Exchange Traded Funds 101: A Beginners Guide To ETFs

Introduction

You've probably heard the acronym ETF getting thrown around a lot lately and wondered what all the fuss was about. The popularity of this security class has been skyrocketing, and you may want to up your financial literacy game and learn what ETFs are and whether they should be incorporated into your investment portfolio.

In the dynamic world of finance, countless investment vehicles vie for the attention of investors. Among these, Exchange-Traded Funds (ETFs) have recently emerged as one to take particular note of, revolutionizing investment strategies for individual investors and levelling the playing field. They have allowed everyday and average investors to leverage the performance and diversification of entire sectors and allowed for limitless customization options in their portfolios.

In this brief introduction, we aim to explore ETFs, their structure, benefits, potential drawbacks, and their critical role in modern investment strategies, as well as why we've adopted them as the benchmark underpinning our investment strategy at Shoestring Investing.

Exactly What Are ETFs?

An Exchange-Traded Fund is an investment fund that can be bought and sold on major stock exchanges, kind of like individual stocks. Each ETF owns underlying assets (such as stocks, bonds, or commodities) and divides ownership of those assets into shares. These shares can be bought and sold throughout the trading day at market prices.

The primary goal of an ETF is to track the performance of a specific index, sector, commodity, or asset class, providing investors with a way to achieve the diversification of mutual funds with the flexibility of stock trading and generally with a much better management expense ratio. The value of the ETF is essentially a reflection of the combined performance of the assets that comprise its portfolio or, more accurately, the investor sentiment towards the assets that comprise its portfolio.

The Spectrum of ETF Varieties

ETFs come in many varieties, each designed to cater to different investment objectives and risk tolerances or a specific interest in a particular industry or asset class.

Are you a passionate advocate for climate change and sustainability? There's an ETF for you. Would you feel more comfortable with a portfolio which directly tracks the performance of the largest companies in the world? There's an ETF for that, too. Do you think AI will play a pivotal role in the future? Yep, you guessed it, there's an ETF with your name on it, and the list continues seemingly ad infinitum from precious metals and cryptocurrencies to ETFs consisting of other ETFs.

Here are the most common types:

1. Index ETFs: Index ETFs aim to replicate the performance of specific indices, such as the S&P 500, offering broad market exposure. They are an efficient way to invest in a cross-section of the market without buying individual securities.

2. Sector and Industry ETFs: These ETFs track specific sectors or industries, such as technology, healthcare, or financial services, allowing investors to gain exposure to particular areas of the economy.

3. Commodity ETFs: These ETFs offer exposure to commodities such as gold, oil, or grains. They provide a convenient way to invest in commodities without the need to handle physical goods or futures contracts.

4. Bond ETFs: Bond ETFs consist of various types of bonds and provide a way for investors to access the bond market with more liquidity and flexibility than traditional bond investing.

5. International and Global ETFs: These ETFs provide exposure to non-domestic markets, allowing investors to diversify their portfolios across different geographical locations.

6. Thematic ETFs: Thematic ETFs focus on emerging trends or sectors like clean energy, artificial intelligence, or ageing populations. They offer investors a way to capitalize on these long-term trends.

7. Inverse and Leveraged ETFs: These sophisticated ETFs use financial derivatives and debt to amplify returns or to profit from a decline in the underlying index. They are typically used by experienced investors and require active management.

8. Actively Managed ETFs: Unlike most ETFs, which are passively managed and aim to track a specific index, these ETFs have a manager making decisions about allocating assets. They aim to outperform, rather than follow, an index.

The Advantages of Holding ETFs

ETFs offer a host of benefits that make them an attractive addition to many investors' portfolios, especially those of us "hands-off investors" who don't want to actively keep track of the performance of individual assets every day.

We, Shoestring Investors, want to capitalize on the exposure ETFs can provide with a sort of set-and-forget mentality and be comfortable that our position is as protected from concentrated market risk as humanly possible.

Here are some of the benefits:

Diversification: ETFs provide instant exposure to a range of assets, helping reduce risk by spreading investments across various sectors, industries, or geographic regions.

For example, if you would like to invest in companies that lead the way in tech but don't want to completely expose your position to the risk of something going pear-shaped at Apple, Intel, or Microsoft, then you can instead buy shares of a tech ETF and spread that risk across the entire sector.

Flexibility and Accessibility: ETFs can be traded throughout the day at market prices, providing the flexibility to react quickly to market conditions. Additionally, they often have lower minimum investment requirements than other investment vehicles, making them accessible to a wide range of investors.

Many platforms and brokers these days offer zero-commission trades for the most common ETFs and are optimized for mobile access, meaning you don't have to leave your couch to make a trade for pennies to nothing.

Transparency: Unlike other investment products, ETFs disclose their holdings daily, allowing investors to see clearly what assets they own through the ETF.

Cost Efficiency: ETFs generally have low expense ratios and can be more tax-efficient than mutual funds due to their unique structure.

The average expense ratio across the managed funds industry, the ratio of annual management and administration expenses to the value of your position, is around 0.5-1% and can even rise as high as 2.5%, cutting into your portfolio's returns each year. This would be $50-$100 to possibly $250 in handling costs for $10,000 invested...per annum.

In contrast, according to an article by Vanguard, a titan pioneer in the index fund space, the average expense ratio for common Exchange-Traded Funds across the entire industry is 0.1% or $10 for every $10,000 invested. The expenses are factored into the ETF share price and deducted daily.

ETF securities also enjoy the added benefit of being more tax-efficient. Investors who buy and sell shares of an ETF are doing so on the secondary market, and the fund itself rarely engages in distributions, potentially reducing long-term tax liability. (Gastineau, 2010, p.74)

In addition, this low turnover means that ETFs are generally held for longer than 12 months and are, therefore, eligible for discounted capital gains tax.

The cost advantages of ETFs may seem insignificant on the surface, but over time, expenses in any form can compound and blow out of proportion.

In the words of Vanguard founder and father of the index fund, John C. Bogle: "In investing, you get what you don't pay for."

What are the risks of ETFs?

Despite their many advantages, it's important to note that ETFs come with their own set of risks and potential drawbacks:

Market Risk: ETFs are subject to the same market risks as the underlying assets they track. If those assets decrease in value, so will the ETF's value.

Liquidity Risk: Some ETFs, especially those tracking niche markets or sectors, may have lower trading volumes. This can make buying or selling shares harder without affecting the price, potentially leading to higher trading costs.

Tracking Error: ETFs aim to mirror the performance of an underlying index, but they may not always match it exactly. This disparity is known as tracking error and can be caused by factors like fund expenses and changes in the composition of the underlying index.

Trading Costs: While ETFs often have lower expense ratios than mutual funds, frequent trading can lead to significant commission costs. However, adopting an "own it forever" mentality like your buddies here at Shoestring Investing can significantly reduce these unnecessary expenses.

The Long and Short

In conclusion, ETFs have undeniably carved out a significant niche in the investment landscape, offering a unique combination of diversification, flexibility, and transparency. They can serve as a powerful tool in building a robust investment portfolio. However, as with all investment decisions, it is crucial to understand the associated risks and potential drawbacks and to seek advice from an accredited professional before proceeding.

References:

Gastineau, Gary L.. The Exchange-Traded Funds Manual, John Wiley & Sons, Incorporated, 2010. 

https://ebookcentral.proquest.com/lib/curtin/reader.action?docID=537335

Vanguard. "Expenses Ratios: What They Are & How They Work."

https://investor.vanguard.com/investor-resources-education/education/expense-ratio