SINGAPORE (Feb 19): Whether you are a beginner investor or a seasoned pro, exchange-traded funds (ETFs) are a good investment to include in your portfolio.

And for good reason. Any smart investor will tell you it is important to have a variety of assets in your investment portfolio due to the fairly volatile nature of the stock market.

Just as you would not put all your eggs in one basket in an environment you are unsure of, a diversified portfolio – which generally comprises a mix of assets including stocks, bonds, and cash – is designed to help you make the most money with the least risks.

Enter ETFs, which are one of the easiest ways to inject diversity into your portfolio.

What are ETFs?
Photo: Pexels.com

What are ETFs?

ETFs are made up of a group of individual stocks, commodities, and bonds that possess common traits or criteria such as an index, industry or asset class. The group of selected assets are then bundled and sold as a collective unit on the stock market in what is called an index basket.

You can think of an ETF as a mutual fund that you can trade on the stock market, and receive returns like you would for individual stocks.

However, take care not to confuse them both. ETFs are more versatile, as they can be traded on the stock market like individual stocks at any time of the day, while mutual funds are limited by the price at the end of each trading day. Mutual funds are also being actively managed by a fund manager, who makes the decisions on what to buy, and what to sell.

Unlike mutual funds, ETFs are not limited by a minimum investment sum required to take part in a fund. You will, however, need to pay commission fees to your brokerage whenever you buy or sell ETFs on the stock market, like any other share.

Notable examples of ETFs include the Straits Times Index (or STI), which is made up of the top 30 companies listed on the Singapore Stock Exchange, or the Standard & Poor 500 Index (or S&P 500) which comprises the top 500 companies listed in the US stock markets.

How are ETFs formed?

ETFs are funds formed by companies (or the ETF sponsor) along with authorised financial institutions (which you can find on the Monetary Authority of Singapore’s website) who want to track the performance of their assets.

These funds are then distributed as shares to investors via the stock market. These companies will also decide which assets to allocate and the number of shares included in the fund, and determine its starting price on the market.

Why invest in ETFs?
Photo: Pexels.com

Why invest in ETFs?

If you do not have the time to do your research on individual stocks, or are unfamiliar with how they work, ETFs are a great way for you to begin your foray into the stock market.

An ETF is a low-cost way of buying into sometimes high-performing companies that may cost a lot more as individual stocks. It also lets you invest in a variety of stocks that spans a number of companies, and sometimes across several industries – all for the price of one unit. This helps diversify your portfolio at a more affordable rate, as opposed to buying each stock in the basket individually. This diversification also means your portfolio is less affected by seasonal or cyclical trends that may affect the prices of these stocks on their own.

As ETFs behave like stocks on the stock exchange, you are able to enjoy a degree of flexibility and liquidity. This means that, should you decide to sell your ETF when you have made a profit, you are able to do so without any restrictions. At the same time, if you are a long-term or passive investor looking at earning dividends, you may also do so.

There is a variety of ETFs for you to choose from. While not all ETFs are index funds, you will find that most of them track an index like the STI and S&P 500, which are made up of some of the top companies in the world. Indices like the STI are automatically made up of the top 30 companies listed on the Singapore Stock Exchange. This means that should a company at the tail end of the list fail to make the cut during its quarterly review, it will be replaced by another with a higher valuation.

Index ETFs are traded at their net asset value (or the total value of assets minus the value of their liabilities). This helps ensure accuracy, and again, minimises the risks.

Risks that come with ETFs

Just because ETFs are low-risk, it does not mean they are completely risk-free. Just like individual stock prices, when the price of an ETF drops, you can choose to wait it out, or sell, if you believe that there is no room for recovery.

If you are a short-term investor, you will have to factor in the brokerage commission fees involved.

Unlike individual stocks, you are unlikely to lose all your money, especially if you invest in ETFs that comprise some of the largest companies in the respective stock markets. However, if you are a short-term seller, you may not be able to make as much profit with ETFs, especially with ones people are looking to keep for the long-term. You will also have to take note of the brokerage commission trade and management fees, should you be looking to buy and sell actively.

Should you be looking at less popular ETFs, there is always the possibility of the fund closing. Once that happens, your stock will be liquidated or converted into cash, and there will be transaction costs involved.

How to invest in ETFs?

That said, there are more advantages than disadvantages when it comes to investing in ETFs. It is also a great starter stock to put in your portfolio – whether you are looking to buy and sell actively, or are passively looking for long-term returns.

Opening one doesn’t take much time. You will need a brokerage account to buy and sell ETFs on the stock market. You will also need to open a CDP account if you are buying and selling on the Singapore Stock Exchange; you do not need a CDP account for foreign trades. You should also do your research – it is best to invest in a stock that you understand closely, and it is no different with ETFs.

For more stories on investing 101, click here. For more news and investment insights, see our print edition here.

See also: