This article provides a brief introduction to ETFs; what they are, and what the pros and cons to consider are, before you invest in them.

So, what is an ETF?

An ETF or “Exchange Traded Fund” is a fund which you can buy or sell daily on a stock exchange, just like a stock, and which tracks the performance of something more diversified than a single stock (which only reflects the performance of a single company e.g. IBM).

So, what does an ETF track?  Well, the first ETFs created were designed to track stock indexes (such as the U.K.’s FTSE 100, or the U.S.’s S&P 500), but there is an increasing proliferation of ETFs which track specific sectors, currencies, commodities, bonds etc.

ETFs have now reached such a level of acceptance within the investment community that the world’s most successful stock-picker, Warren Buffett, recently suggested that investors put 10% of their retirement funds into short-term government bonds, and 90% into an S&P 500-tracking ETF.

Looking at the performance of the iShares Core S&P500 ETF (ticker: IVV), for example, it’s clear that it (blue line, below) does a good job of closely tracking the S&P 500 index (green line, below):

That all said, Warren Buffett is generally U.S.-centric, so if you’d like something a bit more global than the investing version of the baseball “world series”, then you’ll be pleased to hear that there are ETFs which reflect performance of the top companies worldwide.

Advantages of investing via ETFs

1.    Diversification: if you understand the principle of not putting all of your eggs in one basket, then you’ll understand the advantage of not putting all of your money into a single company’s stock. If you believe that the UK stock market will rise, as a whole, over the next period, then you could choose to buy shares in each of the 100 companies in the FTSE 100 index, so as to better diversify your investment.  However, buying 100 stocks would be logistically difficult and incur charges on each of the 100 transactions.  This is where buying a single ETF which tracks the FTSE 100 index neatly meets the requirement.

2.    Cost-effectiveness: the management of an ETF by the company which creates it is essentially “passive” given that all they need to do is to ensure they own (if physically replicating the index) the necessary holdings in index-constituent stocks, in the right proportions. For this “passive” management, these fund houses generally charge less than 0.5% annually.  “Actively” managed funds, by comparison (which actively change the stocks making up their funds according to their view of future prospects), generally charge somewhere between 1% and 2%.  Famously, many of these “actively” managed funds have “actively” underperformed the passive ETFs that track stock indexes, in recent years, hence the relatively good performance of ETFs combined with their low ongoing charges have made them an attractive proposition.

Conclusion

Investing in ETFs can certainly play a part in setting up and maintaining a well-diversified portfolio, however they are not a cure-all.  Just as they have been successful in tracking stock indexes (which have generally risen over the last few years) up, they will be equally successful in tracking stock indexes downwards if and when they fall (whereas one might expect more “actively” managed funds to perform relatively better under those economic conditions).

As always, it pays to diversify, including diversification across both “passive” and “active” funds, and to rebalance your portfolio regularly to take profits off the table from sectors that have risen, and to buy more of sectors which have fallen.

In the journey of investing you may want to consider ETFs as the “public transport” of investment; taking you generally in the direction you want to travel.  Supplement the “public transport” part of your journey with a few “taxis” of actively-managed funds, and you should arrive at your specific investing destination in the most cost-effective way!

Michael Davidson is a Singapore-trained and qualified Financial Adviser with Global Financial Consultants Pte Ltd providing specialist financial advice and portfolio management services to international and local professionals in Singapore.

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*Please note that Michael Davidson is not a tax specialist or accountant and that none of the content outlined here should be taken as personal advice. You should consult your tax specialist and financial adviser to review your current financial situation and futures goals to consider whether this strategy is appropriate for you.  I expressly disclaim all and any liability to any person or organisation, in respect of anything, and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or in part, upon the whole or any part of the contents of this article.