Investing with ETFs like a PRO
Disclaimer: these are my notes on how I personally plan to make money in the stock market. I’m not a certified financial advisor and this article is not financial advice.
My personal experience and recent events in the market tell me that “experts” with skills in investment management are extremely rare. Although many of them are bankers by profession, they are really gamblers or salesman who take a bonus if they sell unknow “safe” (…but toxic) investment products to the customers.
According to investopedia.com, a Credit Suisse study revealed that from January 1994 to October 2018, the S&P 500 outperformed every major hedge fund’s game plan by 2.25%.
I would be a cocky if I say trading or investing is easy job: indeed, it is complex and the results are not always aligned with expectations, but I still think it is possible to obtain good results with simple tools. Enjoy this reading and good luck: if you become the next Warren Buffet, please remember me!
I would argue it is more appropriate for small relatively inexperienced investors to have a highly diversified portfolio of Exchange Traded Funds (ETFs). Many ETFs are relatively cheap, passive trackers of major indexes and are really liquid. If you have a relatively small amount of money I would say there is no value in holding individual stocks.
What is an ETF
Exchange Traded Fund (ETF) is a type of security that involves a collection of securities — such as stocks, bonds, commodity indexes, or a mixture of investment types — that often tracks an underlying index, like S&P 500, DAX, etc. ETFs can invest in any number of industry sectors or use various strategies. ETFs are in many ways similar to mutual funds; however, they are listed on exchanges and ETF shares trade throughout the day just like ordinary stock.
ETFs are the perfect building blocks for private financial investments.
Speaking about ETFs, the reader must be aware that we have also these type of security:
Exchange Traded Commodities (ETC): a type of security that replicate the performances of a specific commodity (e.g. gold).
Exchange Traded Notes (ETN): a type of security that replicate the performances of other securities not covered by ETFs and ETCs like currencies or indexes.
The benefits and drawbacks of ETFs
Benefits
- ETFs are cost-effective: ETFs replicate passively an index, so there is no need of analysis team or experts like in managed funds.
- ETFs are transparent: ETFs, tracking passively a known index, allow investors to be aware of risk/reward, it is known the which kind of securities are into and the price reflect the changes in the underlying stocks.
- ETFs are flexible and liquid: ETFs do not expire and are simultaneously listed on the stock exchange in real time; the investor can therefore modulate the investment time horizon according to his objectives, which can range from the very short term (intraday trading) to the medium / long term. Finally, considering that the minimum trading lot is equal to only one share, it is possible to take a position on indices all over the world even for small amounts;
- ETFs are widely diversified: One ETF can give exposure to a group of equities, market segments, or styles. An ETF can track a broader range of stocks, or even attempt to mimic the returns of a country or a group of countries
Drawbacks
- Spread bid/ask: some ETFs may have significant bid/ask spread, making them not well-suited for intraday trading.
- Lower Dividend Yields: there are dividend-paying ETFs, but the yields may not be as high as owning a high-yielding stock or group of stocks.
- A cost: buying ETFs, the investor has to give back some additional fees (TER)
At this point the reader may wonder if the benefits outweigh the drawbacks: the response is: definitely!
In the next sections, I will present a really quick and not exhaustive overview. There are many books about ETFs and websites, what you will find here is simply the minimum set of information I think relevant for an investor with a small amount of money.
Distributing or Accumulating ETFs
Looking inside one of most famous ETFs theme site www.justetf.com, you may notice on some ETFs these letters: Acc or Dist
Acc stands for “Accumulating”, while Dist for “Distributing”. If you like regular income from your investment you wonder distributing ETFs.
- Equity and real estate ETFs distribute dividends from their underlying holdings.
- Bond ETFs pay interest thrown off by their portfolio of fixed income securities.
- Commodity assets do not produce dividends, so neither do their associated ETFs.
Attention: this income is subjected to taxation!
Accumulating ETFs, indeed, reinvest the income in the fund itself: for an investor this is the better solution in term of efficiency, taxes paid on capital gains and returns (compound interest)
Criteria for selecting the right ETF
Before moving to the portfolio construction, we need to investigate how to select the right ETF for our needs. Just to give you the exact size of the problem, take a look at the image below
There are 9 main asset classes and 2322 ETFs and our final portfolio will contain from 4 up to 8 or 10 ETFs.
We must create a shortlist! What are the main criteria for a given asset class?
Equity ETFs
- Geography (are we going to invest in a specific area like a nation or Europe, or entire world?
- Asset under management (AUM): the total amount of owned underlying securities (bigger the better — famous investors suggest > 500 M$)
- Expense ratio: how does it cost? (smaller the better)
- Volatility: the amount of risk we are going to take in order to get a return.
Bond ETFs
- Geography (are we going to invest in a specific area like a nation or Europe, or entire world?
- Asset under management (AUM): the total amount of owned underlying securities (bigger the better — famous investors suggest > 500 M$)
- Expense ratio: how does it cost? (smaller the better)
- Government bonds (low risk low return)/corporate bond (higher risk, higher return)
- Duration: shorter duration, less volatility, less return; higher duration, more volatility due to interest rates, economic conditions, etc, higher returns
Currency ETFs
Currency values are usually driven by interest rates, economic conditions and government politics. Investors may use currencies for safety, speculation, or hedging. They have a higher volatility than other ETFs, but safer than Forex!
Commodity ETFs
Commodity ETFs seek to capture the return on the major global commodities by tracking a commodity index. It is possible to invest on a single commodity— for example, gold — using Exchange Traded Commodity (ETC).
Whereas an ETF is a fund, ETCs are debt instruments that expose ETC investors to credit risk.
Leveraged ETFs: avoid it.
Short or inverse ETFs: avoid it.
Exchange Traded Notes: avoid it.
Wrap up
Headache?Bored? Probably. This is a really quick and not exhaustive introduction to the ETF world. We need it so in next post we are ready to analyze different portfolio and simulate returns.
