Exchange-Traded Funds (ETFs) are one of the fastest-growing methods of investing [1]. ETFs work by tracking an index. Indices are a way of tracking the movement of a group of companies, commodities, bonds, etc., often sorted into a specific sector or region. ETFs track these indices in turn. This works by many investors giving their money to an ETF, then the ETF buys shares/units/bonds equivalent to what is in the index. ETFs are funds, but they are traded just like a company on a stock exchange, hence the ‘Exchange-Traded’ name.
For example, the S&P/NZX 50 index. This is an index run by Standard and Poor’s (S&P) and tracks the largest 50 stocks listed on the NZ stock exchange (NZX), weighted by market capitalisation (total worth). If you were to invest into an ETF that tracks the S&P/NZX 50, such as the Smartshares NZ Top 50 (FNZ), then you would be buying a little bit of A2 Milk, a little bit of Fisher & Paykel, a little bit of Meridian Energy and little bits of another 47 stocks.
Investing through ETFs helps you to reduce risk through diversification and simplifies the management of your portfolio. Diversification is the spreading of your investment across a range of companies, assets, industries, regions, risks and more. By diversifying your portfolio, even if the value of one holding goes down significantly, the performance of the other holdings will be able to make up for the loss. The reduced management also means you have more time to do other research or even go and enjoy your life.
The first downside to ETFs is the management fees. However, this is a minor downside as ETFs are a very passive investment method and require very little management and so have some of the lowest management fees of any fund type. A more major downside to ETFs is how they react in a downturn. In the case of a market-wide crash, managers of active funds will be able to sell out of stocks they think will crash and buy into stocks they think will rise. However, for ETFs, they must just follow the market and cannot be protected against the fall.
Another downside to ETFs is that they do not confer voting right to the investor, the voting rights fall to the ETF manager. In the case of Smartshares, their policy is to not vote except in the case where not voting would have a ‘material adverse effect on investors’, and when they do vote, they vote in ‘what it considers to be the best interest of investors’ [2]. While this may seem to be acceptable, not all managers have the same philosophy and it must be noted that they should vote in what they THINK is your best interest, not what is.
Overall, ETFs are an effective and easy to use tool for investing. EFTs are how I started investing on Sharesies and they still make up a significant portion of my portfolio to date. I highly recommend them for new investors as they provide easy access to the market, quick diversification, and little effort. They are great for learning how the market works.
References
[1] NZX, "Exchange Traded Funds," 2019. [Online]. Available: https://www.nzx.com/products/nzx-exchange-traded-funds.
[2] Smartshares, "Statement of Investment Policy and Objectives (SIPO)," 2017.
