Investing in Exchange Traded Funds (ETFs)

As you begin your journey in investing, you’ve probably come across Exchange Traded Funds (ETFs). A few questions probably come to mind, such as: What are ETFs? How do they work? Why should I invest in them?

WHAT ARE ETFS?

ETFs are a great tool for simplifying the investment process and diversifying risk, and aspiring investors should learn all about them.

ETFs are marketable securities that can be traded like shares on a stock exchange. Fund managers create ETFs to emulate the movements of indices of stock exchanges. ETFs attempt to track the price of an index, commodity, bonds, or basket of assets.

One example of an ETF is the Vanguard 500 Index Fund (Ticker: VOO), which tracks the Standard & Poor’s 500 Index, one of the most popular US stock market indices. The S&P500 is formed from a basket of 500 of the largest US companies by market capitalisation, which include household names such as Microsoft.

In VOO’s case, as the value of the S&P500 moves up and down, so does VOO’s price. This is what’s meant by “tracking”. Also, it should be noted that tracking is imperfect; a fund’s tracking can be accurate (below 1% difference versus the index’s performance) or inaccurate (several percentage points off versus the index’s performance).

The level of precision depends on how quickly and precisely the index fund executes trades to match its portfolio of securities to the index’s constantly changing composition. This is a complex process, and the variation in timing and real-time changes in prices cause tracking errors.

WHAT ARE THE RISKS AND RETURNS LIKE?

ETFs that track indices or a basket of assets such as stocks are generally – but not always – less risky as compared to, say, a single stock. The diversified nature of ETFs makes them suitable starting points for aspiring investors.

Diversification is an effective way of reducing the so-called “single stock” risk to your investment capital. Let’s say you think that the technology sector is going to do well, and you want to invest in that sector, but you’re not sure which company to invest in.

You might also be afraid that you might pick a company that unfortunately doesn’t perform well that year. You could even end up losing money in that situation.

An ETF focused on the tech sector would then be a better vehicle for capturing the sector’s growth with reduced risk. One company may underperform the sector. Indeed, if you’re unlucky, you might pick a company that fails, or goes into bankruptcy, but it’s unlikely that 100 other companies in the same sector will all fail and be worth nothing.

But that’s an extreme scenario. A more likely scenario is a particular stock performs poorly despite the sector generally doing well. A sector ETF would help eliminate that single stock risk.

In terms of returns, ETFs usually work the same way as stocks. You may be paid dividends (some ETFs pay dividends and others reinvent the dividends) for holding shares in an ETF, and you can enjoy capital gains as the underlying asset’s price increases. Exactly how much in dividends and capital gains depends on the fund’s composition and the market’s performance for the year.

WHY IS BUYING AN ETF BETTER THAN BUYING DIRECT EQUITIES? COULDN’T I JUST DIVERSIFY BY BUYING INDIVIDUAL STOCKS MYSELF?

In theory, you could. But it is impractical to buy all the shares necessary to fully make up the composition of a typical stock market index. The investment outlay would often be larger than what a typical “newbie” retail investor could afford.

For example, to replicate the Singapore Straits Times Index, you would need to buy the stocks of 30 companies in the proportion of their “market capitalisation weight” in the index. Note the minimum “board lot” (trade size) on the Singapore Exchange is 100 units. ETFs make these stocks more accessible.

STRATEGIES IN INVESTING IN ETFS

A good investment strategy for ETFs is Dollar Cost Averaging. With this strategy, you buy into the ETFs at regular intervals with the same dollar amount.

Using the same dollar amount, when prices are high, you buy fewer shares and when prices are low, you buy more shares. By buying at both high and low points consistently, over time you end up with a portfolio of shares in the ETF that have an average share price at neither the highest point nor lowest point on the price chart. This moderates your risk in the event of short-term price corrections and gets you into the swing of investing regularly.

To be clear, dollar cost averaging does not guarantee returns. Market downturns can last years, and your investment could yield no (or even negative) returns throughout that period.

But a time-proven strategy is: 1) avoid trying to time entries and exits in the market 2) have a disciplined schedule of investments 3) hold your investments long-term.

Imagine putting in S$100,000 all at once into stocks and being down 10% of your capital (S$10,000). Seeing a large loss, you could be panicked into selling to cut your losses. Later on, you might see that the market recover and even go beyond your original entry price.

RISKS IN INVESTING IN ETFS

They are the same market risks as buying shares. While ETFs help reduce single stock risk, you are still subject to price fluctuations in the broad market. There is also liquidity risk, which can take the form of an illiquid market. In such a market, more selling than buying is taking place, making it hard to sell the assets that you have bought into.

Also, if you buy stocks on foreign stock exchanges, you are also exposed to foreign exchange rate fluctuations.

ETFS IN SUMMARY

ETFs are effective and cost-efficient investment vehicles. They offer stock diversification for relatively small amounts. They generally follow movements in the market indices they are created to track. But note they may diverge sometimes, in what is called “tracking error”. They are quite useful for aspiring investors in the small outlays required. And while there are fees, those fees are generally significantly lower than those charged for unit trusts.

4 KEY TAKEAWAYS:

• ETFs are good starting points for newbie investors, especially if you don’t want to overthink investment choices.
• They generally track the performance of their chosen market indices
• They offer diversification for small amounts, reducing your single stock risks
• Fees are usually lower than those for unit trusts

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