Wednesday, October 18

Overview of Investment Product: ETF

What is ETF?

An ETF, or exchange-traded fund, is a basket of securities designed to replicate the performance of a stock, bond, or commodity index. Examples are QQQQ (Nasdaq), EWJ (MSCI Japan’s index), and IGE (Goldman Sachs Natural Resources Index). In other words, its performance relies on broad market trend and not the stock-picking skills of individuals (could be good or bad). Each ETF is listed on an exchange and is traded like any other stocks.

Why buy ETF?

ETF has pros and cons when compared with other financial products. Let’s go over it one by one.

1. ETF vs stocks

PROS
  • Better diversity: The greatest advantage of ETFs over company stocks is diversity. Buying ETF for the S&P Latin America Index, for example, is less risky than buying Telefonos de Mexico alone.
  • Better exposure: In fact, we may find it quite difficult to buy individual companies not listed in our local market. ETF gives us an easy alternative.

CONS

  • Do more homework: When picking an ETF, we should have a general understanding of the particular industry/region. What’s good about it – an economic recovery, an oil-rich region, or an industry with high margin?


2. ETF vs index funds

This is probably the most common question because both ETF and index funds allow you to buy into a portfolio of securities without your own active management. Here is my take on the difference and the pros and cons:

PROS

  • More flexibility: ETF shares can be bought and sold during the day, similar to buying individual stocks. On the other hand, we can only buy index funds based on the NAV (net asset value), which is calculated once a day after than market closes. Also, there is normally a minimum investment amount for index funds but not ETFs.
  • Lower cost: For index funds, fund managers have to buy and sell the constituent stocks more frequently to have cash available for investors' redemption (i.e. taking out their money). While for ETF, there is basically no “managers” as the ETF simply tracks the movement of the particular index. Therefore, management fee is generally lower for ETF.

CONS

  • A few index fund managers may waive the transaction commission for their funds. In this case the expense will be slightly lower than ETF.

3. ETF vs mutual funds

PROS

  • Same as above (index funds), except that mutual funds are actively managed and thus incur even more administration costs. This translates to higher management fees.

CONS

  • A few mutual funds manage to outperform their comparable ETFs, index funds and their peers on a consistent basis based on their expertise and “six-sense”. If you are able to identify such a fund manager, the mutual fund can give you a superior investment return. Be careful: for apple-to-apple comparison, make sure you pick the "after-fee" return. And remember to read the small fonts where they bury the miscellaneous fees and restrictions!

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