What is an ETF? Investing for Beginners
If you are new to investing you may feel like you have dived into a whole new world. There is so much to learn, and the more you know the more you realise you don't know. What's worse is that there are so many confusing terms and explanations thrown around. I aim to break some of these down in simple terms, so you can get started in investing confidently. Or at least contribute to the break room conversation without feeling out of your depth. So, let's answer all your questions, and more, about ETFs.
What is an ETF?
ETF stands for Exchange Traded Fund. Cool, but what does that mean? An ETF is a managed fund that consists of shares of different companies. Buying shares in an ETF is a good way to invest in several companies without picking stocks yourself. For example, you might buy stocks in a small companies ETF. The company offering the ETF will pick the best small companies and package that together. When you buy their ETF you are buying a small percentage of each company.
What is the benefit of an ETF?
There are three main advantages to buying ETFs rather than picking stocks yourself. The first is you get to diversify your risk. Let's say your ETF consists of 20 companies. 2 of them are doing badly, 15 are performing OK and 3 are doing really well. Overall, the value of the ETF is growing steadily.
The second benefit is that the stocks are picked by stock market experts. So rather than doing all the research yourself and potentially making mistakes, you can buy an ETF and be fairly confident that it is going to perform well.
The third benefit is that you get to buy into several companies for a lower initial investment. If you buy an ETF that consists of 50 companies, you now own small pieces of each of those companies. If you were trading buying minimum amounts of each 50, that would mean 50 times the brokerage fees and 50 times the minimum investment.
Are ETFs safer than stocks?
Yes, because ETFs are managed by stock market experts, they are safer than picking your own stocks. They do tend to grow slower than some superstar stocks, Afterpay, for example. However, depending on what kind of ETF you invest in, they can still have very strong returns.
What are the drawbacks of an ETF?
One drawback of ETFs is that they often pay lower dividends. You can however buy ETFs that are designed to be high yield. This means that you will receive an income from the shares that you hold, the same as if you own shares in individual companies.
Hang on, what is a dividend?
If you are completely new to investing there might be a bit of terminology that is new to you. That's ok, you'll be an old hand soon enough! A dividend is a payment made to shareholders, mostly 4 times per year. The size of the dividend will depend on the profits of the company. For more info on dividends, head here.
Do ETFs pay dividends?
Some ETFs do pay dividends. In many cases, dividends will be reinvested automatically. This is the case for apps like Spaceship and Raiz. However, companies like Vanguard offer ETFs that do pay dividends, and some are designed specifically to pay more dividends than others.
Are ETFs a good investment?
If you are new to investing ETFs are a good place to start. You can be fairly confident that they will perform well. However, it all depends on what your investing goals are. If you want slow and steady growth for your money, then ETFs are a safe bet. However, if you want to take risks and potentially grow your money faster, it would be better to research companies that you think have growth potential and invest there. Just keep in mind that this style is investing is much risker.
How do I pick the right ETF?
In order to pick the right ETF for you, you need to think about your investment goals. Here are some examples of goals that you might have for your money:
You also need to think about what level of risk you are happy with. An ETF geared towards rapid growth also carries a higher risk of negative return (losing money). Here is a good rule of thumb - if you want long term steady growth go for an ETF that has more large cap stocks. If you want faster growth and are happy to accept a bit more risk, look for a company that invests in smaller companies or startups. If you are looking to get regular income from your stocks, choose a high yield ETF.
What is a mutual fund?
A mutual fund is a pool of money formed by individual investors to invest in stocks and other assets. A mutual fund gives individual investors a way to invest in professionally managed portfolios when they might not otherwise have the means. Mutual funds will generally charge annual fees or commissions.
What is an index fund?
An index fund is a group of stocks designed to mimic the performance of a particular market or sector. For instance Vanguard's Australian Shares index consists of the 300 largest companies in Australia and will mimic the performance of the overall Australian market.
How do I buy an ETF?
Most ETFs are listed for sale on the ASX, so you can buy them like any other stock. I would suggest starting your research with Vanguard, which offers a range of ETFs in both Australian and overseas companies. Commsec is an easy way to buy shares on the ASX and is linked to Commbank services. Their brokerage fee for ETFs is $19.90. Westpac also offers share brokerage from $19.95. However, Commsec fees for a regular trade are only $9.90, so if you are planning on buying shares in individual companies they will end up being cheaper.
Who manages ETFs?
ETFs are managed by portfolio managers, whose job it is to buy and sell stocks to ensure the funds performance. Although it is not required, fund managers will normally hold qualifications in finance or economics.
How is the price of an ETF determined?
The price of an ETF is determined by adding up the value of all the assets in the fund, subtracting any liabilities, then dividing that by the number of shares. The value of the ETF will go up or down depending on the performance of the companies that make up the ETF.
How do ETF fees work?
ETF fees are not charged directly, but are deducted from the fund assets, meaning they are factored into the daily price of the ETF.
How do ETFs make money?
There are two ways that ETFs make money. The first is the value of the ETF. If you buy at a low price and the ETF increases in value, you are growing your money. You can either keep the ETF and continue to grow your wealth or sell them for a profit. At this point you will need to pay capital gains tax. The second way that ETFs make money is the payment of dividends. Put simply, a dividend is a share of the companies overall profits, paid to you as a lump sum or reinvested in the fund.
The Bottom Line
If you are interested in investing and don't know where to start, buying an ETF is a good way to go. You are managing your risk by automatically buying shares in a range of companies managed by a professional. ETFs are a good way to grow your savings in the long term, rather than making money in the short term. If you are interested in an easy way to invest small amounts of money in ETFs, read our article on either Raiz or Spaceship. Happy investing