You’ve heard famous investors like Warren Buffett singing the praises of ETFs… but what are they, how do they work – and are all ETFs the same?
Intro (Reading time 0:36mins)
ETF stands for “exchange-traded fund”. It’s an investment fund, but one you can trade super easily, like a stock: an investor can buy or sell it on a stock exchange at any time during the trading day.
An ETF works by first defining its overarching aim: usually to mirror the return of an index like the S&P 500 (a collection of the 500 biggest publicly traded companies in the US) or to track the value of a specific commodity (like oil). Typically, it then buys the underlying investments – for instance, if it’s tracking the S&P 500, it will buy all the stocks in that index in accordance with their weights in the index (which is based on each companies so-called “market capitalization”).
Why Should I Care? (Reading time 1:45mins)
Many investors argue that low-cost tracker funds (whether ETFs or “index funds”) will outperform actively managed investments over the long term – primarily because of the high fees charged by the latter. Plenty of academic research backs up the claims; more anecdotally, Warren Buffett famously won a bet earlier this year that a simple investment that tracks the S&P 500 would outperform a collection of top hedge funds over a 10-year period.
👊 JARGON BUSTER - ETFs, index funds and “trackers”
It’s important to differentiate between an ETF – which is really just one way of setting up an investment fund – and the strategy that an ETF employs. A lot of ETFs are often recommended for their low cost: the fact that they simply track a broad index means that they don’t have to pay a fund manager to pick investments (this is commonly called a “tracker”). However, some ETFs are more expensive: they’re “actively managed” (i.e. a fund manager is choosing investments in an effort to outperform the overall market).
It’s really the tracker-style investment strategy and the accompanying low cost that many investors find most attractive, not the fact the investment can be traded on an exchange. “Index funds” are similar to ETFs – they’re also low-cost and aim to track an index – but they trade like traditional investment funds (i.e. they can typically only be bought or sold once or twice per day). Most long-term investors don’t require the ability to trade at any time of the day, and so for them there isn’t much difference between an ETF that tracks an index and an index fund that does the same.
What Can I Do? (Reading time 2:22mins)
For most investors:
ETFs offer low-cost exposure to big, broad investment areas, like US stocks, global bonds and/or emerging market stocks. For a relatively small fee, a robo-advisor (check out our WTF on these here) will build and manage a portfolio of ETFs with the aim of meeting your investment aims while taking account of the level of risk you’re comfortable with.
✅ Who is this good for?
This choice is often good for those newer to investing, as well as those with a limited amount of money to invest. But other investors can benefit as well: a robo-advisor will automatically take action to amend your portfolio when appropriate, removing some of the behavioral characteristics (like trying to time the market) that often lead to sub-par investment performance.
For more sophisticated investors:
Some investors won’t want to pay a robo-advisor to build a diversified portfolio for them; they want to do it themselves by investing in a small number of ETFs or index funds which, collectively, create an appropriate portfolio. The investor will usually have to pay trading and other fees, which could make this a more expensive option than a robo-advisor. One benefit, however, is that the DIY investor can choose which investments they own; if, for example, they want to own more emerging market stocks.
✅ Who is this good for?
Those with the knowledge to create and manage a suitable portfolio for themselves. An investor also usually needs to have enough money to make any trading or other fees worthwhile (for example, a $5 transaction fee is much more punitive for someone executing a $100 trade than a $10,000 trade).
Some of the biggest owners of ETFs are big investment managers that use ETFs for specific purposes, such as gaining immediate exposure to the overall market at a low cost (e.g. instead of buying a bunch of stocks, they can just buy a single ETF with one trade).
Similarly, individual investors with sufficient knowledge can use ETFs to supplement their portfolios. One example is adopting a “core-satellite” approach, which relies on low-cost ETFs for broad exposure to the market (technically known as “beta”), while a smaller part of the portfolio owns specific stocks that are supposed to perform better than the overall market (known as generating “alpha”). Alternatively, an investor that is positive on, say, the banking sector may choose to buy an ETF of bank stocks, forgoing the need to choose which individual bank stocks to buy but benefiting if the sector as a whole rises.
✅ Who is this good for?
More sophisticated investors capable of understanding, creating and implementing a strategy that utilizes ETFs for specific, tactical aims.
Remember, ETFs are just a way that investments are structured. Usually it’s the underlying strategy (e.g. a “tracker”) and the cost of owning the investment that’s more relevant than the label. Nevertheless, ETFs have a role to play for most types of investors, including sophisticated investors as well as those that just want an easy and inexpensive way to gain exposure to the markets.
Keep in mind investing is difficult and risky; your capital is at risk.