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Should you invest in a single stock or in multiple companies at the same time? With an ETF (Exchange Traded Fund), you can do the latter by using a single vehicle to invest in several bonds and/or shares simultaneously.
Yet how do they work exactly? In what way do they differ from index funds, and what are the pros and cons to consider as an investor? Below, our team at WMM offers some answers for you to think about regarding your own portfolio.
ETFs explained
If you log into an investment platform you’ll likely see a range of company stocks that you could buy. These tend to have “ticker symbols” next to them (e.g. TSLR for Tesla). However, you can also buy and sell ETFs.
For instance, the SPDR S&P 500 (SPY) is one of the oldest ETFs on the New York Stock Exchange (NYSE) and tracks the S&P 500 Index, comprising the 500 largest US companies.
In other words, rather than buying shares from each of these companies individually, you could simply buy an ETF which invests in all of them.
The difference with index funds
There are two main distinctions between ETFs and index funds – their fees and how they are traded. Typically, the former is cheaper than the latter due to lower running costs. However, they may involve a stock broker fee when they are bought/sold on the market.
Concerning how each is traded, ETFs can be bought and sold at any time during the day – whilst the market is open. Other funds (like index funds) can only be traded at the next “trade point” (usually at the end of the day).
How ETFs work
When you buy a stock directly you become the owner of the underlying asset (e.g. you own a “piece” of Facebook, or something else). With an ETF, the fund manager owns the underlying assets and issues shares of the fund to investors.
When you “buy” the ETF like SPY, therefore, you do not then own shares in all 500 companies that the fund invests in. Rather, you own shares in the ETF. Nonetheless, investors in the ETF should still receive lump sum dividend payments for the stocks within the fund.
ETFs typically track the value of an index or underlying asset (like gold). Yet ETFs often trade at prices which differ to these indexes/assets. For instance, investors may rush to invest in gold within a given period – perhaps due to inflation fears – but they may not choose to do this via an ETF, which could affect its market price.
Pros & cons of ETFs
One of the great aspects of an ETF is that it allows investors to build a diversified portfolio very quickly – without requiring large amounts of capital to invest. For instance, buying shares directly in each of the S&P 500 companies would require a big lump sum up-front. However, you could invest in them indirectly via an ETF using as little as £50 a month.
ETFs also track the movement of an index over time, which is usually a better way to generate returns in the long-term compared to picking individual stocks and trying to “time the market”. One study shows that the S&P 500 beat 60% of active fund managers over the last 1 year, and this rises to 75% when the period is stretched to 5 years.
However, ETFs do have their drawbacks. Firstly, liquidity risk can be an issue. If there is limited interest in buying your ETF when you look to sell it, then the price may need to move down before you can do so. Secondly, there may be companies or bonds within an ETF which you do not want to invest in (e.g. due to ethical reasons), but which cannot be avoided.
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