ETFs have soared in popularity over the last few years as a popular investment option for novice and experienced investors alike. Short for Exchange Traded Fund, an ETF seeks to track the movements in prices of an underlying commodity, asset, stock index or other asset. For example, an ETF tied to the Australian Stock Exchange 200 will increase or decrease by the exact same amount as the ASX index each day. Similarly, a 5% increase in the price of Gold would lead to a 5% increase in an ETF tracking the price of the commodity.
ETFs are often viewed as an alternative to Mutual Funds however the two have some key differences. Mutual Funds are run by a team of managers with a specific investment objective – for example outperforming a specific benchmark index such as the S&P 500 or the London FTSE. In order to pay for the services of the management team, investors pay an amount usually equal to 1-3% of the value of the assets under management.
This brings us to one of the key benefits to investing in an ETF – the low management costs. Mutual Funds tend to employ a team of generously-paid fund managers and these expenses are passed along to the investors regardless of how the fund performs.
Since the funds are simply looking to track the underlying asset or index, fees associated with managing the fund are far lower. Additionally, many ETFs are exempt from trading fees so investors do not need to concern themselves with trading fees eating into their profits.
Given that ETFs seek to track the underlying performance of a particular asset or index and not to outperform it, investors may question why they should invest their capital in them. Would it not be a more prudent investment strategy to allow an experienced team of investment managers handle your hard-earned money?
There are a number of different philosophies when it comes to investing in index funds. Many investors believe a strong fund manager can regularly outperform the market and is therefore worth the management fees they charge. However, there are also a growing number of investors who feel that in the long run investors are better off simply investing in an index fund. Warren Buffet, arguably the greatest investor ever, advocates this approach and went as far as to place a substantial wager against an investment manager that over the long-run, no mutual fund or hedge fund would out-perform the S&P 500 index. Although many funds have outperformed the market in the short run, they do not have the long-term track record to necessarily prove that they can do it in the long run.
Since ETFs track an underlying asset or index – the scope of which can be anything from real estate in Chile to the entire New York Stock Exchange – it provides a great opportunity for investors looking for exposure to a particular market. Think gold would be a strong investment? You can buy the SPDR Gold Trust ETF which will track the movement in prices of the precious metal. Want to diversify your portfolio outside of the first-world markets? You could purchase the iShares MSCI Emerging Markets ETF for exposure to emerging market economies. Even country-specific ETFs like the India Earnings Fund (EPI) or the Market Vectors Russia (RSX) are at your disposal. Every year hundreds of new ETFs are being created and more niches are being covered.
Another advantage of Exchange Traded Funds is that they are available on many of the top exchanges. For example, Australian investors looking for exposure to the US stock market can purchase the SPDR S&P 500 ETF. Listed on the ASX and denominated in Australian dollars, this fund provides Australians the opportunity to get direct exposure to the US market without having to convert their funds to USD (which can cost as much as 4%) or invest on a foreign exchange.
Investing in foreign markets can take time – choosing which stocks or funds to buy, converting your funds, executing the trade and settling it. Likewise, investors looking to get access to funds invested in foreign-denominated stocks first need to convert them back into their new currency. Incurring a conversion cost of, say, 3% each way can really eat into profits!
Fortunately, ETFs are far more liquid than traditional stock purchases. Since investors can get exposure to foreign markets without converting funds, they are able to execute trades far more quickly and at a lower cost. Since these ETFs are traded like individual equities, there is never a shortage of volume being traded every day so investors can liquidate their foreign investments and receive their payout in their local currency quickly.
The main advantage of ETFs over individual share is that it provides investors with diversification. Take, for example, an investor with $500,000 looking to invest in real estate. Purchasing a single house to rent out is the epitome of putting all your eggs in one basket! If that property declines in value, or if the investor is unable to find a tenant, that will have a disastrous impact on their portfolio. However, if that investor were to invest the $500,000 in the iShares Residential Real Estate Exchange Traded Funds, they would have exposure to the entire US Real Estate market! If there were problems with a few of the properties it would have a negligible impact on the investment.
Likewise, investors looking for exposure to a gold mining company would be well protected if they invested in the Market Vectors TR Gold Miners Exchange Traded Funds as it contains a basket of companies – if one particular company was facing financial difficulty the impact on returns would be lessened by the relatively strong performance of the other companies.
As you can see, Exchange Traded Funds provide a great way for investors to add exposure to particular markets, commodities or assets. They are highly diversified so investors reduce the risk of having the poor performance of one particular company bring down their investment. Additionally, they are highly liquid, available on many of the top exchanges in a variety of currencies and feature very low management costs. It is no surprise that Exchange Traded Funds have so drastically increased in popularity over the last few years!