Should you be investing in ETFs? The answer is, as always, ‘it depends’
My favourite part of working in finance is that I get to see the different things come in and out of ‘style’. A year ago, I was talking to a lot of clients about The Barefoot Investor and how exactly to set up their buckets and mojo account.
It’s awesome to see people taking an interest in the world of money and trying to increase their knowledge. After all, knowledge is power… or is it money? Where have I heard this before?
One take away from the podcasts seems to be a driving interest in investing in Exchange Traded Funds (or ETFs). I’m having a lot of clients come to me saying they want to invest in ETFs without really understanding whether they suit their circumstances. Like all things in finance, there is not a right or a wrong investment, there is only the investment that is right for your goals.
In this blog post, I’ll break down what an ETF is and how it works. I’ll also explain the pros and cons of an ETF compared with other types of investments so you can make up your mind about whether this type of investing suits your needs.
So what is an Exchange Traded Fund (ETF)?
When people think about investing in the sharemarket, they usually think about buying a share in a company.
A share in a company is essentially a small part-ownership of a company. For example, if you bought shares in Qantas, you would be a part-owner of Qantas. When the value of Qantas as a business goes up, your share will go up as well. When Qantas earns money, they may do a distribution to its owners of those profits which will mean you receive that profit (called a dividend).
As a general rule, owning a share in one company is a risky proposition. You are betting your entire investment on the performance of that company. This is why financial professionals will usually recommend you ‘diversify’ your risk by investing in lots of different companies. But how do you do that if you don’t have enough money to buy shares from hundreds of companies?
Well this is where an ETF can be helpful.
An ETF is an investment fund that is traded on the sharemarket like a share
Instead of buying a share in one company, you can buy a share in an ETF. An ETF acts a lot like a managed fund in that its job is to invest in many different types of investments and by buying a share in an ETF, you can buy into an already diversified investment.
What can you invest in with an ETF?
Well pretty much anything!
ETFs invest in a range of different types of investments across many countries. Not only can they invest in shares, in some instances they can invest in property or other assets (usually through investing in companies that invest in these assets).
ETFs are becoming hugely popular and each week there seems to be new options available.
So what are pros of investing in an ETF?
A lower barrier to entry
In the past, the biggest challenge to starting to invest was the fact that there were usually minimum amounts you needed to get started.
This is because the process of setting up an investment account was a very manual process involving a lot of human activity, so it really wasn’t worth it to allow people with a small amount of money to invest.
This has all changed over the last 20 years with the rise of technology and automation. As it becomes easier and easier to buy into an investment, these minimums are coming down.
ETFs are a great example of this. You can buy into an ETF with as little or as much as you want (subject to a minimum imposed by your broking account). The caveat however is that every time you buy, you incur a trading fee. These tend to range between about $10-$30 depending on what broking account you use so you’ll need to have a decent amount to make it worthwhile.
Once you’ve bought your investment however, the costs of an ETF are usually relatively low (depending on how much active management is occurring in your investment) and are similar to the costs of other investment options.
ETF’s also allow you to easily diversify your investments. Once you’ve bought into an ETF, depending on the ETF you select, you can be invested across multiple countries, sectors and even asset classes.
Ease of trading
ETF’s are also easy to trade and you can usually easily sell them the same way you bought them, which is through your trading account.
So what are the cons of investing in an ETF?
There are always risks when it comes to investing and these differ based on the type of investment you select. All ETFs are different and understanding what they invest in and how they work is fundamental to making a good investment decision.
The issue that comes up a lot for most people with ETFs however relates to the cost of the trading fee.
Every time you want to buy more of an ETF you will incur a trading fee. This isn’t a huge problem if you want to invest one large block of money and not add to this investment, but if you’re looking to invest regularly and take advantage of ‘dollar cost averaging’, this can quickly eat into your returns.
As a general rule, I never recommend that you try and ‘time’ the market. Whilst the old adage of ‘buy when it’s low and sell when it’s high’ sounds great, in practice, no one is able to accurately predict the top and bottom of markets.
For this reason, it is generally best to invest at regular intervals (usually monthly) so that you can take advantage of dollar cost averaging. Dollar cost averaging is a strategy where you invest the same amount at regular intervals over a long period. The idea being is that the risk ‘averages’ out over the life of the investment.
This is far more challenging to do with ETFs due to the trading fees.
If it is the case that you aren’t going to have huge amounts to put in each month, you may want to hold off until you have a greater amount to invest before incurring a trading fee. This may mean that you can only contribute once every 6 months and you miss out on the opportunity of having that money invested in the meantime.
In addition, the temptation to try and time the market becomes a lot greater. If you have to wait 6 months, there is a good chance you are going to be watching the market trying to pick the perfect time to enter it. You may think you can succeed with this strategy but in my experience, this is not a sensible way of approaching things.
So what are other options to invest if ETFs don’t suit my needs?
Many ETFs have equivalent managed funds that work exactly the same way except instead of buying ‘shares’ in the fund on the stock exchange, you buy units directly with the fund.
The downside to managed funds is there are usually minimums for you to start. These used to be quite high but have been coming down more and more each year. You can now find a good managed fund that has a minimum investment of $2,000- $5,000.
You can also invest through an investment wrap which allows you to invest your money with an investment company who then invests it in these products. You pay a fee to do so but this comes with many advantages including online access, good tax reporting and the ability to buy into managed funds which usually have very large minimums (and subsequently low fees) with much smaller amounts.
Should I invest in ETFs?
It’s important to remember that there is no such thing as the ‘right’ investment. An investment is only right if it meets your goals.
ETFs can be great tools for investing if this suits your goals. But remember there are a lots of investment options out there. All of these come with pros and cons depending on what you are trying to achieve.
In the investment world, it is easy to learn about one thing and decide that is the thing you need. But it is important to remember that there are lots of options and to not get caught up in the hype.
If you have any questions or want to talk about your investments, please reach out.
This post is from our resident Financial Planner Ben Brett, check out his details in the About Us section.
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