Getting Started: What Are Exchange Traded Funds (ETFs)?

As a budding investor, you might be overwhelmed by the number of companies, markets and industries you can invest in.

You might have limited funds as well.

But if that is the case, how can you get started investing?

Let’s look at how a risk averse investor can start his or her investment journey of investing by tapping on exchange traded funds, or ETFs.

What are ETFs?

ETFs are investment funds that trade like a stock on the exchange.

Akin to other funds, it pools money from investors into a basket of different investments including stocks, bonds, indexes and other securities.

The fund’s money is spread out into various securities and each ETF can hold a number of underlying assets.

Some ETFs could include stock and bonds while others mimic indices such as the Straits Times Index (SGX: ^STI).

By buying one ETF, an investor has a stake in the fund’s basket of investments.

Why buy ETFs?

1. Saves time on research

Since an investor can purchase a basket of securities at one go, you stand to benefit from the time saved from making multiple purchases of certain stocks or bonds.

ETFs can be especially helpful for investors who just started out and may have neither the time nor inclination for detailed investment analysis.

2. Portfolio diversification

Investment portfolios that contain a mix of different securities are considered diversified.

Diversified portfolios can help to reduce investment risks.

A Smart Investor should allocate his funds to multiple baskets, rather than just one.

Since ETFs contain a basket of securities, investors gain exposure to a variety of assets in certain sectors, industries or even countries by purchasing one.

Owning ETFs is thus attractive because they can provide instant diversification.

3. High liquidity

ETFs have the added advantage of enjoying high liquidity.

Being a popular asset class, significant volumes of ETFs are traded daily, making them convenient to buy or sell.

Because of this, ETFs can be converted into cash in just a day or two.

4. Minimal capital required

There is no minimum amount needed to invest in ETFs.

Let’s say you only have a hundred dollars set aside for investments.

With this amount of money, you will be unable to buy every company in the S&P 500 index.

However, what you can do is to take the 100 dollars and invest in an ETF that tracks the S&P 500 index instead.

Hence, this option is especially attractive for beginner investors who are just starting out.

5. Low fees

Fees are significantly lower for ETFs compared with standard unit trusts.

Due to the passive nature of ETFs, they have lower management and operational fees thus it is of lower cost.

The expense ratio of Straits Times Index (SGX: ^STI) ETF is about 0.3%.

In contrast, a typical fidelity unit trust would have an average expense ratio of 1.7%

Hence, investors stand to gain from attractive lower fees when buying ETFs.

Note: Expense ratio measures the amount of assets used in a fund to finance management and operating expenses.

A possible drawback

ETFs are popular among investors due to the reasons mentioned above.

However, there are also underlying risks associated with ETFs.

Certain industries are more volatile than others.

If we were to compare an index ETF to an oil and gas industry ETF (made up of oil and gas stocks), the latter ETF will be subjected to more volatile price swings due to the nature of its industry.

The underlying composition of the ETF may ultimately affect your long-term returns.

Get Smart: Understanding your investments

ETFs can be an attractive option for a new investor.

However, similar to any investment you make, it is important to know the pros and cons before putting your hard-earned money into it.

Understanding the benefits and risks of ETFs help in your decision-making and also mitigate the chance of losing money.

As with any investment, money does not grow overnight.

If all goes well, the ETF you invested in will grow and generate a healthy profit.

Over the long-term, investing in the right ETFs can help to grow your wealth and set you on the path to a happy retirement.

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Disclaimer: Jia Yi does not own any of the companies mentioned.

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