What are ETFs?

“One of the most attractive elements of ETFs is their cost structure. Because ETFs are based on indexes, there’s no need for a staff of two-dozen, Porsche-driving Harvard MBAs, so a minimum of your hard-earned money is consumed managing the indexes.” – The Motley Fool

As the name suggests, an exchange-traded fund (ETF) is a basket of securities traded on an exchange. The collections often track an underlying index, such as the S&P500 and the FTSE100. ETFs are like mutual funds in some ways, but they are listed on exchanges and, like shares, are bought and sold on the market. Advanced orders can also be placed with stops and limits. The price of an ETF will change throughout the trading day, whereas mutual funds trade once each day after the market is closed. Some ETFs use various strategies and can include a mix of investments in industry, commodities and bonds. Being marketable securities, ETFs are easy to purchase and sell.

Are ETFs a wise investment?

The ETF can be a useful investment vehicle for large and small investors. They are particularly suitable for those that want to expand the diversity of their portfolio but do not have the time to research and manage their investments. ETFs invest in a range of companies that are linked in some way, usually by business sectors, such as technology or pharma. By buying an ETF, the investor has the benefit of incorporating several companies within a portfolio without directly obtaining shares in each of them.

If the performance of a particular company is difficult to analyse and understand, then an ETF might be a more appropriate investment. Some companies can perform exceptionally well because of some anticipated advance in technology or pharmaceuticals. That can, however, turn around very quickly if there is a setback, perhaps with the technology or a disappointing performance in the testing of a new drug. With an ETF in an overall sector, the failure of one company to perform as expected will not have the same effect as if individual shares were held in one company.

As with share dealing the purchasing or selling of an ETF incurs a commission fee. These trading costs can quickly accumulate if regular trading is carried out and will adversely affect the return on the investment. That is why some investors prefer a mutual fund that does not levy a sales charge or commission. It is essential to take into account the costs involved with buying into an ETF when compared with a mutual fund that is holding the same or very similar assets.

Some fund providers charge low fees and others make no charge at all for buying and selling ETFs. Driven by an increase in the attractiveness of ETFs among investors, some funds no longer charge commission; however, it is crucial to understand about expense ratios. They are to cover an ETFs operating expenses over the course of the year and are calculated as a percentage of the fund’s total assets. The costs are not a fee as such, but if the expense ratio is high, it will adversely affect the returns for investors.

The downsides of ETFs

ETFs do have their drawbacks, and as with all types of investment, anyone contemplating putting money into ETFs should first do their research. They are not, of course, without risk and are subject to the vagaries of the markets like all investments. Some investors prefer to buy shares directly because of their in-depth knowledge of a particular company and its potential for growth or impressive dividend returns. If that is not the case, then an ETF might be a more appropriate investment vehicle.

Conclusion

When investing in companies, either directly by buying shares, or by using mutual funds or ETFs, it is essential to have a knowledge of the sector and the investment fundamentals. It is also vital to keep up to date with news as it affects companies and industries in which you have investments.