What is an ETF? A Beginner’s Complete Guide
Exchange Traded Funds (ETFs) are the silent revolution in investing.
One of the great advantages of our time is the advancement in technology via our smart phones.
Investing has become available to more people than ever before as the barriers to entry are reduced.
With that comes innovation in the number of investment products available to help you and me to work towards achieving our goals faster and cheaper.
ETFs are an example of such innovations, but one that not too many people know enough about to get involved.
To help you fully understand this type of investment, I welcome this guest post from Ian Shadrack (an experienced ETF investor).
I met Ian at one of our Financial Independence meetups in London.
He is using ETFs to work towards creating a life that works for him.
Investing via ETFs (and Index Funds) is one that we support on this site.
I'll now hand over to Ian to share all you need to know to get started with investing in ETFs.
Journey to ETF Investing
I used to invest in individual shares for over 20 years but I had some large loses when a company did not live up to its expectations.
Even though I was an accountant I couldn’t spot how a company could be dependent on one key contract or customer, generally because that fact wasn’t disclosed.
I then learnt more about index tracking and how “rather than looking for the needle in the haystack I could just buy the whole haystack” (John Bogle, founder of Vanguard).
Also, I discovered a movement called F.I.R.E (Financial Independence Retire Early).
People in this community believe in taking control of their investments rather than letting an advisor or a pension fund perform the task for an inflated fee.
My aim is to be sitting on the beach in the Caribbean funded by my investment portfolio and I want a product that doesn’t demand my attention every few hours.
Once I had discovered an investment product that is diversified and tracks the most financially rewarding sectors of the global economy I didn’t look back.
What is an ETF?
ETF stands for Exchange Traded Fund.
Although an ETF is a fund by nature, it acts like a stock because it can be traded on the stock market.
An ETF hold stocks, bonds or commodities such that it aims to track an underlying index (a list of stocks representing a market).
ETFs are labelled as passive investing but I prefer to call them rule based (or algorithmic for those of you with maths A level).
Non-index tracking funds are judgement based (or ego based in their worst extremes) as they represent what a fund manager likes to invest on a given day.
Due to an absence of commissions paid to financial advisers, ETFs aren’t always recommended as an investment choice.
However, ETFs attract significant inflows of funds as the silent revolution grows in strength.
ETF vs Mutual Fund
An ETF is different from other index trackers (unit trusts / mutual funds) in that:
- An ETF is traded in real time, not at end of day prices (but you pay a trading commission to do so),
- There may be lower platform charges when such a SIPP or ISA wrapper.
- If you are investing over £2,000 in a trade then the guaranteed price offered by an ETF should make it a wiser investment vehicle.
Why Invest in ETF vs Index Fund?
For me the real interest in ETFs comes from:-
The Range of ETFs Available
The ETF market is continually evolving and innovating.
New products are being created purely to capture the best returns of global investing.
Examples include automation and robotics for innovation and growth and infrastructure for reliable cash flows.
The range of ETFs is wider than that of other index trackers.
The Information Available About ETFs
The available information makes it easy to select the best ETFs.
Furthermore there are dedicated resources to help you find the best ETFs. These include JustETF.com and MorningStar.com.
How to Select an ETF
When selecting an ETF, look for the following:
1. The Size of the Fund
The larger the fund the more liquid it is meaning you can buy and sell very easily.
Funds below £100m should be avoided.
2. The Diversification of the Fund
The largest holding should be no more than 10% of the total fund. This will help to limit price volatility.
3. The Performance of the Fund in Good Times and Bad Times
Technology funds have done well recently but they perform badly during market corrections.
4. The Morningstar Rating
This is a star rating from 1 to 5 which looks at how the ETF has performed relative to its index (called the tracking error).
The more stars the lower the tracking error.
5. The Currency of the ETF
Most are US Dollar denominated, some are hedged and denominated in £.
If the £ rises in value than the performance of US Dollar funds will lag those held in £.
6. Whether the ETF Distributes or Accumulates Dividends
Outside of the UK, dividends are often quite small so this shouldn’t matter much for worldwide funds.
7. Whether the ETF is Physical or Synthetic
A physical fund holds the underlying shares in the companies concerned.
A synthetic fund does not and so there is a very small risk that the trading arrangement around this type of fund ceases.
8. The Ongoing Charge
The US is the cheapest market to trade so US ETFs will have the lowest charges.
Higher charges could mean poor value for money.
It could also mean more exposure to more expensive emerging markets or more frequent trading to better replicate index tracking.
Only reject a more expensive fund for a cheaper one if they are tracking the same index.
NEW Video on Our YouTube Channel about Index Funds vs ETFs:
Understanding ETF Jargon
Here is an example of an ETF as you might see it named online:
iShares Edge MSCI World Momentum Factor UCITS ETF USD (Acc) (GBP) IWFM
What is this? Let’s break down the components of the name for better understanding:
iShares Edge – the company running the ETF, in this case the largest ETF provider in the world.
MSCI – the name of the company providing the stock market data that the ETF relies on
World Momentum Factor – this describes the ETF. In this instance it invests globally and shares are bought / sold according to their share price growth or momentum
MSCI World Momentum – “MSCI and World Momentum” together represent the index (i.e. list) being tracked.
UCITS – this means that the product passes the European Union regulatory framework on ETFs.
It stands for Undertakings for Collective Investment in Transferable Securities (UCITS).
Essentially, it’s a type of investment product that is available to Retail investors (non-professional investors) across Europe.
USD – the underlying currency of the investments as this is a worldwide fund this is to be expected.
(Acc) – the ETF accumulates any dividends and reinvests in itself rather than distributing dividends.
(GBP) – this ETF is reported in £
IWFM – this is the stock market code / ticker for the product
Performance of Selected ETFs
Below is a selection of some ETFs for illustration only:
If you had invested in the UK stock market you would have lagged behind the global ETFs listed above even after their higher fees.
VWRL is popular with the financial independence community but there are other ETFs which offer better performance from the underlying strategy that they follow.
Vanguard worldwide represents the largest companies in the world.
Ishares minimum volatility removes companies like Apple and Microsoft whose share prices have greater than average volatility.
UBS socially responsible looks at the increasing popular area of ethical investing coincidentally it is under-weight (i.e. reduced holding) in poor performing sectors such as banking.
iShares worldwide momentum ETF has put in a phenomenal performance.
It shows that since 2017 there has always been part of the worldwide stock market that is growing.
The performance of ETFs can be tracked in Google Finance:
For the geeks among us, you can also use Google Sheets (google’s free version of Excel).
Type in =GOOGLEFINANCE(“LON:VWRL”) and a 15 minute delayed price for the Vanguard Worldwide ETF will appear.
If you want to see historic weekly price between say, 01/01/2015 and 01/0/2019, type in:
=GOOGLEFINANCE(“VWRL”,”PRICE”,”1/1/2015″,”1/8/2019″,”WEEKLY”)
ETF Risk Factors
Some ETFs are incredibly risky as they are based around day trading to capture short term movements in prices.
This includes ETFs based around a single commodity such as gold.
If you follow the guidance in the “How to select an ETF” section you will avoid these types of ETF.
The risk that cannot be eliminated is market risk.
Global share prices could fall.
Look at how an ETF performed in 2018 as the market had a small correction in that year yet some ETFs still rose in value.
These were either focussed on more resilient areas of the economy such as utilities or they were able to rebalance their portfolio towards such areas such as a momentum based fund.
When buying an ETF take a longer term view, don’t invest cash that you need for next year’s school fees.
The risks will be no greater than anything an Independent Financial Advisor recommends to you.
The Future for ETFs
ETFs are evolving into new areas such as Automation and Robotics and ETF providers are continually innovating to create new products to grow their business.
The trend in fees is downwards as such fees are transparent and companies like Vanguard have a low cost philosophy.
The more successful ETFs will attract more funds and they will grow in size which, to some extent, generates price rises in the companies that these ETFs invest in.
Conclusion
ETFs are the ultimate mechanism to invest in the best performing stock market indexes around the world.
Not all ETFs are suitable for a passive portfolio but if you follow the selection criteria above you should be able to generate decent returns with an acceptable amount of risk.
NOTE: To learn more about how to invest in ETFs and much more as Beginner Investor, see Super Simple Investing.
Related posts:
- How to Invest in Stocks With Confidence: Beginner Step-byStep
- Passive Investing & Why You Should Care
- Index Fund Investing & The Simple Path to Wealth
- 9 Smart Ways to Invest £1,000 Today
Many thanks to Ian Shadrack for his contribution on ETFs. You can learn more about him by visiting UK ETF Investor.
Are you a Beginner investor? Do you have any concerns about ETFs? Or are you an ETF investor? Please share your experience below.
Do please share this post if you found it useful, and remember, in all things be thankful and Seek Joy.
Hey Ken,
I’m definitely a beginner investor and I still have a lot to learn. I currently use Wealthsimple to do most of my investing for me, but I’ve been thinking about learning how to build my own portfolios recently.
Do you think it’s worth the extra time it takes to manage your own portfolio vs. using a robo-advisor?
Hey Dylan,
I think it’s an invaluable skill to be able to build a simple portfolio. It usually demonstrates good understanding of what one is actually investing in and more importantly, tailors investing to specific financial goals. With building your own portfolio, you usually don’t need to invest in a lot of instruments. 2 – 4 investments can give you sufficient global exposure.
What are you paying to Wealth Simple? Do you know where your money is invested? And did you choose where it is invested?
Good points. I’m paying a 0.5% fee for Wealthsimple right now that I figured was worth it for the time savings, and I can see where my money is invested, but I didn’t exactly get to choose my investments besides being able to decide my portfolio risk level.
I’m definitely going to give building a portfolio on my own a shot just to get the experience. Thanks Ken.
Dylan, please share your progress. I’d be keen to learn any challenges you face.