Investing In ETFs: What You Need To Know


Investing In ETFs: What You Need To Know

Exchange-Traded Funds (ETFs) are surging in popularity among investors. Here we provide a crash course on ETFs and offer some tips on how to choose a fund that is right for you.

Published on 4 September 2017

Exchange-traded funds (ETFs) are nothing new as they have been available in the market since the early 1990s, but – especially in recent years ­– they have become a wildly popular among investors. In the first seven months of 2017, US investors poured US$272 billion into ETFs – nearly breaking last year’s record inflows of US$287 billion, and pushing total ETF assets under management above the US$3 trillion mark for the first time ever.

For those out there who are not already invested in ETFs, we take a look at what makes these funds unique and give you some tips on how to choose the right ETF for your investment portfolio.

ETF basics

ETFs are marketable securities that can be traded daily on a stock exchange and track a particular financial asset such as a commodity (like gold or oil), an index (such as the Dow Jones Industrial Average), a sector, bond, or a foreign stock market.

Unlike mutual funds, ETFs are listed and traded on exchanges just like stocks – and thus have higher daily liquidity. Their value fluctuates throughout the trading day and their market price – as with stocks – reflects the highest price at which buyers are willing to buy and the lowest price at which sellers are willing to sell. Investors can employ share-trading techniques such as limit orders, margin purchases, and stop orders with ETFs.

ETFs enable investors to buy shares in a range of commodities and securities in different geographical regions around the world. ETFs actually own the assets of the fund, and their ownership is divided into a number of shares that are held by shareholders. And the shareholders also get a piece of any profits, such as dividends or interest, generated by the ETF.

Because there tends to be less trading of individual assets within ETFs as compared to mutual funds, their operational costs, fees, and taxation liabilities are lower. Obviously, individual shareholders benefit from this.

Some observers, however, have expressed concern about ETFs, as they promote a “passive investment” strategy, enabling investors to track and match the performance of a particular index without having to make daily decisions about which individual securities to buy and sell. The danger with passive investment tools such as ETFs is that markets  – which are often driven by emotions such as greed and fear – can fluctuate, and ETF investors are in some cases unable to protect themselves against these wild swings or take advantage of the opportunities that they may afford.

Mutual funds, in contrast, typically employ analysts who make “active investment” decisions on individual securities based upon fundamental or technical analysis. These analysts can quickly respond to market developments, and rapidly make buy-and-sell transactions to mitigate risk and maximise returns.

Key information

Here are some key figures and facts about ETFs:

  • According to the latest data, the ETF industry in the US is worth US$3 trillion ($US7 trillion internationally) with over 6,300 ETFs offered by 280 providers on 64 exchanges across 51 countries.
  • ETFs mostly track broad market indexes such as S&P 500, emerging markets, small cap, and gold, for example.
  • Fund management fees are generally low for ETFs, as they do not normally employ high-cost managers – but brokerage fees do apply with every buy-and-sell transaction. The Investment Fund Institute has reported the average annual expense of an ETF is 0.09% – compared to 0.82% for an actively-traded managed fund.
  • The underlying assets of each ETF are reflected in its share price, which is determined by supply and demand and fluctuates over the course of each trading day.
  • If you are looking to invest in an ETF, seek advice from your financial advisor or investment broker before pulling the trigger. Ask to be shown the ETF’s tracking error, which is a measure of how well the ETF matches its benchmark index.

Choosing an ETF

Investment in ETFs has skyrocketed in recent years and there is a wide array of ETFs in the market for investors to select from.

Given this abundance of choice, how do investors choose an ETF that fits their investment strategy, risk profile, and return expectations? Generally speaking, investors should choose an ETF that is diversified, inexpensive to hold, transparent in its investment strategy, and aligned with their investment principles, philosophy, and goals.

For example, if an investor thinks that gloom and doom is coming and that the price of a safe haven asset like gold will skyrocket, then an ETF that invests in the precious metal is the way to go. Those who have faith in emerging markets or the power of the Dow Jones should consider an ETF that specifically invests in them.

To give you a sense of the wide variety of ETFs on the market for investors to choose from, here are a few examples:

  • The SPDR Dow Jones Industrial Average ETF (DIA), launched in 1998, has a history of reliably replicating the performance of the Dow Jones Industrial Average – which is widely seen as a leading indicator of the overall condition of the US stock market and economy.
  • The SDPR STI ETF hold shares in the top 30 companies listed on the Singapore Exchange. These blue chip shares provide a benchmark and barometer of the financial health of the city-state’s stock market and economy.
  • The MSCI Emerging Markets ETF is an international equity index that tracks the performance of stocks from 24 emerging market countries such as China, India, South Africa, South Korea, and Taiwan.
  • The MSCI Japan ETF covers equities across Japan’s stock market. Since its launch in 1996, this bell-weather ETF – which has net assets of over US$16 billion – has been the investment vehicle of choice for those seeking exposure to Japanese equities.
  • The MSCI Australia ETF ­– which has US$1.75 billion in assets – offers a smaller play especially for those seeking exposure in leading Australian companies but not smaller caps, which are under-represented here.
  • The SPDR S&P 500 ETF ­– which tracks the performance of the S&P 500 index, a gauge of the value of the 500 largest corporations in terms of market capitalisation on the New York Stock Exchange and Nasdaq Composite Index – is the most popular ETF among US investors.
  • The SPDR S&P Dividend ETF is made up of the highest-yielding stocks in the S&P 1,500 index that have increased their dividends for at least 20 years.

The bottom line

Avoid ETFs that track obscure benchmarks unless of course you believe that particular investment has the potential for growth. For example, if you believe lithium is the next hottest investment (for powering our insatiable need for batteries), then seek out an ETF that includes the mineral in a mining portfolio. If it’s semi-conductors that you see as the investment future, there is an ETF on the market for you. As with any investment, make sure the ETF you choose matches your investment philosophy and goals.