What is an ETF

What is an ETF?

ETF is an acronym for Exchange Traded Fund.

An ETF in its simplest form is a portfolio of stocks. Unlike investing in individual company shares, you can buy one share in an ETF that contains a portfolio of stocks. 

 

Key Points 

  • ETFs generally have lower fees compared with mutual funds 
  • Many ETFs provide excellent diversification benefits 
  • ETFs are easy for retail investors to use

An introduction to ETFs. 

E – Exchange, T – Traded, F – Fund. 

Unlike traditional methods of investing, you are able to buy shares in ETFs as they are traded in financial markets. So, for example, before ETFs where invented, if you wanted to invest in the S&P 500, you would invest a proportion of your investment in each of the 500 companies, even now, this would-be time consuming and when you wanted to take your money out of the stock market, you would repeat the process selling the 500 stocks. With an S&P 500 ETF you are able to invest in the 500 stocks with on transaction. Exchange traded funds make diversification possible for retail investors with much lower fees. 

An ETF is a portfolio or basked of stocks that and in their simplest form they track stock market indexes. When you see FTSE100 or S&P 500, these are basically collections of stocks. Stocks are gathered in all different kinds of groups, from their geographical location to sectors and lots of place in between. So much so, as of 2017 and according to Bloomberg, there are now more Indexes than Stocks.  

ETFs essentially track these indices, if the FTSE100 goes up and the you have bought a FTSE100 ETF, you will realise these gains. Unfortunately, as will all type of investing if the FTSE100 falls, you will also realise these loses.  

If you have ever invested in a mutual fund, these are similar to ETFs, but instead of an Professional Money Managers deciding where to invest your money, ETFs rely not on the luck or skill of fund managers, but the performance of the underlying companies.  

In addition to this, ETFs can be sold without large fees, so if you invest it can often be simpler to take your money out compared with mutual funds.  

All in all, owning an ETF generally leads to less work, diversifying across a large section of stocks, rather than picking one or two out is also less risky.  

How did ETFs change the investing landscape? 

In order to understand the premise of investing it is first important to distinguish between fundamental analysis and technical analysis.  

Fundamental analysis is when we try to understand the ‘fundamentals’ of a company, in fancy words, this is when we what to evaluate securities by measuring the intrinsic value of a company. This could include, looking at profits, opportunities, the current financial climate for this stock among other things.  

Technical analysis is when only the stock price and volume are the only inputs. Investor try to follow trends and that all known fundamentals are incorporated into the price. Graphs and previous patterns are used to suggest what a stock will do in the future.   

Both fundamental and technical analysis have proven track records and failures, Warren Buffet might be the most well-known fundamental investor, his company looks at the fundamentals of a company buy things that he feels has long term prospects. Technical analysis is given less exposure to the media so famous analyst in this area of investing are often less well known.  

The problem with these strategies is whilst both have proven to be popular, they take a considerable amount of skill, and often argued luck, in order to make sustainable risk adjusted returns.  

Our pitch is to the novice investor, whilst we do not profess to have superior knowledge of the future direction of stock markets, nor will we ever recommend a get rich quick stock pick, we aim to educate our readers in the basics of investing and lost cost strategies that can help get you started on the investing ladder.  

Who created ETFs? 

ETFs are not a new financial product anymore, what is new is that it is easier than ever before for novice investors to invest in the financial markets. ETFs originated in North America, but now versions of them pop up all over the globe. Created by financial institutions, regulators have also played an important part in protecting investors who invest in them. The first ETF was introduced in Canada, specifically, in 1989 on the Toronto Stock Exchange. One of the most well-known ETFs, the SPDR which tracks the US S&P 500 never come until a few years later.  

Apart from ETFs what are my options?

Due to the numerous financial assets available to investors there are a number of options when deciding in the stock market. In this short note, we will take a closer look at the types of investment companies, these are all viable options and depending on the time etc could be viable options for novice investors.

Mutual funds – is a commonly given name for investment companies and they are larger players in the market. Reports from the academic literature suggest that in the United States as an example, assets managed by mutual funds overtakes $10 trillion.

So investing in a mutual fund, you essentially hand your money over to a investment company, this company hire professional asset managers who will allocate your money for you. If these asset managers make a profit, then your investment will go up, if not, your investment will go down.

In simple terms, its similar to holding a stock, this time the stock is in the mutual fund and the businesses primary activities is to try and make money using various financial assets.

So… does they mean that the mutual fund can be very risk why my money and are they guaranteed to make money?

First, as we will always profess, financial markets are dependent upon a number of factors and whilst there are numerous funds with strong track records not investment is without risk, even when its professional behind the asset allocation.  So the short answer to the second part of the question is no, mutual funds are not guaranteed to make money. To answer the first part, the answer is a little bit more complicated. Policies of mutual funds change throughout the world, whilst certain countries have strong regulators who do a better job at protecting investments, others do not. Every mutual fund from a reputable company will have a specified investment policy. These should be studied before you invest and it will describe the funds policy. For example, the risk factors, the investment styles and strategies, among other things will be included.

To make things even more complicated, there are also ‘management companies’, these companies manage a number of funds and the advantage of this is that investors can receive diversification across a number of funds. In a similar manner to diversifying across stocks, if one fund is performing poorly, there may be some advantage in having investments in a number of funds in the hope that not all will perform poorly. Mutual funds also invest in different types of assets so you are potentially covering more assets across the spectrum of financial assets when diversifying across fund.

What are the downside to mutual finds and management companies. The simple answer is fees, generally the fund works in a way so that they have to make a profit before you see a return on your investment. It is important to find the correct balance between the fees a mutual fund charges and the returns you are likely to receive.

If you want to learn more about mutual funds, why not joint our ACFI101 course which will have a specific class on how to read an investment policy of mutual funds and what to look out for.

Frequently Asked Questions

How do stock markets work?

Investing in the stock market is essentially investing in companies. Companies are listed on the stock market and when you buy shares you are essentially a part owner of a company. For large corporations, most retail investors hold a tiny portion of the company.

The main issue with this, and a mistake many novice investors make is that they will invest all of their savings into a small number of companies, however, holding a large portion of your investment pot in a small number of companies is highly risky. Investing in ETFs, what our website advocates for low cost and lower risk investments. Through ETFs it is a low cost way to investing across hundreds of companies at any one time. Then if the average value of the companies within the ETF increases your investment also increases.

In the UK, there are over 3000 companies to invest in. the FTSE 100 are the hundred largest firms listed on the London Stock Exchanges. These companies are not necessarily ‘British’ and it also provides an opportunity for international diversification.

#InvestinETFs