Investing in ETFs: Beginners’ guide

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Investing is not only reserved for experts – any dedicated person with the right mindset can win the game. It is more about your attitude than your financial background. Some of the principles needed are patience, consistency and discipline. Investing in ETFs offer an attractive pathway to successful investing for beginners.

What are ETFs?

Exchange Traded Funds (ETFs) are financial products that track the performance of an index (or simply a bucket of selected stocks or assets) and are traded on the stock market.

Simply put, 1 share of an ETF will give you access to all stocks or assets in the bucket. For example, 1 share of Vanguard S&P500 ETF will spread your money across the top 500 USA companies.

There are many choices to consider when you are investing in ETFs for example:

• Asset specific ETFs – invest in an index of assets of your choice e.g. stocks, bonds, property, commodities etc.
• Industry or sector specific ETFs – invest in an index of assets of a chosen industry or sector e.g. mining, financials, consumer staples, information technology etc.
• Country or geographical region specific ETFs – invest in an index of assets of a selected country or region of choice e.g. USA, South Africa, Europe, World etc.

There are many variations of ETFs on many stock markets and we are not discussing all of them here.

There are some ETFs called Feeder funds. These ETFs are also investing in another master ETF instead of buying stocks or assets directly. Many South African ETFs tracking foreign indices like S&P500 and MSCI World are feeder funds. The fact sheet will tell you if it is a feeder fund or not. The difference is minor and often negligible to a beginner but note that feeder funds may have more costs in comparison to the master ETF.

ETF investing process

When you buy an ETF, a lot of things happen in the background. Simply put, when an investor buys an ETF, the money will go into a fund and then it is invested in the stock market using weights predefined by the index.

Note: With Feeder funds there is an extra node (Master Fund) between Fund and Market.

Why is investing in ETFs suitable for beginners?

Short answer – low risk, small or no minimum investments, low cost and good returns!

When you buy an ETF, you are spreading your risk across many assets in the index. This offers a great way to manage your risk through diversification. This ensures that extreme volatilities of one asset’s prices will not significantly affect your portfolio performance. That is, if one company listed in the index decides to do some crazy decisions, your money will not be wiped out instantly.

In addition, as an ETF investor, you do not need to spend a lot of time analyzing the financial statements of different companies because you are basically taking everything – the winners and the losers! This is why ETFs are open to everyone whether you are a beginner or expert.

Furthermore, investing in ETFs offers an opportunity to minimize your cost of investing. If you are to buy all 500 companies in the S&P500 index separately, your total costs will be massive. An ETF offers you the same exposure but at a much lower cost. ETF costs are also lower than traditional Mutual Funds (known as Unit Trusts in UK, Zimbabwe and South Africa). ETFs are cheaper because they are not actively managed.

Moreover, ETFs offer very good returns. Considering their risk is on the lower side, this is an excellent feature possessed by ETFs. Their performance depends on your ETF choice. An annualized average return of 10% – 12% for an ETF tracking S&P500 index is a good estimate. This is a good offer that can beat inflation and this is extremely better than many if not all savings accounts.

Another great advantage of ETFs is that they have little or no minimum investment amounts. This is very important especially for young people who are still earning small salaries.

ETFs are also great for investors who want to invest for their retirement or big projects. In other words, ETFs are good for long term investing.

Another advantage for South Africans is that you can invest in ETFs in your Tax Free Savings Account (TFSA).

How do you invest in an ETF?

ETFs can be bought from the stock market or directly from a provider of index tracking products like Satrix and Sygnia in South Africa or Old Mutual in Zimbabwe.

If you want to buy them from the stock market then you will need a stock broker or an online share trading platform. In South Africa, Easy Equities is a great start.

Investing in ETFs steps

On this section we will go through basic steps that may be necessary.

Step 1: Know your risk appetite

There are wide ranges of ETFs to choose from. Some invests in assets which offers low risk while others can expose you to high risk. If your risk appetite is high, you can pick ETFs for stocks or other higher risk assets that a market can offer.

Step 2: Know your focus area

As already mentioned, ETFs come in different variations, knowing what you want can help you.

Are you trying to take advantage of a booming mining or IT industry? Are you exposing yourself to the USA market or the European market? Or are you only looking for diversification across all asset classes or all industries or all geographical locations?

Step 3: Compare different ETFs

Remember that two ETFs can track the same index but with very different returns. This is because the costs can differ significantly.

Go through the fact sheets of like for like ETFs and compare the 3 – 5 year returns together with the Total Expense Ratios (TER).

Note:

• Total Expense Ratio (TER) – a lower value is more attractive
• Returns – a high value is more attractive

The quick suggestion will be to take the returns and subtract the TER. Pick the ETF that gives you a high return after removing expenses.

Note:

• By like for like ETFs, we mean ETFs tracking the same index e.g. comparing Satrix S&P500 ETF together with Sygnia Itrix S&P500 and 1nvest S&P500 ETF.

Step 4: Know the components of your ETF of choice

From the fact sheet, get to know the top 10 holdings in your ETF. How do you feel owning those companies? If that makes you happy then that is great.

For ETFs that invests in many sectors or industries or geographical locations, check your exposure in each of those. Are you happy with your money being allocated that way?

Note that buying many ETFs may not give you the diversification you want if the same holdings are repeating in all your ETFs with almost the same weights. This is just unnecessary duplication that can easily be avoided by picking few ETFs that offer different targets.

Investing in ETFs summary

ETFs are very good financial products that can be used by beginners to invest on their own. Investing in ETFs offer many opportunities for anyone to be an investor.

ETFs are great for a beginner in many ways for example:

• ETFs have lower risk in comparison to stocks
• they are cheaper than Mutual Funds (Unit Trusts)
• returns can beat inflation
• little or no minimum investment
• they can be used for retirement investing
• South Africans can invest in ETFs in their TFSA