In this article, we explore some features of exchange-traded funds (ETFs) that make it a great investment opportunity for most people. We hope that our readers will understand:
- What are ETFs?
- Why ETFs are a good choice for retail investors
Investors looking for higher returns on their savings can achieve this via two approaches in the stock market: (1) become a shareholder by buying stocks, or (2) buy a share of a professionally managed portfolio of stocks (mutual fund). In both instances, dividends and capital appreciation make up the returns that increase investors’ wealth.
An ETF is like a mutual fund, in the sense that it forms a portfolio of securities to track the returns of market indices (e.g. Straits Times Index, S&P 500), bonds, commodities, foreign currency, or derivatives. However, unlike a mutual fund, shares of an ETF can be bought or sold on the stock exchange just like any publicly listed shares.
Investors in an ETF own a share of the investment vehicle (can be a corporation or trust depending on the country that it is incorporated in) and don’t directly own the financial instruments (underlying assets) that the fund invests in. Investors may still enjoy dividend pay-outs, as well as capital appreciation through buying and selling the shares in the ETF on the public stock exchange.
Although the returns from investing in the stock market are more volatile, investors can expect higher returns when compared to investing in savings or fixed deposits in the long run (see stacked chart below). Between 1983 and 1990, savings and fixed deposit rates average 4.4% and 5.1% per annum respectively.
In this same period, the S&P 500 averaged 13.8% returns on an annual basis. For the past 10 years (including the period of the global financial crisis), the annual returns on savings, fixed deposits, and S&P 500 are 0.15%, 0.46%, and 6.5%, respectively.
Why Are ETFs Preferable to Individual Stock-Picking and Mutual Funds?
Investing in stocks carries risk in the form of fluctuating prices that can be hard to predict. This risk is made up of two components:
- Systematic risks. Systematic price fluctuations are typically caused by macroeconomic factors and affect every stock in the market.
- Idiosyncratic risks. Idiosyncratic price fluctuations are caused by the actions (or inactions) of the company itself. Such risks are specific to the company and not shared with the wider market.
Idiosyncratic risks can be totally avoided by buying different stocks from companies in different sectors of the market. A market index is a valuation of such portfolios of stocks, and could represent the value of all stocks in an exchange (e.g. Shanghai Composite), or selected performing companies (e.g. Straits Times Index, S&P 500).
Investors can enjoy the benefits of such diversification strategies by investing in index funds or ETFs that track market indices.
2. Low Costs
ETFs that track indices have very low expenses because they don’t need a specialist team to actively buy and sell stocks for the portfolio (overheads + transactions) and they keep cash reserves to meet redemption needs (people who exit the ETF). In addition, ETFs can enjoy better brokerage fees because of the large amount of investible funds they deploy into the market. As such, most ETFs charge less than 1% management fee as compared to a mutual funds’ 1% – 3%.
In jurisdictions where brokerage commissions are not mandatory, ETFs can charge very little (sometimes even 0%) commission fees for trading on the exchange. Mutual funds typically charge higher commission fees in addition to a schedule of other fees such as front-end or back-end load and redemption fees.
3. Trading Features
Like any stock on an exchange, ETFs can be traded any time the exchange is open. Investors can also short ETFs, use a limit/stop-loss order, buy on margin, or write options against them. These features are not available for mutual funds, which must be bought or sold at the end of a trading day.
It Is Really Hard to Beat the Market
Proponents of mutual fund investing believe that active management can “beat the market”, i.e. generate an investment return that is higher than the market index. Financial economists and analysts have investigated mutual fund performance for decades and found no evidence that mutual funds can persistently generate higher net-of-fees returns for their investors1,2.
If investment professionals with their suite of analytical skills, constant information flows, and computing technology could not consistently outperform the market, the odds are stacked further against retail investors who are ill-informed. ETFs are one of the ways investors can use to make higher returns, but as always it is prudent to consider what is best for your current financial situation.
1. Wermers, Russ. “Mutual fund performance: An empirical decomposition into stock‐picking talent, style, transactions costs, and expenses.” The Journal of Finance 55.4 (2000): 1655-1695.
2. Carhart, Mark M. “On persistence in mutual fund performance.” The Journal of Finance 52.1 (1997): 57-82.
Dr. Jack Hong is the co-founder of Research Room Pte. Ltd., a management consulting and advanced analytics company that delivers complex prediction and decision-making capabilities for commercial, government, and not-for-profit organizations. Dr. Hong has extensive research and commercial experience in applying advanced empirical science to drive business, financial and policy value chains. He is concurrently an adjunct faculty with the Singapore Management University (SMU).