Today, I am leaving the world of asset allocation to talk a little bit more about Exchange Traded Funds (ETF). This is probably one of the most popular investment products. Its popularity is soaring amongst smaller investors especially over the past 5 years.
The purpose behind ETFs
Wouldn’t you think that we had enough financial products? That the world of investing is complicated enough that we don’t need another way to invest our money? Well, the purpose behind ETFs is to make investing easy and simple ;-).
In fact, most ETFs track the value of a type of investment. The most common will track a stock market index like the S&P 500 or the Dow Jones. Therefore, if the Dow Jones made 4% in the past 4 months, your investment will show a growth of near 4% too (the index yield less minimal management fees). So it is a very easy way to diversify a small portfolio without having to pay huge fees.
However, there are a few things you must know about ETFs before trading them:
ETFs are traded on the stock market as regular shares. Therefore, instead of buying 100 shares of Apple on the market, you can buy 100 unit of the ETFs replicating the NASDAQ for example. Since they are traded as a stock, each time you buy or sell an ETF, trading fees will apply.
Sometimes, the temptation of timing the market is very high. Therefore, you could be tempted to buy and sell the index at different times of the day or week. If you get sucked into this market timing game, you will end-up with huge trading fees at the end of the month and this will affect your overall yield drastically.
ETFs are for investors with a certain asset size
If you only have $5,000 to invest, you might want to consider mutual funds to build a well diversified as an ETF portfolio could be costly in term of transaction fees. Imagine that you buy 5 ETFs to build your portfolio (replicating the US market, international market, bond market, resources and emerging markets). This will cost you a good $50 of transaction fees (assuming a $10 transaction fee). This is already 1% of your portfolio. But if you have to rebalance your portfolio (or make any other modification) during the year, you will increase your trading fees to 2%-3% easily. If you add up the low but still existing MER fees of ETF, you will end-up paying a 3%-4% overall fees on your small portfolio where you could pay lower than 2% to have a well diversified mutual fund portfolio.
Independent investors DYI
Most investors who choose the ETF route already know a lot about investing and how the stock market works. An ETF portfolio requires knowledge to be built properly. You want to buy the right ETF in order to have the right diversification.
In addition to that, you will have to rebalance your portfolio to match your asset allocation at least twice a year. Therefore, if you don’t want to take care of your investment too much, building an ETF portfolio may not be the right solution for you.
Diversification and not Diworsification
Be careful of the temptation of the Toys “R” us syndrome; when a kid goes into this store, he wants to buy it all. Sometimes, having too much choice is worst than not having any. ETFs are now able to track just about anything you could possibly imagine. So you could enter into a diworsification of your portfolio instead of managing a great asset allocation!
You are better off with passive investing
I am not a believer of market timing. In fact, I am sure that you will always end-up losing if you try to time the market. So if you invest in indexes through ETFs, you are better off doing it for the long run. Try ETFs in your retirement portfolio. This way, you will be less tempted to sell them when the market goes down ;-).