Don't look for the needle in the haystack. Just buy the haystack! - John C Bogle
Are ETFs low cost and low-risk investments? And how good are they?
Exchange-traded funds or ETFs, were first designed way back in 1990, with the aim of giving retail investors access to passive indexed funds.
Since then, the ETF market has grown enormously and is now used by investors and traders worldwide.
Technological advancements and easy access to trading platforms have made ETF investment easier.
With the advent of the Covid-19 vaccine, ETFs have become more popular, owing to their growth and broad diversification potential.
The need for Investment in ETFs?
Thanks to the sluggish global economy and dwindling job market, the need to save and invest is more pronounced than ever before.
Lower returns on fixed-deposits and other asset classes are keeping investors on the back foot.
Lack of liquidity and the unforgiving nature of Real estate investment during adverse market conditions and a longer recovery cycle are significant deterrents for real estate investment.
What, then, can ETFs do for you?
What are ETFs?
An ETF is a type of investment fund that is traded on stock exchanges. Unlike mutual funds that you may purchase and sell based on their value at the end of the day, you may transact in ETFs all through the day.
ETFs may hold different assets such as stocks, bonds, commodities and currencies. Dave Nadig, an ETF industry pioneer, opines;
“ETFs are fundamentally a technology. They are mechanisms to achieve a certain goal, like phones. Traditional mutual funds were rotary phones. ETFs are smartphones: They do the same thing but are in a better package.”
Perception vs reality
A common perception is that ETFs are low cost, low-risk investments, and simply investing in S&P 500 ETFs guarantees good returns. While ETFs make for suitable investments, the fact remains that they are market-linked.
As a result, the risk they bear could be similar to that of other market-linked assets such as stocks, mutual funds, bonds and commodities. What works in favour of ETFs is that they give you access to an array of asset classes at a relatively low cost.
What are the different types of ETFs?
Different types of ETFs serve specific purposes and have distinct places in investment portfolios. Your main options include:
- Equity ETFs. These track equity indexes. Whether you wish to target a niche market, a broad sector, or a specific country, there is a good chance you’ll get a suitable ETF.
- Actively managed ETFs - Typically, ETFs are managed passively managed investments that track an underlying index. However, there a few that are also actively managed. ARK ETFs managed by Cathy Wood are notable of this category
Actively managed ETFs offer many of the advantages of mutual funds but with the convenience of ETFs. Buying active ETFs is a great way to include active management strategies in your investment portfolio.
- Fixed-income ETFs. According to the basics of asset allocation, it is best to diversify. Fixed-income ETFs come with lower risk when compared to equity ETFs while providing reasonably steady returns.
- Commodity ETFs. If you’ve been thinking about exploring the commodities market, commodity ETFs might work well for you. One option is to invest in an ETF that tracks price fluctuations in commodities such as precious metals or oil. Another is to invest in a commodity stock ETF that holds common shares of multiple commodity producers.
- Currency ETFs. Through these, you may invest in a single currency or multiple currencies. With the deprecation of the U.S. dollar, many investors are looking at hedging their bets through foreign currency ETFs.
- Specialty ETFs. These come in the form of inverse funds and leveraged funds. You may profit through the former when a specific index performs poorly. The latter gives you the ability to double or triple your returns through a particular index using leverage. While these offer excellent growth potential, they come with high risk as well.
Some of the other popular ETFs include real estate ETFs, bond ETFs, dividend ETFs, factor ETFs and sustainable ETFs.
Do ETFs pay dividends?
Depending on the ETF you invest in, you may stand to receive dividends – either monthly, quarterly or every six months. Reinvesting your dividends in the same ETF might be an option.
ETF vs Mutual Funds?
- ETFs are easier to buy and sell.
- ETFs, come with typically lower fees.
- You need to pay commissions when trading in ETFs, which is not the case with mutual funds.
- Most ETFs require little to no active management.
- Unlike a few mutual funds, a majority of ETFs cannot beat the market
Are ETFs safer than mutual funds, stocks and bonds?
ETFs, come with risks that are similar to those of mutual funds and stocks. ETFs, like most other investment instruments, can be low-, moderate or high-risk. As a result, you may even end up losing money through your ETF if you don’t play your cards right. While bonds offer reasonably predictable returns, investing in individual bonds is not easy for regular investors.
Are ETFs Good Investments?
ETFs can make for fitting investments provided one is selective about the process. This requires that you understand the underlying index, look at the volatility involved, and compare it with other indices. Aspects that need your attention when selecting suitable ETFs include:
- The returns you may expect.
- The role they play in your portfolio.
- The given index’s performance.
Are they suitable for beginners?
Beginners may benefit by investing in ETFs owing to factors such as a range of alternatives, easy liquidity, low expense ratios, low investment thresholds and the ability to diversify.
How much should I invest in ETFs?
ETFs, come with no minimum investment requirements. However, just how much you should invest depends on your income, wealth and portfolio’s existing asset allocation.
What Are the Pros and Cons of Investing in ETFs?
The main benefits of investing in ETFs include:
- Diversification and risk management
- Flexibility in trading
- Lower costs
- Tax benefits
The drawbacks linked to ETFs include:
- The wide choice of ETFs can be overwhelming, particularly for beginners
- You might need to pay steep/significant brokerage and custody costs at time
- Intraday trading and instant execution of the orders can be a deterrent for long term investment goals
- Unlike a few successfully managed Mutual funds, the majority of ETFs cannot deliver better returns than the underlying index
How I Can Help
I start the financial planning and investment process by understanding your goals and objectives while also considering your risk tolerance.
I can help you construct a robust portfolio and measure its progress while reviewing and rebalancing it regularly.
Get on the path to wealth creation by seeking your first free consultation now.
Author, Blogger & Independent Financial Advisor. My goal is to give you actionable tools for creating passive income and building wealth. More than 10,000 expats have already used my ideas to jumpstart their journey towards financial independence. Connect with me to start yours...