Exchange Traded Funds (ETFs) have grown in popularity year on year over the past decade. But like any investment, an ETF has its fair share of advantages and disadvantages. The real question, however, is whether ETFs are the right investment for you.
A longtime follower of my column in The Star emailed me asking me about ETFs. He had just attended a talk given by an internet investment trading platform.
Feeling bloated after the conference, he shared that he believes ETFs are the best investment product ever invented. It was sold by the fact that ETFs offered the advantages of low cost and diversification conveniently.
Driven by this new “discovery”, he decided to sell all his existing investments in equities and SICAVs in order to invest only in ETFs. Sensing that he might not have a good understanding of investing, I hosted a ZOOM meeting to give him some views on ETFs.
Generally speaking, ETFs are a suitable investment for you if you want diversification at a fraction of the price you would usually pay for a well-diversified portfolio.
This is because the average expense ratio of an ETF is lower than that of actively managed investment funds. Hence, it confers economic benefits.
In addition, for very little cost, you can have access to stocks of certain countries or sectors without having to spend too much time selecting them. Like the iShare MSCI Hong Kong ETF for example, it covers many stocks listed on the Hong Kong Stock Exchange.
In addition, a single ETF is made up of several individual securities in an index. Consequently, in terms of risk, it is more diversified and less exposed to the risks specific to the company.
An ETF is a good investment vehicle if you want to gain exposure to specific sectors or markets that are more difficult to reach. For example, you can tap into the new Chinese energy sector or the American banking sector. In fact, Canada, countries in the Middle East or countries in Latin America are also close at hand.
ETFs are a good option if transparency is important to you. All actively managed ETFs are required to disclose their holdings daily. Hence, you will know exactly what you are investing in.
ETFs are for you if you have the time and skills to research and select the right investment. There are currently over 6,000 ETFs around the world.
You need to know how to select the right ETF that would support your investment strategies. In other words, if you are new to ETFs, you must be prepared to invest the time and effort to research the investment in order to profit from it.
However, while ETFs offer good diversification benefits, some ETFs, like the tech industry, can be very volatile. Prices can fluctuate from 20 to 30%. As such, in order to invest in an ETF, you must be prepared to take volatility into account and be prepared to bear the risk.
On the other hand, an ETF is not a suitable investment for you if you want to achieve higher returns than the index can offer. Most ETFs are passively managed to produce a return that replicates the underlying index. They can only give you the performance of the index.
To outperform the index, you need to invest directly in stocks or take advantage of the expertise of mutual fund managers in certain markets to outperform the index.
If you want to avoid certain stocks in the index, ETFs are not for you. Investors have no say in the individual stocks in the underlying index of an ETF.
This means that an investor looking to avoid a particular company or industry does not have the same level of control as an investor focused on investing in individual stocks. For example, you might want to reduce your exposure to a particular stock or focus only on stocks that are syariah compliant.
Warren Buffett, one of the great investors of our time, has been a strong supporter of the S & P500. This has led many people to think that they can invest all of their money in S&P index ETFs and nothing else.
But did you know that history has shown time and time again over many 10-year periods that a globally diversified portfolio can also deliver as high a return on investment as the S&P index, and with much less? of risks?
Therefore, if you are planning to buy a single ETF and not build a diversified portfolio, this idea may not work in real life.
Meanwhile, many people who claim to be able to tolerate prolonged stock market declines are finding out that they really can’t. Just ask anyone who sold in 2020 as the markets went down. Most didn’t have the stomach for volatility and had to sell low, incurring big losses in the process.
In the same year, hundreds of thousands of people lost their jobs or went bankrupt, forcing them to liquidate their investments due to an unprecedented pandemic. Many have seen their long-term horizons evaporate before their eyes
Therefore, while history shows that the stock market has been the best performing asset class over long periods of time, you are not living in a spreadsheet. You live in the real world and life gets in your way sometimes. This is why you need to diversify, in case you need to interrupt your long term strategy.
ETFs may not be the ideal investment for you if you believe in using the best strategy to access designated asset classes.
Historically, ETFs have not performed well in all markets.
In developed areas like the US and European markets, ETFs are much more effective than Asian markets (where there is less chance of outperforming the benchmark over the long term), making it difficult for Mutual funds generate alpha (additional returns than average market returns) relative to the market.
In contrast, trust funds tend to perform better in less efficient developing markets. For example, mutual fund managers in Malaysia and China are generally able to outperform the index and ETFs.
Indeed, in these markets, fund managers are always able to discover opportunities from fundamental or technical analysis to determine which stocks are undervalued or overvalued in order to increase their chances of achieving returns above the market. market average.
ETFs would not be ideal if you are not a disciplined investor.
One of the most beneficial aspects of investing in an ETF is the fact that you can buy it like a stock. However, it also creates risks which can adversely affect the return on your investment. Why? It can change your mindset from investor to active trading.
Once you start trying to time the market or pick the next hot sector, it’s easy to get caught up in regular trading.
Regular trading adds costs to your portfolio, thus eliminating one of the advantages of ETFs – low fees.
The cost of an ETF is relatively low. However, as more and more niche ETFs are created, they are more likely to follow an index at low volume.
This could lead to a high supply / demand gap and increased costs. In addition, an actively managed ETF also charges higher fees. Prior to 2005, the expense ratio of all previously issued ETFs averaged 0.4%, according to Morningstar.
Since 2005, the average spending of new ETFs has jumped to over 0.6%, while some of the new ETFs charge more than 1% in fees.
ETFs offer diversification benefits. However, just because an ETF contains more than one underlying position does not mean that it cannot be affected by volatility.
If you expect a guaranteed capital and a fixed income stream, ETFs aren’t for you. The extent of volatility will depend primarily on the underlying securities.
An ETF that tracks a broad market index such as the S&P 500 is likely to be less volatile than an ETF that tracks a specific industry or sector such as an Oil Services ETF.
Every time you add a fund for just one country, you increase the risk.
If you buy into a leveraged ETF, you amplify how much you will lose if the investment goes down. So, not all ETFs are the same, and so is their risk.
ETFs are not the perfect investment as most people think. At best, an ETF can be used to improve your investment portfolio, but it should not be viewed as a comprehensive solution to achieving your investment objective.
At any time, don’t rush into a new investment based on face value. You owe it to yourself to know more about investing before you part with your hard-earned money.
If you want to be sure that you are using the investment correctly, it is always wise to consult a licensed financial planner.
Yap Ming Hui is a Certified Financial Planner. The opinions expressed here are those of the author. Any reliance on shared information is therefore strictly at your own risk.