Investors trying to manage the risk in their portfolios often look to diversification, but it’s a tricky thing to get right by yourself. That’s why investors are increasingly turning to exchange traded funds (ETF) to help them protect and grow their money.
Funds come in all shapes and sizes, and some aim to outperform the general market. Unfortunately, the expensive management fees attached to these active funds can diminish investor returns, and they don’t always outperform.
ETFs are a low-cost, simple and transparent alternative to expensive funds. But how do they work and what’s the best way to invest in them?
What is an ETF?
A form of passive investment, ETFs aim to track and replicate the returns of an index, specific commodity, bond, or basket of assets.
An ETF can give investors exposure to a wide range of asset classes and investments, with funds able to track an index like the FTSE 100 or S&P 500, investments like high yield bonds, or commodities, for example.
An ETF will buy the underlying assets of the investment it wants to track. If it’s an index, it will buy all the shares in that index, usually replicating the proportion of their market capitalisation. This fund is then sold on the market with a set number of units.
ETFs are simple investment vehicles. As they’re traded over an exchange, they act like a share on the stock market. ETFs have a bid and ask price – the point at which a buyer wants to buy and a seller wants to sell. Their price fluctuates throughout the day as they are bought and sold by investors. Importantly, you can trade an ETF in seconds.
This provides investors with transparency and flexibility, which can be essential for families that feel alienated from the traditional financial system.
Why liquidity matters
When it comes to your investments, it’s important you know how easily and quickly you can turn your investments into cash, without this impacting the overall value of your investment. This concept is called liquidity.
Mutual funds are generally priced once a day, and it can take a couple of days to either invest in the fund or withdraw your money. This time can alter the price you pay for a share in the fund.
Mutual funds are open ended, which means they don’t have restrictions on the amount of shares that can be issued.
The brains of smart beta
As the ETF market has matured, so have the products available and investors can now trade physical ETFs, synthetic ETFs, or different factor-based ETFs that value the investments in different ways.
Physical ETFs trade the underlying funds of an index, whilst synthetic ETFs use derivatives to achieve the same results. A synthetic ETF can track an index without owning any securities – by relying on swaps to execute the investment strategy, for example. A swap is a contract to exchange cash flows over a set period of time.
Many ETFs value investments by their market capitalisation, but this isn’t the only way to judge whether an asset is a good investment. Smart beta tries to deliver a better risk/return trade off by using alternative weighting strategies. This could be constructed by a number of different factors, including volatility, dividend payments or the momentum behind performance.
Active versus passive
As the traditional wealth management industry feels the heat from margin pressures, increased regulation and competition, ETFs have surged in popularity. Over the last decade, Global ETF assets jumped from $800 billion to $4.2 trillion ($3.2 trillion) by the end of August, numbers from industry data provider ETFGI show.
When it comes to the discourse surrounding ETFs, the active versus passive debate takes centre stage. Arguably, when fees are chomping into investor returns, the debate should really just be about cost.
There’s nothing wrong with trying to beat the market, but investors should be able to keep as much of their own money in the process. Whilst it’s necessary to pay for a service, fees act as a drag on performance – every percentage point you spend on fees has a negative impact on your returns.
How to invest in ETFs
When you build your investment portfolio, you need to know it constructed in a way that suits you and your financial goals. The composition of the investments within your portfolio should reflect your risk level and the market conditions of the time.
Strategic asset allocation defines the long-term goals of the portfolio, whilst the tactical strategy makes the most of any alternative options along the way. ETFs can be used as the crucial building blocks of your portfolio to reach your long-term goals, whilst their flexibility and liquidity means they can make the most of shorter-term market trends.
When you’re picking which ETFs to include in your portfolio, you need to look at the benchmark it’s tracking and monitor its efficiency. How much will it charge you in fees? What’s the tracking difference or volatility of its performance? You also need to make sure you’re getting the diversity you’re paying for.
The ETF universe is huge, and your options are growing by the day. It can feel intimidating when you’re trying to pick the best investments that will help you and your family.
Investing by yourself takes in-depth knowledge, skill, and quite a bit of money to do successfully. Many investors prefer to give their money to the experts to invest for them.
At Moneyfarm, we build and manage your portfolios, rebalancing them to keep it in line with your requirements. We use ETFs to build out portfolios, to provide a low-cost, transparent, flexible and efficient investment solution to our customers.
Each portfolio is specifically constructed to match your investor profile, and help you reach your goals.
Once you invest your money, you can focus on the important things in life. Our team of experts monitor the markets daily on your behalf, analysing any investment opportunities, and executing trades – you don’t need to do a thing.