What is an Exchange Traded Fund (ETF)?

There’s a lot of talk among financial experts that support the idea of investing in Exchange Traded Funds (ETFs). 

They come highly recommended to those new to investing and are seen by many as a staple in a good investment portfolio. In this piece I’m going to cover what an ETF is, why they are loved and if they are actually a good investment.

 

What is an Exchange Traded Fund?

An exchange traded fund is a pool of investments that follow an asset class or an index. So, let’s say we have an ETF that follows the ASX 200.

This is the top 200 stocks that make up the Australia Stock Exchange. This means that the performance of your investment is going to be linked to the performance of companies like ANZ, IAG,A2 Milk and JB HI-FI.

It highlights that you will have exposure to a variety of companies in a variety of industries.

This means that your investment will be very similar to the overall return of the top 200 stocks in Australia. If the ASX goes up by 11% for the year, your ETF investment will go up by a very similar amount.

Difference between an ETF and managed fund

This is different to a managed fund or a mutual fund who rely on the expertise of the investment manager.

It is up to the investment manager and the investment team to pick and invest in stocks that they believe will do well. They are constantly running analysis on various companies trying to find the one with the best potential and biggest return.

This also means that the results of the investment manager will be independent of the market. If the ASX went up by 11% a good manager may have picked stocks that went up by 20%.

Thus outperforming the market.  The opposite is also true. The ASX could have a positive return but the managed fund could have a negative one. It all comes down to the fund manager.

The main reason experts like ETF’s is that they have less fees. An ETF will automatically track a group of assets with little input from an investment manager.

Whereas a managed or mutual fund will pay a base fee + performance fee to the fund manager depending on the overall outcome. A base fee can be 1%+ and very opened ended performance fees.

This investment vehicle also suits a hands off investor. You don’t have to worry too much about specific companies or industries’ as you have diversity.

And, to give you an example, from 1985 to about 2013, the Australian Stock Exchange returned 13.5% per annum, as an average. So, if you tracked that as an index, you’d average out to receive 13.5% per anum, as a return.

Now, the risk is that you can get ones that are only relying on one asset class. So, you might get an exchange traded fund that follows just financial firms in Australia, which means you’re going to track their exact performance.

If the financial sector does really well, your fund’s going to do really well. In the same breath, if they do really bad, then your financial return is also going to be bad.

Finding a Fund

One of the most popular index funds, or exchange traded funds, in the world is probably the Vanguard 500. And that tracks the top 500 companies in America.

It goes up when it goes up, it goes down when it goes down. There’s no picking stocks, there’s no worrying about trying to come up with the perfect analysis for the next one.

It’s just pulling it together, and tracking that. It’s a favorite recommendation by Warren Buffett

That’s the difference between an exchange traded fund, and a managed fund. And, that gives you an idea that they really do perform well over a long period of time, because you’re not trying to time the market, it’s more just time in the market.

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