An introduction to exchange traded funds

Investments
By hiveup,

You may have heard of Exchange Traded Funds (ETFs) before, but for whatever reason, never found out exactly what they are, or whether it would be a good idea to invest in them. Here we will provide a guide on what exactly ETFs are, while highlighting the product’s advantages and disadvantages. These marketable securities can consist of a wide array of financial products such as indices, commodities (oil, gold, livestock etc.), bonds, or even a basket of varying assets, and have the capability to be traded in exchange markets like common stock. These characteristics allow ETFs to offer the diversification of a mutual fund (a fund manager makes investments with funds pooled together from a variety of people), but with the liquidity that naturally comes with regular stock. ETFs have several advantages over other types of securities. Some of these are outlined below.

Diversification
The fact that ETFs come in a wide variety of forms make them perfect for the diversification of your portfolio. There are ETFs for everything, from oil and energy to pharmaceuticals. This makes investing in these industries a lot easier and a lot less time consuming than individually analysing and picking shares within an industry. However just like any individual stock or bond, you must try to understand your own risk appetite and gauge the risk level of the investment.

Flexibility
Unlike mutual funds, ETFs trade based purely on the laws of demand and supply and not net asset value, they can be bought and sold at anytime the stock market is open. This is a huge advantage when investing opportunities arise.

Transparency
ETFs are required to report their holdings daily, this allows the ETF holder to more accurately analyse and comprehend the securities that make up their ETF. This provides investors an opportunity to discover any gaps or overlaps that might exist in their portfolio. This is in contrast to another popular investment choice like a mutual fund, which have no requirement to daily disclose their holdings.

Photo courtesy of the third ETF Asia summit

Like most things in life, no security is without its shortcomings, and this includes ETFs. The following are some of the main drawbacks of ETFs.

Performance compared to market
In general ETFs do not generate higher returns than the returns you would have received from directly investing in common stocks. This is because ETFs are not very actively managed. This means that a specialised fund manager is not required, as the fund will simply track an index or benchmark.

Brokerage costs
Every time you buy or sell an ETF, you encounter brokerage costs. These can add up to significant figures over time. Research has shown that in general the more successful traders are those who make less frequent calculated trades. Therefore the ability of ETFs to be traded daily, should be exercised with caution.

Dangers associated with specialised funds
There are so many different types of ETFs you can invest in. This makes it so important that proper research and analysis of the risk involved is done on the individual ETFs that you are considering to invest in. Some ETFs are not designed for your average investor and can be very specialised. These include leveraged and inverse ETFs, where you have the potential to lose much more than you originally invested. These securities should only be played around with, by those who have the knowledge and experience, otherwise you may be exposed to some serious risk.

ETFs may not be for everyone, but they can be a part of a lot of people portfolios. Once you weigh up all their pros and cons, you can see that they might be a safer bet for many people as they are designed to track an index, commodity, bond or group of stocks in a particular industry. However it is important not to take this article as investment advice, as every individual will have different requirements, preferences, and risk tolerance levels. In other words an ETF that suits one person may not be applicable for another. With so many ETF’s out there, it is important to do your own research to come to your own conclusions.

 

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