Smart Investment for Beginners: Demystifying ETF (Exchange Traded Funds)

What Is Exchange Traded Fund (EFT)

An ETF, or exchange-traded fund, is a basket of securities designed to replicate the performance of a stock, bond, or commodity index. Examples are QQQQ (Nasdaq), EWJ (MSCI Japan’s index), and IGE (Goldman Sachs Natural Resources Index). In other words, its performance relies on broad market trends and not the stock-picking skills of individuals (which could be good or bad). Each ETF is listed on an exchange and is traded like any other stock.

Why buy ETF?

For nearly a century, traditional mutual funds have offered many advantages over building a portfolio one security at a time. Mutual funds provide investors with broad diversification, professional management, relatively low cost, and daily liquidity.

Exchange-traded funds (ETFs) take the benefits of mutual fund investing to the next level. ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts.

There are drawbacks, however, including trading costs and learning complexities of the product. Most informed financial experts agree that the pluses of ETFs overshadow the minuses by a sizable margin.

ETF has pros and cons when compared with other financial products. Let’s go over it one by one.

1. ETF vs stocks

PROs

Better diversity

The greatest advantage of ETFs over company stocks is diversity. Buying ETFs for the S&P Latin America Index, for example, is less risky than buying Telefonos de Mexico alone.

Better exposure

In fact, we may find it quite difficult to buy individual companies not listed in our local market. ETF gives us an easy alternative.

Cons

Do more homework

When picking an ETF, we should have a general understanding of the particular industry/region. What’s good about it – an economic recovery, an oil-rich region, or an industry with a high margin?

2. ETF vs index funds

This is probably the most common question because both ETF and index funds allow you to buy into a portfolio of securities without your own active management. Here is my take on the difference and the pros and cons:

PROs

More flexibility

ETF shares can be bought and sold during the day, similar to buying individual stocks. On the other hand, we can only buy index funds based on the NAV (net asset value), which is calculated once a day after than market closes. Also, there is normally a minimum investment amount for index funds but not ETFs.

Lower cost

For index funds, fund managers have to buy and sell the constituent stocks more frequently to have cash available for investors’ redemption (i.e. taking out their money). While for ETF, there are basically no “managers” as the ETF simply tracks the movement of the particular index. Therefore, the management fee is generally lower for ETFs.

Cons

1. A few index fund managers may waive the transaction commission for their funds. In this case, the expense will be slightly lower than ETF.

3. ETF vs mutual funds

PROs

1. Same as above (index funds), except that mutual funds are actively managed and thus incur even more administration costs. This translates to higher management fees.

Cons

1. A few mutual funds manage to outperform their comparable ETFs, index funds, and their peers on a consistent basis based on their skills, expertise, and knowledge in a particular area.
2. If you are able to identify such a fund manager, the mutual fund can give you a superior investment return. Be careful: for apple-to-apple comparison, make sure you pick the “after-fee” return. And remember to read the small fonts where the mutual funds bury the miscellaneous fees and restrictions.