What is an ETF?
What is an ETF? How do they work? How much money can you make from them and which type of investors should own ETFs? We answer all these questions below
What is an ETF?
An Exchange Traded Fund (ETF) is an investment fund like any other: It pools investors money and uses it to invest in various assets classes, this can range from stocks, bonds, gold, and even crypto-currencies.
You can find investment funds pretty much everywhere, whether that be at your local bank, or through the financial advisor that just cold-called you. You should stay away from these products at all times. Investment funds that are offered to you are rarely those you want. Instead they are the funds that will bring the bank, and the salesperson calling you, the biggest commission.
ETFs are different.
ETFs differ in three main ways: They have lower fees, higher performance, and are easily accessible. Here’s a breakdown.
Advantage #1 - ETFs makes investing easier
ETFs are publicly traded. This means that you can buy in and out of ETFs the same way as you would a stock. You simply log-in to your brokerage account, select an ETF of your choosing, and click buy.
The fact that ETFs are publicly traded makes investing exceptionally easy.
The biggest issue investors face is stock selection and diversification, here’s why: While finding a good stock takes time, effort, and often luck, wise investors never invest in a single stock. In fact, Benjamin Graham (Warren Buffett’s mentor) advised to diversify across at least 15 stocks. Finding 15 great stocks that will bring you satisfactory returns is a challenging task, and even if you do find them, knowing when to sell them, buy new stocks, and efficiently managing your portfolio is tremendously difficult.
ETFs take care of all that.
ETFs allow you to track an index, such as the USA’s S&P 500 or Europe’s Eurostoxx 600. Buying just one of these ETFs help you get exposure to hundreds of stocks at once. The best part? There’s no maintenance. If a new stock enters the index (e.g. Tesla entering the S&P 500) the ETF will reflect that automatically. This means that you never need to sell an ETF to buy another one (as you may need to with individual stocks).
For more on index funds, check-out my mini-guide on index funds.
Advantage #2 - You won't get ripped off
ETFs are cheaper than most investment funds are there. This translates into significantly better performance. This is due to two main reason:
1. Most index funds are passively managed. This means that the fund manager does not need to pay an army of traders and analyst to trade in-and-out of hot stocks (this strategy doesn’t work anyway). This keeps costs low, and thus maximizes your investment earnings.
2. ETFs are publicly traded. This brings some competition to the market and drives costs down. Think of it this way: If you’re faced with two ETFs tracking the same index which are identical in every way, which would you choose? I would pick the ones with the lowest fees. Even if you made a mistake and bought the wrong ETF, you can always sell it and buy the cheaper ETF in just a minute.
Banks, brokers, and some financial advisors have bad reputations for good reasons: They rip people off. They charge new investors an obscene amount of fees. Unfortunately too many people haven’t done their research and they believe that a 2% annual fee is reasonable. It isn’t. Most index funds will charge as little as 0.15%.
Advantage #3 - There's an ETF for that
Remember Apple’s popular slogan in the 2010s “There’s an app for that“? Well the same applies to ETFs.
No matter what you’d like to invest in, whether that be oil, green energy, bitcoin, or even cannabis, you can be sure there’s an ETF for it.
Do you believe artificial intelligence is the future? Buy an AI ETF! Do you think China will take over the world? Find an ETFs that tracks China’s stock market. Do you want a steady stream of income to supplement your pension but you don’t know which stocks to buy? Buy a dividend growth ETF that distributes dividends.
Although I wouldn’t recommend it, traders can also utilize ETFs for quick gains by buying highly leveraged ETFs. For example a triple-leveraged ETF would make three time the gains (or losses) of the underlying asset performance during the trading day.
No matter what you want to invest in, there’s an ETF for that, and buying into them can take less than a minute. ETFs are great to diversify your portfolio or to invest in the simplest possible way.
Advantage #4- Taxes
As you may have already guessed, you can do pretty much anything with ETFs, even minimizing your taxes.
Let me explain, if you hold an individual stock which pays dividend, you will have to pay taxes each time you receive this dividend. This does not happen with ETFs. If you select an ETFs that reinvest dividends (also sometimes referred to as accumulating ETFs) this will be done automatically, thus reducing your total tax rate.
You also won’t be paying any taxes while your ETF is appreciated in value. Instead you will pay taxes only when you sell this ETF. This means that you can delay paying taxes as much as possible (provided you don’t sell the ETF). This gives you an edge and is part of the reason why ETF and index funds investor have greater returns than stock-pickers over the long term.
So where's the dirt?
No article is ever complete without an overview of the possible downsides of investing in ETFs. Lucky for us, there are very few drawbacks, here are the main ones:
1. Beware of issuers. ETF providers are well aware that ETFs are successful and popular investments. Some providers take advantage of this fact by charging higher management fees hoping that new investors won’t notice. Do yourself a favor and check out the ETF’s factsheet before you buy.
2. Beware of transaction fees. Even an ETF with dirt-cheap management fees can become expensive if your broker is charging high transaction fees. While this isn’t specific to ETFs and has more to do with the choice of your broker, don’t forget to pick a cheap broker.
3. Beware of counterparty risk. This is an extremely low risk and is very unlikely to happen but here goes: When you buy an ETF, you buy shares in the ETF, not in the underlying stocks themselves. This means that you own the ETF that owns the stocks (or in other words you only have indirect ownership of these stocks). If the issuer of the ETF (e.g. a bank) goes bust, there is a chance that the insolvency court may come after the bank’s asset (in this case the underlying stocks that make up the ETF). This is a highly unlikely scenario, but is another reason why you should opt for ETFs that are domiciled in countries with strong investor protection laws such as the USA, the EU, Switzerland, or Singapore.
4. There is a better option. ETFs are cheap, accessible, and help maximize returns. ETFs are much cheaper than investing through an actively managed mutual fund and thus can provide higher return. But there’s an option which is even cheaper: directly holding Index funds. While you can invest in index funds through ETFs (in fact this is their most common use) you can also open at account at low-cost providers such as Vanguard or Fidelity and invest in index funds directly without going through your broker. This will save you transaction fees, and the management fees should be a bit cheaper too.
This difference of 0.11% is tiny, but investing 10,000$ over 40 years, assuming the historical average yearly return of 9.1%, will grant you an additional 13,402$ (approximately 4% extra). Yes we're nitty-picky here, but that's still free money!
Summary
ETFs are an investor’s best friend. They can be used in various ways from investing in index funds (something we should all do) to diversifying your portfolio through bonds, commodities, or real estate.
ETFs make it easy to invest. Want to build a sound investment plan? Invest in an ETF that tracks the MSCI world index and add a world bond ETF for the added stability (at the expense of performance). This is a simple process that should take you less than a minute once your brokerage account is open.
ETFs allow you to combine simplicity with superior returns, all without giving any fees to greedy bankers or corrupt financial brokers.
Whatever you’re into, there’s an ETF for that.
FAQ
A traditional ETF that tracks an index such as the S&P 500 will usually hold each stock within the index individually. For this reason these ETFs are know as physical (because they physcially own the stocks).
Some ETF provider like to keep things simple and minimize costs, to do so they sometimes enter in a swap agreement with another fund provider. The ETF provider will pay a fee in exchange for the gains (or losses) of the underlying index (the S&P 500). This is what we call a swap and, as the ETF does not physically own the stocks in the index, this is known as a synthetic ETF.
For investors, there is very little difference between the two, but the physical ETF will usually carry less counterparty risk and can therefore be considered a little bit cheaper.
You will often notice that some ETF are hedged against currency risk. This often means that the ETF issuer has entered into a currency swap agreement with another counterparty to ensure that the value of the portfolio at the start of the trading day will not be affect by currency volatility.
The truth is, if you invest for the long term, there is no need to worry about currency risk. Let’s illustrate this with the example of a European investor investing in the S&P 500 through a currency hedged ETF.
If the value of the dollar falls, a currency hedged ETF will not lose any money. However, an unhedged ETF would appear to have lost value as the ETF is denominated in euros. But here’s the thing: It’s only an appearance. American companies are still worth as much as yesterday. And if the value of the US dollar stays low for a long time, even if it looks as if you’re euro-denominated portfolio is declining, you may take comfort in the knowledge that a cheaper US dollar is beneficial to US firms, and vice versa.
Over the long term, it does not matter much. Opt for the cheapest ETF instead.
However, and while we stray here into portfolio management, it’s important to not keep all of your assets in foreign currency as you may be adversely affected if there are wide swings in currency valuie right before you need to cash-out for a purchase or if you need to periodically sell to live (e.g. you achieved financial independence and you now live in Thailand).
Low risk – Holding an index funds that tracks a broad market such as the MSCI world, the S&P 500, or the Eurostoxx 600 will ensure that you hold hundreds of stocks at once across multiple industries. This will help ensure that you are never wiped out by any sudden bankruptcy or stock market crash. Over the long term index funds should beat the market if they reinvest your dividends.
The only risk that you really have is counterparty risk- the risk that your index fund issuer will go bust and committed fraud. You can reduce thar risk by investing in reputable providers (e.g. Vanguard or Fidelity) and invest in index funds which are domiciled in countries with strong investor protection regulations (e.g. the EU, US, Canada, or Singapore)