For the lazy investors who want to capture market returns without having to sift through countless annual reports and studying businesses, index funds or Exchange Traded Funds (ETFs) are a popular investing vehicle.
Index funds or ETFs track the performance of a market index and as an investor, you get to enjoy ease, flexibility, and liquidity while ensuring that your investments grow steadily.
Compared to other investment vehicles, the ETF is very similar to the common stock.
With ETFs, investors are subject to lower fees, usually because of the passive management mechanism (although there are exceptions like the actively managed ARK ETFs). On top of that, ETF investors do not need to spend hours picking individual stocks, instead you only need to choose your ETFs based on a broader market theme.
If this sounds like the perfect way for you to grow your money without having to spend hours reading financial statements and following the news, then this ETF investing guide is for you.
What is an ETF?
An Exchange Traded Fund (ETF) is a basket of securities. It trades on an exchange, just like a stock where prices fluctuate when the stock market is open.
ETFs can track the performance of an index, bond, sector, commodity and more. They provide investors with an easy, low-cost solution to investing.
You’d probably heard of index funds like the SPDR S&P 500 ETF (SPY) which tracks the S&P 500 Index.
Why ETFs?
ETFs are a unique investing vehicle and can provide several advantages to the busy investor who wants to improve their returns.
Advantages of ETF investing
1) Lower Costs
ETFs provide the following attractive advantages for investors:
- lower broker commission rates (as compared to buying each underlying security separately)
- low expense ratios
2) Ability to gain exposure to investing themes
Themed ETFs allow investors to gain exposure to specific investing themes without having to analyze and bet on individual companies.
For example, if you can gain exposure to specific industries or sectors if you’re bullish about their future, there’s usually an ETF for it. Some examples include cybersecurity, fintech, semiconductors, Metaverse ETFs and many more!
3) Transparency
Most ETFs update their holdings periodically and investors have full access to the constituents, weightage and fees involved.
Although ETF investors are not overly concerned about picking individual stocks, knowing what stocks you’re exposed to via your ETF portfolio gives you a peace of mind, especially during volatile markets.
4) Access to top fund managers and professionals
Additionally, actively managed ETFs have gained popularity thanks to ETF managers like the popular ARK Invest and even teams of professional fund managers from institutes like PIMCO and JP Morgan.
Such ETFs are usually managed by a team of professional fund managers who select the underlying securities based on an investment theme and allow retail investors to gain access to big name fund managers who may charge a bomb if they were to manage your money directly.
Disadvantages of ETF investing
It’s not all rosy.
ETFs have their disadvantages too – they have a glass ceiling of growth. Returns from ETFs are usually averaged out across the underlying assets in the fund.
DIY investors who believe that their investment returns can outperform indices or ETFs, tend to prefer building their own portfolio by picking individual stocks.
How to choose a suitable ETF to invest in?
What suits me may not suit you, hence I cannot give you a step by step method to choosing a suitable ETF here.
However, I can give you 2 key questions that’ll help you choose the best ETF for your investing needs.
1) Why are you investing?
Do you wish to grow your money or build an ETF portfolio that pays you regularly?
If you’re looking for capital gains, you might want to start by look at ETFs with strong historical returns.
If you prefer dividend payouts, then you’ll want to look at their historical dividend yields.
2) What investment theme are you bullish about?
Do you like the prospects of novel industries like the Metaverse? Or do you prefer the consistency of REITs or Market Indices?
Knowing this will give you a general direction to start from.
By answering the questions above, you should have an idea of the types of ETFs that may suit you.
At this point, you may still be overwhelmed by the selection of ETFs available to you. Hence, the following may come in handy.
3 Key Metrics to selecting the best ETFs
1) Expense Ratio
Expense Ratio is a measure of how much of the fund’s assets are used for administrative and operating expenses. It is derived by dividing the operating expenses by the Assets Under Management (AUM).
In other words, it’s the fee you pay.
Knowing the expense ratio of an ETF tells you how much of your investments will be used to pay for fees. Passively managed ETFs usually have a lower fee of <0.5%.
Actively managed ETFs, ETFs with small AUMs or ETFs covering small investing themes tend to have higher expense ratios.
Not sure how much is too much? We explore the good ranges of expense ratios for ETFs here.
2) Assets Under Management (AUM)
Assets under management is the number of outstanding ETFs multiplied by the ETF price.
The AUM tells you how big the ETF is, and gives you an idea of its liquidity.
Ideally, you want to invest in bigger ETFs because they tend to have lower expense ratio and better liquidity. The latter is important especially when you wish to sell. You don’t want to be stuck with an ETF with low liquidity when you wish to exit.
Having high liquidity also means that the bid-ask spread is usually tighter, which is also better when you wish to sell.
3) Tracking Error
This applies to passive ETFs that track an underlying index.
You’ll want ETFs with low tracking errors, which means that they’ll accurately track the underlying index.
If you wish to learn more, we shared an entire ETF Investing Course for free on the Dr Wealth YouTube channel, you can watch it here:
How To Buy ETFs?
It is easy to invest in ETFs as the process is very similar to investing in stocks.
Step #1: Open a brokerage account
Your broker will be the middleman to fulfilling your buy and sell orders. You’ll want to look for brokerages that give you access to ETFs. Some popular choices include Interactive Brokers, FSMOne, and many more.
Step 2: Decide on the ETFs
You should select ETFs depending on your goals and beliefs in investing.
We covered the best ETFs across various sectors and markets, you can read about them here:
- Best China ETFs
- Best UK ETFs
- Best World ETFs
- Best Fintech ETFs
- Best Cybersecurity ETFs
- Best Semiconductor ETFs
- Best Commodity ETFs
Step 3: Buy the ETFs
Don’t try to time the market. Decide on the ETFs you’re interested in, buy them and start putting your money to work
Step 4: Increase your portfolio size with regular cash injections
Most ETF investors aim to grow their money steadily, at levels similar to the market returns. To best exploit this characteristic of ETF investing, you may want to increase your positions over time.
Here’s a quick guide on Dollar Cost Averaging vs Lump Sum Investing
How to build an ETF portfolio?
There are many ways to build an ETF portfolio, and your choice depends on your investing goals. (We discussed in greater detail here)
Here’re two popular ETF strategies:
1) Three Fund Portfolio (aka lazy portfolio)
The Three Fund Portfolio is a simple strategy for lazy ETF investors, all you need to do is to pick three types of ETFs that give you exposure to:
- Total Stock Market Index Fund
- Total International Stock Index Fund
- Total Bond Market Fund
The FIRE community seems to like this strategy and the most common allocations for ETF investors consist of the following ETFs:
- S&P 500 ETF
- Global Bond ETF
- International Stocks ETF
2) Core and Satellite strategy
This strategy breaks your portfolio into two segments – core and satellite.
The Core component is where most of your investment funds go. This component consists of long term, diversified investments. This could be done using a global stock market ETF and Bonds ETF.
The Satellite component is a smaller portion of your total portfolio where you invest in higher risk plays like specific markets (eg. China, Emerging markets, etc) or themes (eg. Metaverse, 3D printing, etc).
The split between the Core and Satellite components is highly dependent on your risk profile and how much effort you would like to put in.
A similar strategy would be the Barbell strategy.
FAQ
Which ETF does Warren Buffett recommend?
Index Fund, more specifically, the S&P 500 index ETF. Warren Buffett reportedly said that “the best thing to do is buy 90% in an S&P 500 index fund and 10% in treasury bonds.”
