Exchange-Traded Funds (ETFs) are all the rage these days. Should you buy and sell ETFs, managed funds, or single stocks?
What are exchange-traded funds? They are like an updated version to a managed fund. A typical managed fund has a manager who picks stocks and then has to time his purchases and dispositions of such stocks to maximise investor return. Managed funds must buy and sell physical shares from current shareholders, which can have a huge impact on prices.
Exchange-traded funds work differently. A designated broker buys a basket of stocks. We will talk about what stocks he picks in a minute. He then switches this basket of stocks for a massive amount of ETF units. Each of these ETF units represents a fractional portion of the basket of stocks. These are bought and sold on a secondary market.
This might seem almost the same as a managed fund, but consider some of the differences:
- ETFs can be bought and sold short. You can buy options or buy on margin for additional leverage.
- You can buy and sell ETFs during the day where managed funds are at the end of day.
- ETFs can mirror an index, sector, or even an entire country.
- You can see the holdings of an ETF at any time. Managed funds usually only offer such information every 3 – 6 months.
- ETFs trade on a stock exchange, have prices that change throughout the day, can be purchased through a full service or a discount/online brokerage, and often have lower management fees.
If you want to trade a basket of stocks simply and effectively without having to buy each individual company, then ETFs might be right for you. What are some of the big perks to buying ETFs?
Although ETF trading in Australia is not as popular as in the US (currently trading in ETFs accounts for over half of all daily sharemarket trades in the US), ETFs have experienced explosive growth recently.
Reasons to Buy ETFs
One of the biggest perks of buying ETF’s is a reduction in volatility. You gain diversity, or a wide selection of stocks all combined in one ETF. Diversification leads to less volatility. If one stock in the mix reacts wildly to news, the performance of the other stocks should moderate the effect. A reduction in volatility lowers investor risk.
Another reason many people will buy ETFs is due to the variety of products you can invest in that would otherwise be unavailable. For example, an ETF can mirror the movement of the S&P 500 index, the price of gold, silver, copper, the technology sector, bonds, or the Russian stock market. Most of the above investments are difficult, if not impossible, for the average investor without the aid of an ETF. This means that investors and traders can buy trade products indirectly that are not even available on their local exchange.
ETFs allow you to analyse broad markets and sectors instead of trying to dig through annual statements of individual stocks. Perhaps you read up on the economy and feel that gold will go drop and oil will go higher. Normally you have the option of buying time sensitive futures contracts or purchasing oil and gold based stocks. Purchasing stocks can be more time consuming as you need to analyze each company for metrics and ratios not directly related to the rise in commodity. Why not purchase an ETF that mirrors the price of the commodity, or even an ETF representing the entire sector? Thus you can profit by forecasting change without worrying about accounting problems of individual firms.
Risks of ETFs
Despite the many upsides to ETFs, you should be aware of a few downsides and caveats to watch out for.
- Some ETFs are leveraged. This means that they can move 2 or 3 times the daily movement. Such ETFs do not typically make good long-term holdings. They are geared for day-traders, or short-term investing. Leveraged ETFs provided 2 or 3 times the daily underlying movement, but have a tendency to greatly underperform over longer periods of holding.
- ETFs are made up of baskets of stocks. Never forget that the ETF is firmly rooted in real assets. You should understand what the underlying assets are to ensure it fits with your overall investment strategy. For instance, an ETF could be designed to track a small cap index. This ETF will no doubt be far more volatile than a larger cap one. Or it may be invested in emerging markets or certain sectors that will expose you to additional risk.
- Ensure the ETF has decent liquidity. If an ETF is thinly traded, you could experience tracking error. This happens when the price of the ETF starts to deviate from the net asset value. For instance, imagine the SPY fund (which 1/10th mirrors the S&P 500) is thinly traded. The S&P 500 index is at 1,300 and the SPY fund at 130. But because there is such little liquidity, your big purchase drives the price of the SPY fund up to 140. After prices settle, you are sitting with a quick loss. (The SPY is anything but illiquid, but you get the point)
Final Word
There is a huge variety of options when it comes to trading ETFs. Whether you like commodities, stocks, currency, bonds, global investments, or industrial sectors, there is an ETF for you. They trade on the market just like a stock, however, each ETF is a small slice of a much larger basket of investments.
ETFs are typically passively managed unlike managed funds which have a manager trying to time his purchases and sales of stock for investor profit. The ETF investment product provides broad diversity and enables the smaller investor to use strategies that were previously unavailable.