Imagine the following scene: you walk into a grocery store and you stumble upon the fruit aisle and begin to cast your gaze upon an assortment of exotic fruits. The question is, today will you buy blueberries, kiwis, or mangos? Or will peaches, cherries or passion fruit satisfy your taste buds? Given the extensive options available to you, you become overwhelmed and you simply cannot decide which fruits will find their way into your shopping basket. The customer service assistant discovers you in a heap; looking disheveled, overcome with choice overload and decides to walk you over to their new smoothie bar. The assistant cajoles you into buying a smoothie containing all of your favorite tropical fruits blended into a single carton. Delight! You are thrilled; you eagerly collect your smoothie in haste and head on your merry way. Congratulations, you have just purchased yourself an ETF. ETF stands for Exchange-Traded Fund.
An ETF is a basket of individual financial assets (securities), such as stocks, bonds, or commodities, that are bundled together into a single investment vehicle and trades on an exchange, just as a stock does.
ETFs free you from the decision to buy individual stocks (or fruits from our example) and allow you to get exposure to an entire market or region (or sector).
ETFs are passively managed and look to replicate a specific index. They come in various forms; you can buy an ETF containing a specific sector, like technology companies, or country, as well as ETFs for specific asset classes (i.e., bond ETFs, stock ETFs, or commodity ETFs). They can provide an array of benefits when compared to individual security selection. Let’s briefly explore:
Key Benefits:
Diversification: This is by far the greatest benefit. Choosing individual stocks (or other financial assets) comes with extensive individual and unique risks and those risks come in all shapes and sizes. You can materially reduce this risk by “buying the entire market” and save yourself the hassle of working out which is the riskiest (or least risky) investment option.
Lower Cost: Simply put, transacting in individual securities come with transaction costs and those costs rise the more “transacting” you do. Therefore, a single ETF grants you access to an entire market at a meaningfully smaller price to pay for your efforts.
Transparency & liquidity: You very much know what you are buying. The individual holdings are often disclosed and you can, in most cases, buy efficiently. ETFs are “liquid” in the sense that they can be bought and sold through the trading day with very little, if any, delay.
What are the drawbacks?
Control: If you choose to buy an ETF, you cannot choose the individual components and bundle them up. They are “ready-made” for you to take off the shelf, so it’s tough luck if you don’t quite like some of the individual components. Or, you can choose a different ETF that suits you better.
Risk & performance: ETFs are designed to track a market. Some companies will perform better than others, so although you are reducing your downside risk, this is at the expense of possible upside as some individual stocks may provide a higher return.
Commissions & expenses: All ETFs come with an expense ratio. This is essentially the total cost of running the ETF as a percentage of the fund’s assets. They can vary substantially based on the type of ETF you buy. It is therefore important to pay attention to these costs as they can detract from your net-net return.
To conclude, the rise of ETFs has been transformative in the investing world and they are, in large part, suitable for all kinds of investors. Whether you are a newbie or a seasoned financial market professional, they are easy to access across a variety of platforms and are cost-effective to execute. As with any investment decision you make, however, careful due-diligence is crucial in ensuring it tallies up with your risk tolerance and investing objectives.
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This paper is general in nature, for informational and educational purposes only and is not intended to be legal, accounting, investment, or tax advice. The information presented may represent MIO’s views based on various assumptions that may not occur or differ in the future. This presentation does not constitute a recommendation, solicitation, or offer to sell or buy securities, and should not be considered a recommendation to adopt any investment strategy. It should not be regarded as individualized, investment advice, or a suggestion to engage in or refrain from any investment-related course of action. In addition, MIO believes the information provided was accurate at the time of publication and is subject to change without notice. MIO does not assume any duty to update this information.