If you have been reading about index funds, you have surely come across ETFs, and you did not understand very well what an ETF was.
They are very similar to index funds, but they have some important differences.
ETFs are one of the best ways to invest, and today I am going to explain you why.
Do you want to know what an ETF is and how it works? Let’s begin!
What is an ETF?
What is the meaning of ETF? The name ETF comes from Exchange Traded Funds.
ETF is a mutual fund whose main characteristic is that it is traded on stock exchanges around the world. This means that they can be bought and sold at any time.
Therefore, its price varies constantly, like it happens when you buy a share of a company. This is one of the main differences with respect to mutual funds, and I will cover it later.
An ETF holds multiple underlying assets, whose aim is to copy a market index. It can be an index of equities, bond, gold, bitcoin, etc.
ETFs stand out for their low cost and great liquidity, which means that it is very easy to buy them with your broker.
Let’s see the main characteristics of ETFs
- Great diversification: ETFs can contain many different financial assets. They normally cover a certain sector or a country.
- Low fees: its costs are lower than mutual funds because they do not need a fund director to actively manage them
- High liquidity: they are bought and sold at any time
- Transparency: you can know its price at all times, and decide the purchase and sale price. With mutual funds you do not know the price you are going to sell or buy them
- Tracking error ratio: it tells you how well the ETF tracks the index performance
- Great variety: you can invest in any type of financial asset, since the amount of ETFs available is huge
- Currencies: ETFs are quoted in any currency, so you have exposure to currency exchange
These characteristics make them a great way to invest.
Advantages of ETFs
ETFs are one of my favorite investment tools. Let me tell you their biggest advantages.
This is its best quality. ETFs have very low management costs. Their expense ratio is much lower than the typical mutual funds your bank offers you.
This is because they belong to passive investment. ETFs, like index funds, do not require a manager to do financial analysis of individual companies and find the ones that will perform best.
Mutual fund managers carry out active management. This requires work, and they charge for it. So the mutual funds expenses are higher.
An ETF just copies an index, and this allows them to lower their fees.
In addition, mutual funds obtain lower returns than the reference index in the long term. In my index funds guide I talk more about this topic.
You would be surprised how much mutual funds charge on annual fees. Go to any investment platform website, and compare mutual funds fees with ETFs fees. You will be shocked!
ETFs are very similar to stocks, they are listed on the stock exchanges. This makes them highly liquid.
The liquidity of a financial asset is the volume of transactions that asset has on a daily basis, and it is a very important factor. When you want to buy an asset, you need someone to sell it to you, and vice versa. If you invest in assets that lack liquidity, you will most likely have trouble buying or selling it.
That is why a great advantage of ETFs is that in general they tend to have great liquidity, there is always supply and demand.
Types of ETFs
ETFs have become very popular recently. This means that you can invest in practically any industry through an ETF.
The main types of ETF are:
- Equities: their target is to replicate the indices of world stock markets. Any index that comes to your mind will have its ETF, such as the FTSE 100 and Nasdaq.
- Fixed income securities: invested in bonds and debt. Their performance depends highly on the interest rates and the security credit rating
- Commodities: you can find ETFs on any commodity, like silver and oil. For example, the gold ETF is very popular
- Regional: these ETFs focus on the assets of a country or a specific geographic area
- Global: they invest in worldwide companies. One of the most famous is the MSCI World Index
- Inverse: these ETFs create short positions, investings in assets whose value is expected to drop, and thus earn money
- Derivatives: you can trade options and futures using ETFs. I don’t recommend these leveraged products due to their high risk
The list goes on and on, including technology, emerging markets, energy, real estate, etc. The ETF sector is having a huge growth, so investors can create portfolios with any kind of asset. They currently represent a large part of the investment business pie.
My favorites are the Equity Index ETFs, since they track stock indexes like the S&P 500, which has yielded a 9% annual return over its 150-year history.
What is the difference between ETFs and index funds?
I imagine you are wondering: If ETFs and index funds copy market indices, what is the difference between an ETF and an index fund?
Well, although they are very similar products, they have two important differences.
The first difference is in the price. ETFs are listed on stock exchanges, their prices change throughout the trading session. In contrast, index funds are not listed on the stock markets. Their price is established once a day, and the same price applies to buy and sell.
ETFs have the advantage that you decide the time and the price at which to sell. When you want to close your position in a index fund, you give the sell order, and the value you get will be the day the order is executed (it usually takes one or two days).
In ETFs there is always a small difference between the buy and sell price. This is known as a spread. This is the same thing that happens when you buy shares.
The second important difference is related to dividends.
If the dividends are distributed they will be taxed. When you get paid dividends you must pay taxes, so it is better that the dividends are reinvested in order to delay the payment of taxes.
Delaying the payment of taxes makes your capital grow faster thanks to compound interest.
Both ETFs and mutual funds can distribute the dividends or reinvest them, but in my experience I have seen more ETFs distributing the dividends than reinvesting them. That’s why when you invest in an ETF, you should check its dividend strategy.
The best ETFs to invest in
Surely you are thinking now: Gonzalo, what are the best ETFs to invest?
When you are going to invest in an ETF, the most important data you have to review are the annual fees and the average returns obtained in recent years.
The strategy that I recommend is to invest in ETFs with low commissions and high yield. The best ETFs in my opinion are:
- S&P 500: follows the United States economy, and has achieved a 9% annual return for 150 years
- MSCI World: global ETF formed by more than 1600 companies from 23 countries, with a 10% annual return in the past decade
I recommend that you buy these ETFs from a high-level issuer, such as iShares and Vanguard. They are international fund managers with a long track record, provide you with quality services and currently manage trillions (yes, with t) of dollars.
Both Vanguard and iShares give you access to any ETF you can think of. Their fees are much lower than other companies, such as Fidelity. For example, my Vanguard S&P 500 ETF I pay 0.07% on annual commission, almost free! 🙂
How to invest in ETFs
Investing in ETFs is very simple, since nowadays most brokers and investment platforms offer them.
It is important to invest with a broker that charges low fees, has an easy-to-use platform and is regulated.
You can confirm if a platform is regulated checking the Financial Conduct Authority register.
I invest my money through two easy to use and fully regulated platforms:
- DEGIRO: broker with very low fees and a great platform. This is ma favourite broker, since they allow you to access companies and ETFs all around the world with low costs.
Access here my DEGIRO super-guide.
- Hargreas Lansdown: they are the biggest investment platform in United Kingdom. They offer a large range of mutual funds and index funds. Their fees are higher than DEGIRO but they allow you to invest through ISAs and Pension Plans, which is tax efficient since you don’t pay taxes on your capital gains.
If you are thinking of your retirement plan, take a look at my Hargreaves Lansdown guide
- Robo advisors: they design an investment portfolio adjusted to the investor profile. Your money is managed by professional investors at a very low cost. My favourite robo advisor in UK is Nutmeg
Depending on the type of investment you want to make, it will be better for you to open an account on one platform or another. For example, I have my pension plan with Hargreaves Lansdown, and my stocks and ETFs with DEGIRO.
We are nearing the end, I hope by now you have learned that investing in ETFs is one of the best investment strategies.
More articles related to investing in stocks
If you want to continue to learn about about investing in stocks and personal finance, I recommend the following blog articles:
That’s all on ETFs, thank you very much for reading the entire post, I hope you liked it!
If you have any questions or need more information, use the comments section, I would love to help you 🙂