As ETFs continue making their way to our shores, this article will explore their attractiveness, the risk they represent, and what you need to know to successfully utilise this unique product.
ETFs have many appealing advantages. You have the flexibility to buy and sell ETFs like you would stocks and they come with built-in diversification benefits. Investors may choose from a wide category of ETFs. If you are only interested in investing in specific countries, there are ETFs that mirror the benchmark index of specific countries such as the US' S&P500.
There are also ETFs which track specific segments of the market, such as different industries, shares of a certain characteristics; real estate investment trusts (REITs) and more. If you are interested to invest in global bonds, there are ETFs that reflect long-term or short-term bond indices. And if you need that potentially high-risk or high-return asset class in your investment portfolio, there are also ETFs that track commodities such as gold or silver.
From a strategic standpoint, ETFs can be quickly and easily used to assemble a broadly diversified index portfolio invested in major market sectors. Perhaps you are interested to ride on India and China's growth prowess but are uncertain which specific share to invest in. An ETF that tracks each country's benchmark index can provide that exposure along with instant diversification (because it holds a basket of securities that mirrors the benchmark index).
Logically, it is very unlikely that all companies will collapse at the same time. All an investor needs to do is execute the simple buy-hold strategy to ride on further development from these economic giants. This would be a far less complicated strategy than investing in individual stocks.
Lower cost of investing
Perhaps the biggest advantage ETFs have over an index unit trust fund is its low cost. If the ETF tracks less widely accepted stock themes, its annual expense ratio may inch up to between 0.8 per cent and 1 per cent. This is still substantially lower than charges imposed by index unit trust funds in Malaysia.
There is one caveat to remember though - that ETFs trade on an exchange, so you will need to pay brokerage commissions to buy and sell them, just as you would with stocks. Therefore, trading costs will pile up if your strategy is to trade ETFs frequently.
Flexibility
There is, however, an advantage to trading ETFs on the stock market. Acquisition and disposal is done during trading hours and investors can lock in a price for the ETF immediately. If your ETF tracks a volatile market that suddenly starts tumbling down, you can dispose of your investment during market hours, before the price of the ETF drops any further.
In a traditional unit trust fund, your sell order is transacted at the fund's net asset value at the end of the day, irregardless of when you put in your order to sell during the same day.
Time efficiency
Many investors do not have the time to monitor the progress of individual stocks or to study the company's annual reports. Due to the diversity of its holdings, ETFs are ideal for investors that lack the time or inclination to research a selection of individual stocks.
However, it's important to know that ETFs are not foolproof. ETFs are also subject to market risk, the same risk you face with investing in stocks and unit trust funds. An ETF is not exempted from volatility as it replicates performance of an index by investing in the same basket of securities and in the same proportions. If the index performs well, the ETF is likely to do the same and vice versa.
As an investor, you can mitigate this risk with a little discretion. As with any investment product, don't invest in an ETF without understanding what it is based on. Read and understand the ETF's prospectus as it will provide a clear indication of its underlying assets. Ensure the outlook for the ETF and its objectives are aligned with yours to avoid the pain of an uninformed purchase.
Too much flexibility?
Once you know exactly what the ETF is going to bring to your portfolio, stay away from excessive trading. The ability to move in and out of ETFs quickly can lead to the temptation of jumping into markets or industries that you see poised for growth and bailing out when performance tumbles.
This is a great strategy in theory; but in reality, it is extremely difficult to execute. Investors tend to make the common mistake of buying into a "hot" sector after prices have been pushed up, only to sell at a loss when prices start correcting.
From a cost perspective, frequent trading could eventually lead to the brokerage commission exceeding the fees imposed by index unit trust funds. For these reasons, it would be wise to think like a long-term investor and view the ease and flexibility of trading ETFs as a just-in-case feature to be used only when the market springs an unexpected and unpleasant surprise.
In principle, an ETF is not any more complicated than its underlying securities. If you know enough about what it holds, you know enough to invest in an ETF. To avoid the most common weaknesses, all you need is a little due diligence on its investments and exercise some trading restraint. If you believe its unique design and flexible nature can be leveraged on, here are some tips on how to pick an ETF.
Choosing an ETF
Whenever you are faced with a new product or a new asset class, go back to the asset allocation of your portfolio. To be successful, investors must know the percentage each asset class should occupy. The importance of asset allocation cannot be overstated. Many investors spend too much time and too much money picking individual stocks instead of evaluating what type of stock or fixed income instrument they should be holding.
This same process applies with ETFs. Prior to investing in ETFs, you need to identify the required key exposures for your current portfolio i.e. a specific market, industry or stock type. Then, identify ETFs that are available to you. Read up on the investment objective of each ETF and obtain its top ten holdings or sector distribution to ensure it is invested in the industry or assets that you want.
ETFs must file annual or semi-annual reports on their investments, hence these materials and their prospectus would be a good source of reference for your research.
There may come a time when you find competing ETFs invested in similar securities. If this is the case, select the ETF with a lower expense ratio as listed in its interim and annual reports.
In conclusion, there is much to like about investing in ETFs. As passive investments, they harness the power of the broad market without the risk of single stock exposure. It appeals to investors as an alternative investment tool as individual and institutional investors are getting the best features from stocks and unit trusts.
(This is a final instalment of CIMB's series of articles on investing in ETFs )
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