ETF is short for ‘exchange traded fund’. This is an increasingly popular product in the financial world. And it’s also one of the cheapest and easiest ways for us to enter the world of stock market trading.
They are a relatively recent product – well, in terms of the share market at least. They first came on to the market in the 1970s and considering the stock market has been around for centuries that makes them young.
Even though they’re a relatively new concept, it’s been estimated that more than three trillion US dollars are now held as ETFs.
While there is some debate about whether they are distorting the traditional stock market – like a tail wagging a dog – it’s recognised they are here to stay.
What is an ETF?
It’s called an exchange traded fund because it is a fund which trades on the stock exchange.
To break this down further, a fund is something you can invest in which gets you a bundle of investments, rather than just one. The stock exchange is where you buy and sell shares (mostly online these days).
So instead of buying a share in Commonwealth Bank, for example, you can buy a share in an exchange traded fund which in turn holds shares in lots of the companies listed on the Australian Stock Exchange.
Or instead of being limited to investing in Australian Companies, the bundle purchased can be from a much wider range of assets. That is, you can invest in a bundle of bonds, international shares, a commodity such as gold, or a currency such as the US Dollar.
You can also buy ETFs which bundle up a range of different assets classes for you, such as Australian shares, international shares, property, bonds and cash and invest these accordingly to different risk profiles, for example a ‘Conservative,’ ‘Balanced’ or ‘Growth’ ETF.
The benefit of diversification
By investing in this way, you can easily gain access to a well-diversified bundle of investments that is spread across many asset classes, regions and companies. The beauty of this is that it dramatically lowers risk.
When the investment is scattered across, say 200 companies, it is far less risky because if one company tanks, you’ve got the others potentially performing well. For you to lose your money entirely, all 200 companies have to go bust which is highly unlikely.
Diversification also smooths out your returns. For example, say you owned an international share ETF right now. That fund would be invested in a range of different sectors, including the technology sector which is doing very well, and others such as the airline sector which is really struggling.
Passive vs Active Investing
An ETF usually tracks an ‘index’. When you listen to the financial news you often hear commentators talk about the ‘All Ordinaries Index’ or similar. The index is a list of companies on a particular stock exchange and the combined performance of this list of companies is reported each day, so it is easy to follow (Up or down!).
For example, The All Ordinaries index tracks the change in the value of the top 500 largest companies listed on the Australian Securities Exchange. The ASX200 Index tracks the top 200 companies, and the ASX100 Index tracks the top 100 companies.
Technological wizardry has developed since the 1990s, allowing complex computer algorithms to do most of the grunt work behind the scenes. The result is an ETF that mirrors or replicates the index. This means that the return you achieve by investing in this product will be very close to that of the index. You won’t do better than the index, but you also won’t do worse. This is a ‘passive’ way of investing.
By contrast ‘active’ investing, is when the busy trader buys, sells, buys, sells – hovering, watching, running around researching and trading shares with the aim of buying those going up in value and selling those going down. The aim is to outperform (or do better than) the index.
All this effort that goes into ‘active’ investing for the client costs money, since someone has to do the work of watching, monitoring, and then selling it at the right time. There are offices to rent, salaries to pay, etc, etc.
As a result, ETFs typically cost less than half as much to run as traditional managed funds.
One of the arguments often made in favour of active investing, is that active investment funds outperform passive investments funds, and that this justifies the higher fees. However there is plenty of research which shows that this is often not the case.
Each year S&P publishes the ‘SPIVA (S&P Indices Versus Active) Scorecard.’ This year’s report showed that:
- 62% of actively managed Australian equity funds failed to beat the S&P/ASX200 Index over the 12 months to 31 December 2019
- 75% failed to beat the S&P/ASX200 Index over the 3 years to 31 December 2019, and
- 81% failed to beat the S&P/ASX200 Index over the 5 years to 31 December 2019.
In other words, actively managed funds don’t always do better than the index anyway. With an index tracking investment you can be confident that you will not underperform, whereas with active investing, the research shows that you are more likely to underperform than outperform the index.
So, with all of this in mind, ETFs offer a really good investment. With ETFs you can start trading with small parcels of money, the products are diverse so you can buy a whole lot of assets in a single trade, they’re transparent, they have low management expenses and they are easy to trade.
If you would like to know more about investing or how ETFs could fit into your financial plan, please Contact Us.
To see the SPIVA report, go to: