Etfs: A Beginner's Guide To Getting Started

Exchange-traded funds (ETFs) are an increasingly popular investment vehicle for both active and passive investors. They are similar to mutual funds in that they hold a collection of stocks and bonds in a single fund, but they are bought and sold on stock exchanges, can be traded anytime the exchange is open, and typically have lower fees. This makes them an attractive option for beginner investors.

ETFs are also well-suited to beginners because they are fairly simple to understand, can generate impressive returns without much expense or effort, and are considered safer than stocks due to their inherent diversification. They are also more liquid (easy to buy and sell) than mutual funds.

However, there are some potential drawbacks and risks associated with ETFs that beginners should be aware of. These include trading fees, potential liquidity issues, the risk of the ETF closing, and the possibility of paying a premium above the cost of the underlying stocks or commodities in the ETF portfolio.

Overall, ETFs can be a great way for beginners to get started with investing, but it is important to do your research and understand the potential risks and costs involved.

Dollar-cost averaging

DCA with ETFs allows for diversification and regular investing in various market sectors or indexes. It also helps you overcome emotional barriers to investing by removing the pressure of trying to "time the market".

• Decide on your ongoing contribution and frequency: Determine a set amount you can invest on a regular basis, such as $50 or $100 per month, and decide on the frequency: weekly, monthly, quarterly, etc.
• Open a brokerage account: Choose a broker and open an account. Opt for one with low or no commissions to keep costs down.
• Research and select appropriate ETFs: Focus on broad market index ETFs with low expense ratios. Avoid niche or leveraged ETFs.
• Invest your set amount: On your decided schedule, invest your set amount into your selected ETFs or use a DCA investment plan offered by your broker. Stick to the same ETFs instead of constantly changing them.
• Reinvest dividends: Reinvest any dividends from the ETFs to compound your returns over time or pick ETFs that automatically reinvest dividends.
• Hold for the long term: Resist the urge to alter your investments based on market swings. Remain patient and consistent for long-term growth. Tune out short-term noise and focus on long-term gains.

DCA is a well-understood way of building wealth, especially when combined with a strategy to create a diversified portfolio. It is a smart way of investing in the markets, provided that asset prices rise in the long term and fluctuate in the short term.

Passive vs active ETFs

Exchange-traded funds (ETFs) are an excellent entry point for beginners into the world of investing and stock markets. They are simple, cost-effective, and provide broad diversification, lowering the risk for new investors.

ETFs can be categorised as either passive or active.

Passive ETFs:

Passive ETFs are also known as index funds and are designed to track a specific stock market index, such as the S&P 500. They aim to match the performance of the index they are replicating, and their primary objective is to achieve the same returns as that index. Passive ETFs tend to follow a buy-and-hold strategy and have lower fees than their active counterparts. They are also more transparent, as they disclose their holdings daily.

Passive ETFs are ideal for investors who prefer a long-term, buy-and-hold approach, allowing them to implement indexing or passive investment management. They are also more cost-efficient, with lower management fees, as there is no active manager trying to beat the index.

Active ETFs:

Active ETFs, on the other hand, aim to outperform the benchmark index. They hire portfolio managers who actively trade securities within the ETF, using their expertise and strategies to try to beat the market and generate higher returns. Active ETFs provide more flexibility, as they are not confined to mirroring an index, and the fund managers can make allocation decisions beyond those of the index.

Active ETFs tend to have higher management expenses than passive ETFs due to the costs associated with active research, trading, and decision-making. The performance of active ETFs depends on the skills and expertise of the portfolio managers, and there is no guarantee that they will outperform the market.

Both passive and active ETFs offer benefits to investors. Passive ETFs are ideal for those seeking a long-term, low-cost investment strategy, while active ETFs offer the potential for higher returns but come with higher fees and the risk of underperformance. As such, passive ETFs may be more suitable for beginners due to their simplicity and lower costs.

Expense ratios

When evaluating an ETF, it is essential to consider its expense ratio in conjunction with other trading costs, such as commissions and bid/ask spreads. A fund with a low expense ratio but high trading costs may not offer better value than a fund with a slightly higher expense ratio but lower trading costs. Therefore, it is crucial to analyse the total cost of ownership when selecting an ETF.

The expense ratio of an ETF is an ongoing expense that is particularly relevant for long-term, buy-and-hold investors. Over time, even small expense ratios can add up and significantly impact your investment returns. For example, an ETF with a 1.5% expense ratio could reduce your returns by over $55,000 on a $100,000 investment over 20 years, assuming a 4% annual return.

When comparing expense ratios, it is important to consider the type of fund and the assets it invests in. ETFs that track well-known broad-based indexes, such as the S&P 500, tend to have lower expense ratios, while actively managed funds, funds that track more complicated indexes, or funds that invest in cryptocurrencies or derivatives tend to have higher expense ratios.

Additionally, the size of the ETF can impact its expense ratio. As an ETF's assets increase, its fixed costs become a smaller percentage of its net assets, leading to a decrease in the expense ratio. This is why larger, more established ETFs often have lower expense ratios than newer, smaller funds.

When selecting an ETF, it is crucial to compare its expense ratio with other funds, especially those tracking the same index or investing in similar assets. A good expense ratio is typically one that is below the asset-weighted average for similar funds. As a general rule, lower expense ratios are preferable as they result in lower costs for investors.

While expense ratios are an essential factor in evaluating ETFs, they should not be the sole criterion. It is also important to consider the fund's investment objectives, performance, and risk profile to ensure it aligns with your investment goals and risk tolerance.

Diversification

ETFs are an excellent tool for diversification because they are baskets of individual securities, allowing investors to buy multiple stocks or bonds at once. This means that even with just one ETF, you can achieve diversified investments globally, gaining exposure to thousands of companies in a single investment.

Sector ETFs:

Sector ETFs concentrate on specific fields, such as financials or healthcare. Choose ETFs from different sectors that are largely uncorrelated. For example, instead of investing in just biotech, you could also invest in a medical device ETF.

International ETFs:

These ETFs may focus on emerging markets, developed markets, or both. They can track an index that invests in a single country or an entire region. Be sure to look at the makeup of each ETF in terms of individual stocks and sector allocation.

Commodity ETFs:

Commodity ETFs can track a wide range of commodities, from gold to cotton to corn. Unless you have expert knowledge in a particular commodity, a broad commodity ETF can be a good choice.

Asset Classes:

A diversified portfolio should span various asset classes, such as stocks for growth, bonds for stability, commodities for inflation, and cash for security.

Robo-advisors:

Robo-advisors are online investment advisors that can build and manage a diversified portfolio of ETFs for you.

Single-Ticker "Asset Allocation" ETFs:

These ETFs use a "fund of funds" structure to encompass multiple other ETFs, giving them a conservative split between global equities and global fixed income.

Broad Market Index ETFs:

For beginner investors, buying ETFs that track broad market indexes, such as the S&P 500, is a good way to get started. This gives you exposure to some of the largest companies in the country, with the goal of long-term returns.

Remember, diversification should be practised in moderation. While it is important to reduce risk, too much diversification can lead to portfolio bloat and overdiversification, where the marginal loss of the expected return outweighs the benefit of reduced risk.

Liquidity

ETFs are generally more liquid than other investment vehicles, such as mutual funds, making them attractive to investors. This liquidity is due to their unique creation and redemption mechanisms, which allow for the adjustment of the ETF's supply to meet investor demand, thus maintaining price stability.

The liquidity of an ETF is influenced by two main factors: the trading volume of the ETF and the liquidity of its underlying securities.

Trading Volume

The trading volume of an ETF is the number of units or shares traded on an exchange. A high trading volume indicates that an ETF is frequently traded, which can lead to lower trading costs. However, it is important to note that trading volume is not the sole determinant of liquidity.

The liquidity of the individual securities or assets within an ETF's portfolio also plays a crucial role in determining the overall liquidity of the ETF. If an ETF invests in securities with limited supply or those that are difficult to trade, it may impact the ability of market makers to create or redeem units, affecting the ETF's liquidity.

When assessing the liquidity of an ETF, it is important to consider both the trading volume and the liquidity of its underlying securities. While a high trading volume can indicate strong liquidity, it does not always guarantee it. Similarly, low trading volume does not necessarily equate to low liquidity, especially if the ETF invests in liquid securities.

Advantages of ETF Liquidity

The liquidity of ETFs offers several benefits to investors, particularly beginners:

• Reduced trading costs: Higher liquidity in ETFs leads to lower trading costs, as there is less impact on the ETF's market price when buying or selling shares.
• Ease of entry and exit: Liquidity allows investors to easily enter or exit positions without encountering significant price discrepancies, providing flexibility and convenience.
• Price stability: The creation and redemption mechanisms of ETFs help maintain price stability by adjusting the supply of shares to meet investor demand.
• Diversification: ETFs provide instant diversification across a range of securities or assets, reducing the risk associated with investing in individual stocks.

Considerations

While ETFs generally offer strong liquidity, there are a few considerations to keep in mind:

• Potential liquidity issues: Less frequently traded ETFs or those with illiquid underlying securities may face challenges in maintaining liquidity.
• Impact of market prices: When selling an ETF, investors are still subject to the current market prices, which may differ from the desired price.
• ETF closure: In rare cases, an ETF may close if it fails to bring in enough assets to cover administrative costs, requiring investors to sell their holdings earlier than intended.

In conclusion, the liquidity of ETFs is an important feature that makes them attractive to beginners. The ability to easily buy and sell shares, along with the benefits of diversification and reduced trading costs, makes ETFs a suitable option for those new to investing. However, it is essential to assess the liquidity of specific ETFs by considering both the trading volume and the liquidity of their underlying securities.

Frequently asked questions