What Are ETF's?
The term ETF stands for Exchange Traded Fund. ETFs, like other types of funds, pull together money from investors to invest into a basket of different assets or securities.
In a general sense, ETFs are usually designed to track the price of an index or collection of underlying assets with there being a broad range of ETFs based on many kinds of securities and assets. Each investor owns an individual share of that fund meaning that they have proportional claims on its earnings.
For this reason, ETFs offer immediate diversification benefits as investors can invest in a basket of multiple assets without having to buy all the components individually. However, ETFs are inherently different to other funds as they are bought and sold like stocks on the stock exchange.
How are ETFs categorised?
ETFs are designed to track the price of an index or collection of underlying assets. Therefore, ETFs are broad but can be categorised by the assets or securities that they cover. The primary ETFs are Index ETFs, Bond ETFs, Commodity ETFs and Currency ETFs alongside others based on more niche assets or securities.
For example, a Bond ETF may invest the fund's money into a broad basket of short and long-term debt instruments. In contrast, a commodity ETF may only invest the fund’s capital into particular commodity securities.
These ETFs can be actively managed whereby a fund manager or team makes decisions about the fund's underlying portfolio allocation. However, passively managed ETFs seek to replicate a broader asset class or equity market's performance.
How ETFs generate returns?
As we know now, ETFs allow investors the chance to invest money in a way that tracks the price of an index or collection of underlying assets. However, we generate returns through either capital gains or dividends received.
ETFs generally make money when the value of the ETF's underlying assets rises, formally known as capital gains. Capital gains can effectively be 'cashed in' by selling the ETF once the price has appreciated. Historically, there has been an upward trend in asset prices over time.
In contrast, if the ETF tracks high-dividend securities, investors can generate return through these dividend payments. The two methods of generating return are not mutually exclusive, so you may generate returns from asset value increases, dividends or both.
Considering these ways of generating return are essential as it must align with your investment strategy and subsequent ETF investment. However, this must not be considered in isolation when investing and should consider other factors such as market preference and risk appetite.
What are the advantages of ETFs?
ETFs are unique and therefore have three unique advantages. The primary benefit of investing in ETFs is the immediate diversification benefits. Investors can gain exposure to a broad range of industries, sectors or equities, even if they do not have expertise in that specific area.
Likewise, as we previously mentioned ETFs are bought and sold during the day, meaning that investors have a high level of trading flexibility. This means that investors, should they choose to, can benefit from making timely investment decisions.
The last major advantage is the lower operating expenses from ETFs. This is because they are passively managed.
What are the disadvantages of ETFs?
One of the disadvantages of ETFs is over-diversification. Diversification reduces investment risk. However, ETFs are generally programmed to follow a specific index or underlying assets. This means that the index, and therefore the ETF, may not own the very best stocks.
The second disadvantage is the lack of rebalancing. Most ETFs do not rebalance their portfolios. Since many ETFs track an index, as the stock increase in price they become a larger percentage of the index, and vice versa, This means that by having an ETF that tracks an index, you may own more expensive overpriced stocks and less under-priced value stocks.
The third disadvantage of ETFs is the lack of control. When you own an ETF, you have no direct say in what stocks are bought and sold in the ETF you own.
How to mitigate ETF investing disadvantages?
When considering ETFs as a part of an investment strategy, it is important to mitigate their disadvantages.
All stated disadvantages can be mitigated by combining ETFs with individual stocks. This allows investors to have greater control over their portfolios, therefore allowing investors to construct an investment portfolio that aligns with their individual investment goals.
New investors who use ETF funds may consider adding individual stocks as their portfolio grows since ETFs are relatively easy to invest in. While investors with larger portfolios may use ETFs to gain a level of diversification.