ETF simplified, level: Beginner
ETF Definition: An ETF, short for Exchange-traded product, is a group of stocks or other instruments grouped as a bundle.
To exemplify, let’s use a simple pizza analogy. An ETF is the pizza and stock is a pizza slice. The slice is just one part of the pizza, but with enough slices together they form a whole.
This whole pizza could be the entire automotive industry, instead of buying Tesla, the pizza slice.
One major advantage of owning an ETF is risk or portfolio diversification. In pizza language: imagine buying 12 slices of different pizzas.
Your taste buds would have a field day with the diverse flavours and are likely to find at least 1 slice that you like.
Shedding off the pizza vibes. Let’s take a closer look at the actual name and usage of ETFs.
Exchange Traded Product
Exchange stands for the name of the financial marketplace. These can be accessed through a broker.
Traded means the ability to buy and sell. In reality, the word traded can also be substituted by investing.
Product refers to the actual type of investing ‘thing’. Meaning, an ETF, Stocks or Bonds are products. Whilst Tesla, a specific stock, is an instrument.
ETFs are mostly used to spread out risk and investment across countries, industries, sectors and themes.
For example, I could buy a clean energy ETF that consists of stocks from companies that do business in water, solar or wind-generated energy sources.
Buying 1 unit of an ETF, saves investors:
1. Time it would take to find all clean energy companies individually
2. Cost on commissions by having to buy each stock individually
3. Buy or sell stocks based on developments that could negatively, or positively, impact performance.
So what is the catch? Well, most ETFs still need to be managed by someone, even if that someone isn’t you!
So instead, a percentage of the fund value is taken out yearly, to pay for the management of said ETF.
This doesn’t come out of your pocket and isn’t noticeable in your investing account.
However, it can be a good practice to compare ETFs on their cost(sometimes called) OTC. Because even though you won’t see it outright, it can lower your return to a certain extent.
What’s the alternative? You can own stocks or bonds from individual companies and create your own diverse portfolio. But this comes at the disadvantage of your time & cost.
There are many ETF providers out there and many websites compare the ETF offering out there, this one included!
You have achieved a basic understanding of an ETF. Take a well-deserved break, and continue reading ‘How to dissect an ETF‘ when you are ready.
Alternatively, we go into a bit more depth below concerning ETFs and answer some questions that might be relevant to a beginner investor such as yourself.
ETF explained, level: Advanced
ETFs are investment vehicles that closely track an index. They combine the advantages of stocks with those of a mutual fund. ETF, passive fund, and a tracker: they are different names for the same product.
Example sentence: ‘Wow, that company I heard about is down 10% since last week. I am glad I bought the sector ETF instead, which seems to be up 2% still.’
Technically, an ETF is a mutual fund in which all the stocks of an index are listed in an identical ratio. As a result, an ETF is almost equal to the position of an index or a fraction thereof.
Index investing overall
An ETF tracks not just one company, but an entire index. It is therefore very easy to invest in the 100 largest companies in the United States: you can do this with an ETF on the S&P500. ETFs are available on multiple indices, such as the Dow Jones and Nikkei or real estate and gold indices.
ETF vs Mutual Fund
A major reason for the success of ETFs is that they are a cheaper alternative to mutual funds. In particular, the low management costs. Some ETFs already track an index for 0.15% of the value.
This makes ETFs attractive if you compare them with an investment fund that quickly reaches 2%. You will save more than 1.5% in costs annually.
In addition, various scientific studies show that the results of ETFs are on average significantly better than the results of mutual funds. Mutual funds are actively managed, with the fund manager aiming to outperform the benchmark in the form of an index.
However, a majority of mutual funds lag behind the index they need to beat. You therefore not only pay lower management costs with an ETF but there is also a statistically greater chance that your return will be higher than with an investment fund with the same index as the benchmark.
What are the advantages of an ETF?
Just like investment funds, ETFs are an ideal investment vehicle to start with as a novice investor. You can work on your capital growth in an accessible way with ETFs.
ETFs are transparent, have low management costs and have good diversification. For example, if you buy one unit of the iShares MSCI World ETF and invest in the MSCI World index. This is made up of over 1,600 stocks of the world’s largest companies. ETFs also offer the opportunity to invest in sectors and themes that are normally unattainable.
Read more about how to dissect an ETF & start investing in them here.