Exchange-traded funds (ETFs) are a popular investment vehicle for both active and passive investors. They are similar to mutual funds but trade like stocks, offering investors a way to broaden the diversity of their portfolios without increasing the time and effort spent on managing and allocating their investments. ETFs are typically cheaper than mutual funds, with average fees of 0.17% compared to 0.44% for mutual funds. They are also more tax-efficient, as financial institutions can swap the underlying assets for others without triggering capital gains for investors.
While some ETFs track broad market indices like the S&P 500, others focus on specific sectors or industries, such as technology or energy. These sector-specific ETFs can be more volatile and carry unique risks, including market risk, tracking error, liquidity risk, concentration risk, and tax exposure.
When choosing an ETF, it's important to understand its underlying holdings and investment objective to assess its level of diversification. Costs, dividends, taxes, and liquidity are also key aspects to consider.
Characteristics | Values |
---|---|
Investing strategies | Dollar-cost averaging, sector rotation, short selling, betting on seasonal trends |
Accessibility | Low investing thresholds, instant diversification, low expense ratios |
Investment choices | Stocks, bonds, commodities, currencies, real estate, bitcoin futures |
Risk | Not all ETFs are diversified, some ETFs are risky, e.g. leveraged ETFs |
Liquidity | Liquidity depends on the volume of trading interest |
Tax efficiency | ETFs are more tax-efficient than mutual funds |
What You'll Learn
Dollar-cost averaging
- Decide on your ongoing contribution and frequency: Determine a set amount you can invest regularly, such as $50 or $100 per month, and decide on the frequency: weekly, monthly, quarterly, etc.
- Open a brokerage account: You will need a brokerage account to trade ETFs. Look for one with low or no commissions to minimise costs. Many brokers now offer commission-free ETFs, but be sure to read the terms carefully.
- Research and select appropriate ETFs: Focus on broad market index ETFs with low expense ratios. Avoid niche or leveraged ETFs. Some factors to consider when choosing ETFs include assets under management, diversification, dividend yield, expense ratio, tracking error, and trading volume.
- Invest regularly: On your chosen schedule, invest your set amount into the selected ETFs. Stick to the same ETFs instead of constantly changing them. You can also use a DCA investment plan offered by your broker.
- Reinvest dividends: Reinvest any dividends from the ETFs to compound your returns over time. Many brokers offer automatic dividend reinvestment options.
- Hold for the long term: Maintain patience and consistency for long-term growth. Ignore short-term market noise and focus on your long-term investment goals.
DCA is a well-understood strategy for building wealth, particularly when combined with a diversified portfolio. It is effective when asset prices rise in the long term and fluctuate in the short term, which is often the case in financial markets.
DCA offers several benefits, including mitigating market timing risks, imparting discipline to the savings process, and potentially generating higher returns by accumulating more units at a low price. It is a smart strategy for beginner investors, particularly those with a modest sum to invest each month.
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Sector rotation
Exchange-traded funds (ETFs) are a popular investment vehicle for both active and passive investors. They are similar to mutual funds but trade like stocks, providing investors with low-cost access to a variety of sectors and international markets.
There are three main sector rotation strategies:
- Economic-Cycle Strategy: This strategy assumes that the economy follows a well-defined economic cycle, with different sectors performing better at various stages. Investors buy into sectors that are about to experience an upturn and sell when they reach their peak.
- Calendar Strategy: This strategy focuses on sectors that tend to do well during specific times of the year, such as retailers during the Christmas holiday season.
- Geographic Strategy: This strategy involves selecting ETFs that take advantage of potential gains in global economies, such as countries with high-demand products or fast-growing economies.
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Low investing thresholds
Exchange-traded funds (ETFs) are ideal for investors who are just starting due to their low expense ratios, instant diversification, and a wide range of investment options. They also tend to have low investment thresholds, meaning you don't need a lot of money to get started.
ETFs are traded on stock exchanges, and you can transact in them throughout the day. They are also more tax-efficient than mutual funds, which is integral to their appeal.
ETFs have different tax rules depending on their assets. Profits from selling ETFs held for under a year are taxed as short-term capital gains, while those held for longer are considered long-term gains and are given a lower rate.
ETFs are known for having very low expense ratios compared to other investment vehicles. The expense ratio is a measure of what percentage of a fund's total assets are needed to cover operating expenses each year. While not exactly a fee paid to the fund by an investor, it impacts the total returns for investors.
The low investment threshold for most ETFs makes it easy for beginners to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance. For example, young investors in their 20s might be 100% invested in equity ETFs, while those in their 30s might opt for a less aggressive mix of 60% in equity ETFs and 40% in bond ETFs.
ETFs are also naturally structured to be diversified. For instance, an ETF tracking a broad market index like the S&P 500 would hold a diverse basket of stocks from various sectors. However, not all ETFs are diversified; some track specific industries like technology or energy.
Dollar-cost averaging (DCA) is a smart strategy for beginners. It involves buying a fixed-dollar amount of an asset regularly, regardless of its changing cost. This reduces risk and shields the investor from market volatility by minimising the impact of short-term market fluctuations.
Beginners can also benefit from swing trades, which seek to exploit sizeable price changes in assets like currencies or commodities. ETFs are suitable for swing trading due to their diversification and tight bid/ask spreads.
In summary, ETFs are a great option for those new to investing thanks to their low investment thresholds, tax efficiency, diversification, and ability to implement strategies like dollar-cost averaging and swing trades.
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Capital gains distributions
It is important for investors to understand how an ETF treats capital gains distributions before investing in that fund. While ETFs are generally tax-efficient, they are not tax-free, and capital gains distributions can impact the overall return on investment.
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Tax efficiency
Exchange-traded funds (ETFs) are considered a tax-efficient investment vehicle. Their structure and the way they are traded means they typically generate fewer capital gains than mutual funds, resulting in fewer taxable events.
ETFs are designed to be tax-efficient in several ways:
- Low portfolio turnover: ETFs tend to have low turnover, which reduces the number of realised gains that need to be distributed. This also means that ETFs generally hold underlying securities for longer than 12 months, which usually qualifies any gains that are realised for favourable long-term capital gains tax rates.
- Secondary market transactions: When an investor sells their ETF shares on the stock exchange to another investor, the ETF portfolio manager does not need to buy or sell any of the ETF's underlying investments. This means that one investor's sell decision does not impact others, helping to keep capital gains distributions low.
- Primary market transactions: ETFs have a unique creation and redemption mechanism, allowing authorised participants (APs) to build or disassemble baskets of ETF shares when demand increases or decreases. These transactions are typically conducted in-kind, meaning securities are exchanged for ETF shares rather than cash, and do not trigger a taxable event for the fund.
- Trading on an exchange: When ETF investors buy or sell shares, these transactions usually occur on the secondary market between two market participants and not the fund itself. This means that existing shareholders are insulated from taxable transactions within the ETF.
- In-kind primary market ETF transfers: When the demand for certain ETFs exceeds the supply of shares, or vice versa, a transaction occurs between an AP and the ETF issuer on the primary market. Instead of the ETF raising cash to meet a redemption, a pro-rata slice of the ETF portfolio is directly transferred to the participating AP on an "in-kind" basis, meaning no capital gains are incurred by the ETF or its shareholders.
- Custom baskets: Portfolio rebalancing can be done via a "custom basket" transaction with an AP in the primary market, which is conducted on an in-kind basis without realising any taxable gains on the basket's securities.
Despite their tax efficiency, ETFs still have tax implications that investors must consider. For example, investors may need to pay taxes if the ETF holds dividend-paying stocks or interest-yielding bonds. Additionally, taxes on ETF distributions must also be considered, as these are typically paid out monthly, quarterly, semi-annually, or annually.
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Frequently asked questions
Exchange-traded funds (ETFs) are investment funds traded on stock exchanges, much like stocks. They hold assets such as stocks, commodities, or bonds and generally aim to track an index, sector, or other assets.
ETFs offer advantages such as diversification, flexibility, and cost-effectiveness. They are also more liquid and have lower costs compared to mutual funds.
Like any investment, ETFs carry unique risks, including market risk, tracking error, liquidity risk, concentration risk, and tax exposure.
ETFs differ from stocks in their structure and investment approach. While a stock represents ownership in a single company, an ETF holds a collection of assets and typically tracks an underlying index.
ETF investing strategies can vary in their focus. Some ETFs track broad market indices, offering instant diversification across various sectors or industries. Other ETFs may focus on specific sectors, industries, or asset classes, providing more targeted exposure.