ETF (Exchange Traded Funds) – What is this!?!

I am back, had some busy weekends. Moved to a new place. Hope new home will help to deliver even better content to this blog. Today, we will continue with the subject of various assets. The particular asset we will be reviewing will be ETFs. I personally believe that this is one of the best options for many retail customers and is a fantastic tool to diversify your portfolio with minimal time, cost and effort. Also one of the easiest way to invest in foreign countries with minimal cost.

ETF Definition:

There are many options for ETFs in the market. It can be a bit overwhelming, they can cover various assets, regions, sectors and markets. The key thing to keep in mind, you what to minimise cost and get good diversification, also need to look into your overall portfolio and make sure that there are no considerable overlapping. For example, if you have a significant investment in technology stocks, you need to ensure that your ETF has lower exposure in this sector. Of course, if you like more exposure opposite is true.

Let’s go now via name and what means:

Exchange – The asset class is traded on some exchange like LSE or NYSE. This is a venue, where buyers and sellers can exchange financial products like ETFs, stocks, bonds.

Traded – You can buy and sell this product in exchanges any time while these are open.

Fund – Mean that include multiple assets in a particular combination.

ETFs are run by computers, thus, low running cost (0.2%-0.8%). You can have ETF tracking FTSE 100, small-cap stocks in all over the world, world index, bond index, etc.

Another product you may encounter that has similar properties is ETC (the exchange traded commodity). As it says in the name, the fund tracks the price movements of commodities: oil, agricultural goods, gold, silver, etc. Then fluctuates in value based on underlining.

So you may have realised already that ETFs can be used as a core for your personal portfolio. If you decide to construct your portfolio just from ETFs, need to consider different geographies and sectors too.

You can also combine ETFs with stocks but make it a majority holdings of your portfolio leave 5-15% to invest in a few stock. These are of course not just any stocks, but those you have spent considerable time investigating. This strategy is called core-satellite strategy/portfolio.

Trade Execution:

To buy ETF, you need to go to your broker (Had some listed in my previous blogs, The practical way to create investment Portfolio!). There are many in the market. You find the one you would like and buy it as a stock. There will be transaction cost involved.

The way I investest in ETFs:

Investigate good ETF that I need to make my portfolio diversified via Investor Chronicle. Then go to “Aj You Invest” find ETF there and mark it for regular investment. This means that “AJ you Invest” will buy me this ETF on 10th of the month. This will cost just £1.50. Then if I do not like to buy more next month, I just turn it off. You may say that you had to wait for a month or shorter period of time before you acquired the asset, but as a long-term investor, you should not care about one month too much in normal circumstances. What you should care about are diversification and transaction cost.

Additional Info:

There are more and more ETFs, which are not just tracking an index but also specialises say ETF with minimal risk (volatility). These could be any other combinations that deviate from a standard index. All are called smart beta ETFs. Note that this is still different from active funds as they still try to track an index and not outperform. Also, ETFs provides you with better transparency as you can check every day where they invest. Plus, you can trade every day.

Synthetic ETFs and Physical ETFs:

Synthetic ETFs get exposure to assets via derivatives SWAPs. The biggest risk with SWAPs is that counterparty can default. But if you buy ETF from a large provider like BlackRock iShares, it has multiple counterparties and if one fails there are others BlackRock can rely on.

Physical ETFs has a risk as well. Sometimes ETFs (companies behind ETFs) lend to underlining companies. This boots return and income. But if company become insolvent money are lost.

Word of caution:

There are various degrease of tracking, and you should always check ETF historical tracking performance in the index you are interested. Also, as mentioned multiple times before, keep your transaction costs low.

Furthermore, I am writing this blog on 01/10/2017, where we are in the environment of low-interest rate and “cheap money”. Thus, a lot of investors look for a higher return than what current government/corporate bonds offer. A lot of retail and professional investors invest in ETFs or stock. Most of the indexes are all times high or close. On a face value, ETFs are a safe investment, but some would argue that concentration is so high in a stock market that if something would happen to change views on stock investment, investors, who have shorter investment horizon, would drop their investment and the whole market could go down close to 20% or even more. As ETFs are tracking market their value would decrease by same or higher value.

That doesn’t mean that you should not buy ETFs, this is to make you aware of a risk that if the overall market goes down, ETFs will go down as well. Besides, you need to diversify your overall portfolio, house, job, bond investments, gold, stocks. Use holistic view when thinking about your portfolio. Also, if you are aware of this potential risk, you can make money if eventually, this event occurs. Most of the investments are a good buy for the right price.

Also, if you are aware of this potential risk, you can make money if eventually, this event occurs. Most of the investments are a good buy for the right price. When the market goes down, this will be the real time to start buying. And if you so happen to be in the market, when all starts, make sure that you did not overpay for your investment in the first place. When you buy ETFs you can see their underlining value, do not buy without good reason ETFs that have a price much higher. If you did not overpay, stay tight, after the rollercoaster is finished you should be where you were before or even better off. Note this process could take multiple years.

Good start to investigate various ETFs is

Morningstar – ETF Link

Investor Chronicle (you may need subscription to get access) – IC ETF Link

 

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