Exchange-traded funds (ETFs) are an investment fund that own assets and are traded on a stock exchange, similar to stocks. Investors who buy ETFs own a unit of the fund. Being a unit holder you indirectly own the fund’ assets.
ETFs are designed to produce a return of a specific index such as stocks (e.g. STI), bonds (e.g. ABF), currency, commodity (e.g. GLD) or even an investing style (e.g. size, value, sector and etc.).
ETF index fund was started in Aug. 31, 1976 by Jack Bogle, the founder of Vanguard. It was a revolutionary and unorthodox investment concept at the time as the investment industry was dominated by the mutual funds which practised active equity management (i.e portfolio managers make buy and sell investment decisions).
(Note: The first successful ETF (S&P SPDR) was started on Jan. 1, 1993. Jack Bogle started with the Index fund first before launching ETF two decades later. Click here to find out the difference between index fund and ETF.)
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Jack Bogle believed that passive management (index investing) would outpace active management and in return provide higher returns to investors because of its efficient cost structure (i.e low advisory fee, operating expenses, sales charge and portfolio transaction).
Wall Street ridiculed the idea and referred to the Vanguard 500 Index Fund (it was called Bogle Fund back then) as “Bogle’s Folly.” Yet today, the Vanguard S&P500 ETF alone has reached a market cap of $52.2 billion. The ETFs industry is no doubt dominating today’s investment industry.
In a recent report by Deutsche Bank, it shows ETFs assets totalling nearly $3 trillion by the end of 2015.
Here’s a quick breakdown of the advantages and disadvantages of using ETFs as an investment tool.
The benefit of ETFs
A common misconception about stocks investing is that stocks investing equals to stocks picking, and investors would have to flip through hundreds of annual reports and follow the latest business news in order to succeed.
This could not be more wrong in today’s ETF world. The truth is, you need neither of those. With the STI ETF, an ETF that tracks the index of top 30 blue chips companies in Singapore, investors can make benchmark returns without putting in hours on picking the right stocks.
Furthermore, numerous studies have shown that the average investors who cherry-pick stocks under perform the benchmark returns.
Other than the usual brokerage fee, investors are charged with a very small fee (less than a percentage) by most ETF providers. ETF expenses is paid in the form of dividends, and the dividends you are collecting is the net of the fee.
In comparison the expense ratio of a unit trust can be as high as 3-5%. Lower expenses mean higher returns, and the compounding effect on cost saving over a long period can be huge.
The daily trading prices of ETFs are open to investors on the exchange. As compared to unit trust where prices are reported based on yesterday’s closing NAV.
Low capital requirement & Diversification.
A single lot of SingTel shares would require $375 (It used to be $3,750 before the 100 shares per lot kicked in), but with the STI ETF all you’d need is $290 and you can own 30 SGX blue chips stocks. Diversification is easily achieved through ETFs, but not with individual stocks as the capital required is often huge.
The downsides of ETFs
ETFs replicate the performance of an index by owning a group of stocks which the index suggests. This tracking does not come without error, high tracking error means that the ETFs would not closely replicate the result of its tracked index.
When selecting ETFs, tracking error is an important consideration.
Inflexible and rigid.
ETFs do not give investors the discretion for stocks selection. There may be stocks that investors do not wish to own but is forced to because it is part of the index. It is both a blessing and a curse, average investors think they can do a better job by selecting the right stocks but often end up losing their hard earned money.
Research has shown that even knowledgeable professional fund managers fail to outperform the market on a consistent basis over long term. The chances that the average retail investors can is likely to be slim.