ETFs 101: Using Common Sense to Avoid Common Mistakes pt 1
This is the first post in a multi-part series about exchange-traded funds (‘ETFs’) written in plain English.
Whether you are a complete beginner or an expert, this guide will help you avoid the rookie mistakes that many investors make. In this way, I hope you will be better equipped to make sounder investment decisions.
I firmly believe that, if you break everything down into easily-understandable chunks, most of this stuff is common sense. As such, I will start with the basics and build your knowledge from there. My mission on Steemit is to help spread financial literacy, and I hope that this series will be the first of many.
Wherever possible, I will try to distinguish between US & UK terminology and post links for further reading. As we go, I will provide explanatory notes and calculations at the end of each post. I will denote each footnote with numbers like so: ‘(0)’. Fear not, you are in good hands!
This guide is NOT intended as financial advice. It should be read for educational purposes only. You alone are responsible for your investment decisions.
Now let’s get going :-)
Background
I recently spent a lot of time re-investing my retirement savings. As part of this, I read a lot about ETFs. As a university finance lecturer, I thought I knew it all. I was wrong (1).
The more I read, the more I realised that ETFs are dangerously overhyped. Too many people put their savings at risk without really understanding what they are getting themselves into.
Does this mean you must stay away from ETFs and run for the hills?
Not necessarily.
Not all ETFs are ‘bad’. Like everything, some ETFs are better than others. But as small investors, we have to wise up and be a little more careful about what we put our money into.
Think of getting a new car or a new computer. How much research would you do before you buy?
It’s the same with ETFs - like all products, they have different features which may or may not be suitable for you.
So what exactly is an ETF (exchange-traded fund)? To understand what an ETF is, we first have to understand:
- What a ‘conventional’ mutual fund is (2).
- How an ETF is different from a conventional mutual fund.
What is a ‘conventional’ mutual fund?
A mutual fund is simply a pool of cash that is invested in various assets (e.g. stocks, bonds, property etc). If you’re unsure of what the word ‘asset’ means, think of it as cash or anything that can generate cash or be turned into cash by selling it to someone else.
As we go, I may use the terms ‘stocks’ and ‘assets’ interchangeably (3). This is because the explanations I provide are best understood in the context of ‘the stock market’. Once you master the basic theory, however, you can just as easily apply it to other asset classes (e.g. bonds, property, gold/silver etc).
Mutual funds help private investors access the stock market as follows:
They provide diversification. If you only have a small pool of cash (say $ 1000), you would find it very hard to invest in more than 5 - 10 companies because of the transaction costs involved. For example, say your broker charges you $10 commission every time you trade a stock. If you invested in 10 different companies, you’d be 10% down right off the bat (4).
By the same token, if you wanted to invest in 15 companies, you’d be 15% down (5)! As this would be far too costly, you would have to invest in fewer companies and be less diversified. You would effectively be putting all your eggs in too few baskets! A mutual fund solves this problem by pooling many different investors’ funds together, enabling them to invest collectively in a much wider range of stocks (6).
Mutual funds also give investors access to economies of scale (i.e. bigger is better). Similar to the example above, imagine a mutual fund with 1000 investors putting in an average of $ 1000 each. That would make $1m. If the fund invests in 100 companies at a cost of $10 per trade, this would only cost the investors 0.1% (7).
In addition, Mutual funds save time. Picking winning stocks takes A LOT of time and effort, trust me. Not only do you have to thoroughly analyse each company before you invest, you also have to keep regular tabs on your investments as a shareholder. In other words, it’s a full-time job (or a very time-consuming hobby!).
Putting your money into a mutual fund solves this problem because the fund manager does all this work for you, thereby freeing up your weekends and evenings for other, more pleasurable pursuits such as hiking, eating pizza, or drinking beer in the park with your friends (unless you’re like me and enjoy speculating in shares).
Of course there is no such thing as a ‘free lunch’. In return for these services, the firm that manages your mutual fund charges you an annual fee, which is taken out of the fund. (I will discuss this subject in much greater detail in the next few posts).
What is an ETF?
An ETF is simply a mutual fund that is listed on a stock-exchange. Just as you would buy stocks in Apple, you can buy stocks in an ETF. Whereas Apple’s stock goes up or down depending on the profitability of Apple, the ETF’s price will rise or fall in tact with the performance of the stocks inside the ETF itself. Stocks go up, ETF goes up; stocks go down, ETFs goes down.
In effect, an ETF allows you to gain exposure to a wide basket of stocks without personally investing in any of them. For example, you could ‘invest’ in the S&P 500 index by buying stocks in the Vanguard S&P 500 ETF (I will talk much, much more about stock indices as we go).
How are ETFs different?
Unlike a conventional mutual fund, ETFs are closed-ended. Under normal circumstances you cannot deposit or withdraw cash from the ETF. If you want your money back, you sell your ETF to someone else like a hot potato. Similarly, if you want to invest in the ETF, you would buy it on the stock exchange through your broker.
In a conventional ‘open-ended’ mutual fund, this is not the case. These vehicles allow investors to deposit and withdraw funds from the fund (much like a bank account). Every time an investor does this, the fund manager has to rebalance the fund accordingly (i.e. by buying or selling some of the fund’s underlying investments).
This can become problematic for the fund manager if he is forced sell the fund’s underlying shares at inconvenient times in order to finance fund withdrawals. This perverse dynamic plays out most poignantly during stock market downturns when everyone is rushing for the door (i.e. cashing in their chips by taking their money out of mutual funds).
By forcing the fund manager to liquidate the fund’s investments when the stock market is down, the investors are effectively ‘selling low’ at the worst possible time. This is because stock markets tend to rebound violently after a period of sustained declines, and the fund manager is unable to position the fund to take advantage of this (i.e. by buying more shares when they are cheap) because investors are taking their money out of the fund.
By the same token, too much money flowing into a fund can also be problematic because the fund manager has to invest it in something (8). The general public usually becomes very interested in the stock market when it is at or near an all-time high (like now) and most of the good (and some of the bad) companies are trading at historic highs.
Again, the fund manager’s hand is forced and this time he is ‘buying high’ at the worst possible time because all that money coming into the fund has to be invested in something. Long periods of sustained price rises are usually followed by spectacular declines in the stock market.
The net result of both scenarios, is that fund managers are often forced to do the opposite of ‘buy low, sell high’ because of the investing public’s irrational whims, thereby diminishing the fund’s returns. This problem is made worse by the fact that the fund incurs trading costs every time an investor withdraws money from/deposit money into the fund.
ETFs solve this problem because there is no money flowing in and out of the fund on a daily basis. This leaves the manager free to focus on managing the fund’s investments rather than worrying about balancing its outflows and inflows.
In addition, because there is no money coming in or out of the fund on a daily basis, the fund does not incur transaction costs every day. Rather, ETFs tend to be rebalanced on quarterly basis (4 times per year), greatly reducing their internal transaction costs. In theory, this should reduce the cost of running them.
The advantages mentioned above are some of the key reasons why ETFs are enjoying greater popularity among big and small investors alike. However, in truth, I don’t think ETFs are as great as they are made out to be. Nor do I think open-ended mutual funds are all that bad.
The usefulness of either really depends on what you are trying to achieve as an investor. That said, there is a lot of ETF-hype out there which I will do my best to debunk as we go.
Next Week...
That is it for Part 1. Next week, we will explore what I call the ‘passive investment boom’ which is one of the main reasons why ETFs are currently so popular. I will try to have this ready by June 30 2017 and post a link to it in the comments below.
I’ve spent quite a lot of time putting this together, so if you have comments, corrections or questions, I’d greatly appreciate you feedback.
In the meantime, I wish you health, prosperity, and happiness :-)
Notes:
- I am also a Chartered Accountant. Chefs really don’t cook at home!
- ‘Mutual fund’ is a US term. They are known as ‘Open-Ended Investment Companies (OIECs)’ or ‘Unit Trusts (UTs)’ in the UK. There are a few legalistic differences between OIECs and UTs, but I don’t feel they are important for understanding the basics.
- When I say ‘stocks’ I mean shares of companies that are traded on a stock exchange. For example, when you buy stocks in Apple you become a co-owner of the company. I will also use the words ‘equities’ and ‘shares’ when I mean ‘stocks’. My apologies for this, it is just how we talk in the financial industry :-)
- $10 x 10 trades = $ 100 so $100/$1000 = 10%
- $15 x 10 trades = $ 150, so $150/$1000 = 15%
- Of course, the returns (or losses) of those investments are shared proportionally among the investors according to their share of the pie. If you hold 10% of the fund, you get 10% of its returns.
- 1000 * $ 1000 = $ 1,000,0000 and $10 * 1000 = $1000, therefore $1000/$1,000,000 = 0.1%
- Though this varies from country to country, retail mutual funds are generally only allowed to hold small portion of their investments as cash.