ETF: What’s All The Fuss About Exchange Traded Funds?

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ETF is an acronym that’s been doing the rounds for quite some time. For those of you who don’t speak investment jargon, it stands for Exchange Traded Fund and just might be worth learning about if you intend on growing your money.

What is an ETF?

In formal terms, an ETF can be defined as an investment vehicle that tracks an index. To phrase this more simply: an ETF is an investment that tracks a particular market or portion thereof. 

For example, if you were to invest in an ETF that tracks the FTSE/JSE Top 40 index (the 40 biggest shares on the Johannesburg Stock Exchange), you would effectively be exposed to the market movements of those 40 shares.

In other words the performance of those shares will be directly replicated in your ETF investment.

How do ETFs work?

ETFs are traded on stock exchanges such as the JSE and can therefore be bought and sold just like regular shares.  

You can therefore purchase ETF units via your stockbroker, an online share platform, financial planner or directly from an ETF provider.

Why are ETFs referred to as passive investments?

The reason for this is that there’s no active management (stock picking by exercising investment judgment) in selecting the underlying shares as the fund simply tracks the performance of the market.

This is both a benefit and a drawback as it results in lower fees as you do not have to pay additionally for active management, but this also means that you will never outperform the index you’re tracking.

What benefits do ETF’s offer?

Diversification

ETFs allow you to spread your risk by diversifying your funds over multiple holdings.

Eliminate managerial risk

This basically means that by investing in an ETF you no longer have to choose a specific fund manager who you believe will be able to actively manage your investments most efficiently.

Cost efficiency

Due to the fact that ETF’s track indexes without trying to outperform them, they trade less, which results in them being cheaper than actively managed funds such as Unit Trusts.

Tax efficiency

Fewer trades means fewer taxable distributions. This tax saving leads to a more efficient overall return on investment.

Liquidity

Because ETF’s are traded as shares on the stock exchange, investors are able to get into and out of investment positions with relative ease.

In conclusion ETF’s provide a simple, cost effective form of investment. It is however important to bear in mind that ETF’s aim to be the market and will as a result never beat the market.

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About Author

Raul Jorge is a CFP® professional at PSG. He specialises in estate, investment, retirement and risk planning. Prior to joining PSG, Raul completed his BSc (Honours) in Business Administration through the University of Wales and more recently completed his Postgraduate Diploma in Financial Planning through the University of Stellenbosch.