Hopefully, by now you have set your brokerage account and you are somewhat familiar with the online interface. Good job! If you haven’t done that, don’t worry. The best day to start investing was 20 years ago. The second best day is today.
What is an Index?
A stock index (market index, stock market index or simply an index) is a measurement of the value of a section of the stock market. Simply put, indices are benchmarks which track the performance of specific sectors of the market – US companies, tech companies, real estate, small-cap companies, etc. An index can track anything.
An index is a mathematical construct, so you can’t invest in it directly.
What are the most popular indices?
- Dow Jones Industrial Average or simply the Dow is an important index many people watch to get an indication of how well the overall stock market is performing. It is based on the 30 largest publicly owned companies based in the US.
- S&P 500 is a common benchmark for the American stock market. It is concentrated in the largest 500 US listed stocks.
- NASDAQ is heavily weighted towards information technology companies.
- MSCI World is an index of 1654 ‘world’ stocks.
- EURO STOXX 50 is an index of 50 of the largest and most liquid stocks in the Eurozone.
- DAX (German stock index) is an index consisting of the 30 major German companies.
What is an ETF?
An ETF (exchange-traded fund) or index fund is an investment fund traded on stock exchange. It owns assets (bonds, stocks, commodities, gold bars, etc.) and divides ownership of itself into shares that are held by shareholders.
An ETF is a financial product which you can buy or sell. The shareholders indirectly own the assets of the fund. They are entitled to a share of the profits, such as interest or dividends, and they may get a residual value in case the fund is liquidated.
Most ETFs track an index, such as a stock index or bond index. These ETFs are designed to follow certain preset rules. Those rules may include tracking prominent indices like the S&P 500 or the Dow Jones.
What are the advantages of ETF investing?
My advice to the trustee could not be more simple. Put 10% of the cash in short‐term government bonds and 90% in a very low‐cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, individuals—who employ high fee managers. – Warren Buffett in a letter to shareholders about 2013 results (pdf)
ETFs are attractive as investments because of their low costs and stock-like features. The lack of active management generally gives the advantage of lower fees.
- Lower costs: ETFs generally have lower costs than other investment products because most ETFs are passively managed and therefore cheaper to run. ETFs typically have lower marketing, distribution and accounting expenses.
- Buying and selling flexibility: ETFs can be bought and sold at current market prices at any time during the trading day.
- Market exposure and diversification: ETFs offer exposure to a diverse variety of markets, including broad-based indices, broad-based international and country-specific indices, industry sector-specific indices, bond indices, and commodities.
- Transparency: ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day.
- Continuous growth over the long term despite crashes: the dividends trend upward over the years and the principal grows as well (with many ups and downs, to be sure). For example, S&P 500 has an average yearly return of 11% (7% adjusted for inflation) in the period 1950-2009. DAX has an average yearly return rate of 9% (7% adjusted for inflation) in the past 26 years.
- Almost 0-time investment: with an ETF you invest regularly in a dynamic selection of the best-performing companies. You can set an automatic monthly investment plan. There is no need to research individual companies and constantly follow the trends.
- Simple, understandable strategy: Buy regularly every month over the good and the bad times. You don’t need to worry if the market is about to crash or is in a high phase. Stay for the long run – 10-20 years and the average return would be positive.
- Lower risk than investing in individual stocks. You are not an expert, and you don’t need a second full-time job as an investment manager. ETFs guarantee you good return with relatively lower risk.
- Past performance should not be considered an indication of future performance. That being said, no one can guarantee how the index funds will perform in the future.
- The returns may vary depending on the exact market conditions in the moment you start investing or expect to sell the investment.
What to consider before investing in an ETF
ETFs are a low-cost way for investors to get exposure to different investments, but you have to be selective when deciding which one to buy.
The ETF market has become an intensely competitive environment. In a bid to differentiate themselves from the competition, some ETF issuers have developed products that are either very specific in focus or are based on an investment trend that may be short lived. Given the wide selection of ETF choices, it’s important to consider the following factors:
- Your intention: Before you compare other aspects of ETFs, you have to know what you want to invest in and why. If you are risk-averse and seeking a way to get stock exposure, then you may want to look at more stable stock focused large-cap companies ETFs. For risk-seeking investors, there are more exotic ETFs that could give them a higher return. Without understanding what the aim of the investment is, you are quickly going to get overwhelmed by the number of different ETFs on the market.
- Underlying index or asset: Consider the underlying index or asset class on which the ETF is based. From the point of view of diversification, it may be preferable to invest in an ETF that is based on a broad, widely followed index, rather than an obscure index that has a narrow industry or geographic focus.
- TER or Total Expense Ratio: a measure of the total costs associated with managing and operating an investment fund. While generally, ETFs are cheaper than other fund investments; some ETFs can be quite pricey. According to the Wall Street Journal, the average expense ratio on an ETF is 0.44%. ETFs that invest in more focused, risky industries, regions or investments can cost more than the average.
TER is typically 0.05% to 0.70% yearly, which is only 1/12th the average for active mutual funds. It’s less than 1/30th of the typical 2% charged by a hedge fund (and that isn’t counting performance fees, which are usually 20% of any profit) again quoting Buffet.
- Dividend paying or re-investing: Always prefer ETFs which re-invest the dividends. In the long run, the investment will grow exponentially due to the compound interest effect.
- Full physical replication: Make sure the ETF is backed up by real shares from the companies in the index. Some ETFs use synthetic replication to build a fund. This means that the fund manager buys a derivatives contract (a category of security) based on the underlying index. This exposes you to “counterparty risk”. This refers to the risk that the fund may not receive the performance of the index from the bank as per the derivatives contract if that bank goes bankrupt. It is a small, but a non-negligible risk to be aware of.
- Level of assets: To be considered a viable investment choice, an ETF should have a minimum level of assets, a common threshold being at least $10 million. An ETF with assets below this threshold is likely to have a limited degree of investor interest. As with a stock, limited investor interest translates into poor liquidity and wide spreads.
- Tracking error: While most ETFs track their underlying indices closely, some do not track them as closely as they should. All else being equal, an ETF with minimal tracking error is preferable to one with a greater degree of error.
- Saving automation: I prefer setups where the monthly ETF transaction is performed automatically so I don’t need to do anything except for feeding my account with enough funds.
While the world of investing can seem intimidating at first, with some persistence you will get the hang of it. After all, building wealth and financial independence is a long process and there are many experiments to be made and lessons to be learned.
The bottom line is you don’t need a smart financial advisor or anyone to get your investment going. Let me know in the comment section below if I missed something.
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Upwards and onwards!
I am not an investment consultant and all the opinions I share are inspired by my own experience. I learn by doing, and I try to keep the risk at a minimum. So far I enjoy a double-digit growth of my portfolio. This doesn’t mean it will always grow at this rate, but I am in it for the long run and well aware of the fact there will be many ups and downs along the way.
Before taking any action, do your own research – all the information you need is a google search away.