the time but not all of the people and not all of the time.
The first step is to get good advice. Speak with the team at Arisaig Wealth Management. The first step is to understand what you are aiming for, your goal. When we know the target we can compose the most appropriate investment portfolio for you.
Contact us at info@arisaigwealth.eu.
