Like many of you, I had no idea what an Exchange-Traded Fund (ETF) was until I took a module on it in school. I’m sure terms like stocks and bonds come naturally when talking about investments, but ETF is actually one of the more prominent categories in the finance industry as well!
What is an ETF?
In order to understand what an ETF is, it is important to understand what a mutual fund is.
A mutual fund is a financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, and other assets.
In essence, an ETF is like a mutual fund that trades like a stock. The ETF represents a basket of securities that reflects an index, such as the S&P500, or STI. The difference however, is that while a mutual fund has a net asset value (NAV) calculated at the end of each trading day, an ETF behaves like a stock, with price fluctuations throughout the entire day.
*It is important to note that an ETF is not a mutual fund
Yes.. this can be quite confusing, so let me illustrate with an example.
Straits Times Index (STI)
STI tracks the performance of the top 30 companies listed on the Singapore Exchange. The stocks chosen in the index represent five different sectors and 19 different industries, in order to show a variety that best represents Singapore’s economy. It is periodically rebalanced in order to stay relevant with the current economy. As the stock value of these companies fluctuate, so will the STI, which is an aggregate of all 30 companies.
STI ETF
I’m sure that there will be buyers interested in the performance of the STI, but you can’t just simply buy an STI. This is where the ETF comes into play. An STI ETF seeks to replicate and track the performance of the STI. This can be achieved through investing in the same companies that make up the STI in the same weightage. If the STI increases the weight of a company, the managers of the STI ETF will increase their investment in this particular company as well.
Using the STI ETF is just an example of what the ETF can track. There are many other examples out there: other indexes like S&P500, Gold, and even prices of livestock! The possibilities are endless.
Now that you actually understand what an ETF is, what are its upsides and downsides?
Upsides
1. Diversification
A single ETF gives exposure to a group of equities from various market segments. It can also track a broader range of stocks, or attempt to imitate the returns of a country.
2. Lower Fees
As ETFs are passively managed, they tend to have much lower expense ratios compared to actively managed funds. This would mean that they tend to be more attractive (in terms of cost) as compared to mutual funds, which are actively managed.
Downsides
1. Fees Higher than Stocks
Although ETFs are cheaper than their mutual funds counterpart, they are definitely more costly than stocks. Stocks do not have management fees, unlike ETFs. Also, as more niche ETFs are created, they will most likely have a lower demand and supply, resulting in a higher bid/ask spread.
2. Lower Dividend Yields
Yes sure, there are dividend-paying ETFs, but these ETFs may not pay as much as a high-yielding stock. This is because of the lower risks of owning ETFs. Even if you pick out the stocks with the highest dividend yields to form your ETF, these stocks usually track a broader market (more sectors), causing the overall average yield to be lower.
Summary
ETFs are non-conventional when compared with standard assets like stocks and bonds, but they pack their own pros and cons as well. Typically used to build a portfolio or gain exposure to specific sectors, ETFs are a good addition when you are looking for diversification. But even after all that is said, it is important to do your research before starting anything (especially if you are unsure)!
