Exchange Traded Funds – Everything You Need To Know

While acronyms are usually reserved for highways and government bodies, Exchange Traded Funds (or, ETFs) is one you should pay attention to, to avoid missing out on an effective investment tool.

From get go to understanding the outset of the concept to even the very word “ETF”, it can be a little bit confusing. But the truth is ETFs are actually a very simple financial product.  They are straightforward to use and can be a great addition to a portfolio when you are looking to capture the gains of diversification. Year after, investors are buying ETFs at an accelerating rate.

What is an ETF ?

An exchange-traded fund (ETF) is an investment product that is traded on stock exchanges in a similar way stocks.

How does it work?

By purchasing an ETF you can invest in a number of different investments in one go – without having to manage each individual investment yourself. For example, an ETF can cover stocks, commodities, or bonds. This means that investor money is pooled into a fund and each investor gets a slice of the returns. Many ETFs are put together to replicate an index, such as a stock index – like the FTSE 100 – which is the 100 biggest stocks traded on the London Stock Exchange.

What are the benefits?

The great thing about investing your money into an ETF is the costs are much lower – you get to invest in a wide variety of assets without all the extra hassle of trading each one and paying each individual commission fee. You also save time and do not need to monitor each individual investment. Another benefit is that investing in an ETF is typically, more tax efficient compared to other investments. However, as a Singapore resident who enjoys a zero rate of capital gains tax this is not an important attraction.

Currently, lots of investors across the globe find ETFs an effective investment choice and they have therefore become the most popular type of exchange-traded product. The most appealing characteristic of an ETF is that if you have limited funds you do not have to put all your money into just one stock or bond investment. With an ETF you can buy a share in the ETF and in exchange you get to invest in a wider range of assets without having to spend lots more money and without having to spread your limited funds too thinly.

These days you can buy an ETF that covers specific industries, countries, types of assets (such as stocks or bonds). You can also buy an ETF that is higher risk but might give a higher return or if you prefer a more conservative investment you can find an ETF that is low risk with a more modest expected return.

By buying an ETF you can get a piece of a certain markets performance with less risk and complication.

A Simple Example

Say for instance, you keep hearing in the news about rocketing house prices Instead of buying an entire house, which is expensive, unrealistic, time consuming and risky, you can instead by an ETF which covers real estate companies, construction companies and/or decorations businesses.

As these companies grow and make profits you will earn a return on your ETF investment.  In case you are nervous about investing in ETFs and are wondering if it is a new fad or trend do not fear – ETFs have been around and making investors good returns for over two decades now and are becoming the more and more popular choice each year.

In fact the number of ETFs for you to choose from has been growing at an accelerating rate year on year. In fact, the number of ETFs available to investors has grown by over 10 times over the past decade – from around 200 funds in 2003 to over 2000 by 2014.

Seek variety

If you are not sure which ETF is right for you it can be a good idea to buy a share in an ETF from a few different sectors – this will give your portfolio diversification and variety and can lead to better returns and lower risk to your money.

An example ETF

As an example you might begin by purchasing an ETF that covers the retail sector. This can be a great choice when the economy is going through an upward phase – growing and improving. This is normally a time when everyone starts shopping more and profits grow for retail outlets.  The risk in the sector is also quite low because the retail sector normally includes companies that sell products that everyone will always need – products that sell even when the economy is bad. These companies make profits whether the economy is good or bad. By buying a retail sector ETF you can get a slice of this sector’s return for your investment.

A popular example is the SPDR S&P Retail ETF (XRT) which gives you exposure to 97 American retail companies covering a range of retail business categories, including general stores, pharmacies, grocery stores, department stores, automotive retailers and clothing stores. The top ten holdings in these ETF include popular names and strong performers such as Groupon, Ulta, Expedia and Dollar Tree. You can buy a share in this ETF for around $90 and this fund has a high probability of returning over 15% return in one year.

In summary

Like investing in the stock market the price of ETFs can go up as well as down. There are risks involved so it is a good idea to do a bit of research before investing in an ETF – check out what is included and the track record of the ETF for example.  With a little bit of attention an ETF can be a great investment choice for your money.

Read more on The New Savvy’s articles on investment ideas or market analysis.