Beginner’s Guide: What Are Exchange Traded Funds (ETFs) and Why Invest in Them?

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Beginners Guide What Are Exchange Traded Funds (ETFs) and Why Invest in Them

If you are new to investing, exchange traded funds (ETFs) are definitely something worth your attention. ETFs can be a great investment vehicle, especially for someone who is new to investing or who has little capital to begin with.

What are ETFs and how do they work?

ETFs are open-ended investment funds listed and traded on a stock exchange, just like any other stock you know. An ETF is a type of fund that owns the underlying assets (shares of stock, bonds, oil futures, gold bars, foreign currency, etc.) and divides ownership of those assets into shares.

Instead of buying stocks of a single company, ETFs allow you to buy a basket of stocks in one transaction. By owning a single share of an ETF, you are essentially the legal owner of every underlying asset the fund owns. ETF shareholders are also entitled to a proportion of the dividends that each underlying asset distributes.

Pooling of investment resources through ETFs

The concept of ETF is simple. ETFs attract many small investors like yourself to pool your investment capital together. After which, your ETF manager will use the pooled capital to invest in a basket of stocks. This basket of stocks is chosen based on the investment mandate of the ETF.

Taking one of the ETFs (SPDR Straits Times Index ETF) that tracks the Straits Times Index as an example, their investment mandate or fund objective states:

“The Investment objective of the Fund is to replicate as closely as possible, before expenses, the performance of the Straits Times Index (“Index”). The Fund will seek to achieve this objective by investing all, or substantially the same weightings as reflected in the Index.”

Read also: 4 Easy Ways to Double the Money You Make

Why should you invest in ETFs?

1. Diversification

As the old saying goes, “Never put all your eggs in the same basket”. This applies to investing as well. The thought of putting all your investment into one single stock should never cross your mind. With an ETF, you get to enjoy the diversification benefits of owning a cluster of stocks. You do not have to worry about whether the company you invested in is facing cashflow problems. Neither do you have to worry about the company being disrupted by startups.

Franklin FTSE China ETF

Snapshot of the diverse stock holdings in the Franklin FTSE China ETF. Source: Liberty Shares

2. Simple, easy to manage for beginners

Buying ETF is as simple as clicking a few buttons on your electronic trading platform. You simply just log in to your brokerage platform, search for your desired ETF and make an order. If there is a corresponding seller for your bidding price, the transaction gets completed. You are now a proud owner of a basket of stocks that are picked based on the ETF’s investment mandate.

Just imagine if you had to buy 30 stocks in the Straits Times Index (STI) to mimic the returns of STI. You have to go through the same buying procedure 30 times, you also have to monitor the performance of 30 stocks. Moreover, how much of your portfolio should you allocate to each stock? Is it 2%, 5% or 10%? Which stock warrants a higher weightage in your portfolio? And why? Not to mention, you have to do a quarterly review of your holdings to rebalance your holdings.

Now look back at your first option, which is to purchase an ETF that tracks the STI. Do you still want to manage a portfolio of 30 stocks when one ETF will do it for you?

3. Low transaction cost

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Aside from your psychological biases, the biggest nemesis to investing is cost. For every trade that you make, you have to make a commission payment to your broker. Imagine the scenario where you are executing 30 trades to own every single stock in the STI. You would have to pay your broker each time you execute a trade to buy a stock. In total, you would have paid the commission 30 times.

However, if you had invested in an ETF, you are essentially only buying one stock through your broker. This means that you only have to pay commission once. Yet, you are able to enjoy the diversification benefits of owning 30 STI stocks. Well, isn’t that value for money?

Related: Beginner’s Guide: How To Test Your Risk Appetite When It Comes to Investing

4. Sleep easy and stress-free at night

Indices are used to track the investment performance of funds, be it hedge funds or institutional funds (e.g. Temasek). This means that ETFs provide an indicative overall market return that hedge funds and institutional investors use as benchmark. Every minute, investors are busy wrecking their brain to beat benchmarks, like the STI or US’ Dow Jones and Nasdaq. But do you really need to chase for returns above benchmark returns?

By investing in ETFs, you are “fixing” your returns to whatever return the benchmark is generating, a.k.a. the market return. Even if the ETF you own plunges, it just means that the whole market is facing a downturn. Once the economy recovers, the ETF would pick up again. Remember how US S&P 500 index ETFs plunged and returned even stronger 10 years later? So, why not just settle for benchmark returns through an ETF and sleep comfortably at night?

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5. Lower barrier to entry

There are certain asset classes that require a minimum investment sum. Bond investing is one of them. The minimum lot size for wholesale bonds in Singapore is 250,000. This means that, as a retail investor who wants to diversify your portfolio using individual bonds, you will need a large investment capital. This will exclude many retail investors who might be interested in bonds.

Through an ETF, you will be able to invest in bonds without a large investment capital. The ABF Singapore Bond Index ETF, which holds 45 different Singapore Bonds, only costs $116.20 per lot (100 shares).

Read also: Beginner’s Guide: When Should You Start Investing and What to Do First 

 

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