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Top Tips! Exchange Traded Funds

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Invest in the stock market, without buying stocks! Boon Tiong Tan explains why ETFs are the better bet
PHOTO COURTESY OF Pexels

The US stock market is hot. The China stock market is not. Whether you are a growth or value investor, there are plenty of stocks for you to choose from. Most people who are looking to invest in the stock market, think they must buy stocks – specifically Amazon or Alibaba. Well, we used to only make phone calls, but now we use FaceTime and Zoom. Communication has evolved, and so has the stock market. Nowadays, you can invest in the stock market without buying stocks!

While many people are familiar with exchange traded funds (ETFs), very few realise that they are a much better way to invest in the stock market. When you buy an ETF, the fund manager uses your money to buy a basket of companies. An ETF is a collection of tens, hundreds and sometimes thousands of stocks or bonds in a single fund.

During trading hours, ETF prices change all the time just like stocks. You buy and sell an ETF exactly the same way you buy and sell a stock. You can buy an ETF immediately at the market price or leave an order to buy at a lower price. All you need is a broker account. Just like stocks, many ETFs pay dividends too.

There are more than 2,000 ETFs in the US alone, giving you lots of options. You can pick an index – Dow Jones Industrial Average, S&P 500 or Nasdaq. You can pick a single country – Malaysia, Japan or Nigeria. You can pick a group of countries – emerging market, frontier market or Asia Pacific. You can pick an industry – financials, utilities or even marijuana. There are more and more choices as the ETF industry’s global assets race past US$9 trillion this year. In Hong Kong, there are ETFs that follow major indexes like FTSE China A50 and Hang Seng, and industries like semiconductor and electric vehicles.

While ETF prices do not shoot to the moon like Tesla, Inc and GameStop, some can move really fast. Global X Copper Miners ETF (COPX) went up more than four times in slightly over a year, and Invesco Solar ETF (TAN) went from US$20 to US$120 in less than a year. KraneShares CSI China Internet ETF (KWEB), which has Tencent and Alibaba as its biggest holdings, fell 60% in six months in 2020.

Most conventional and big ETFs charge an annual management fee of less than 0.5%. The Tracker Fund of Hong Kong (tracks Hang Seng Index) charges 0.1% a year and Vanguard S&P 500 charges only 0.03%. Though most ETFs are sound, you should avoid leveraged ETFs, which promise to double or triple returns in a day. Not only can you double or triple your loss on a bad day, the hidden high cost will slowly and surely chip away your principal. Also be mindful that some US commodity and currency ETFs may require additional tax reporting.

BETTER THAN STOCKS
An ETF’s diversification means you aren’t putting all your eggs in one basket. If you were to create your own portfolio of stocks, you would need at least 20 stocks to reduce the companies’ risks. And here is the problem. It is hard to find more than 20 worthwhile companies that all do well. It is time consuming to manage the portfolio. You need to study each company. You need to know the earnings dates and monitor the dividends. You need to decide when and at what price to buy and sell each stock. The more decisions you make, the more mistakes you’ll make. An ETF solves all these problems.

ETFs put you on auto-pilot. You just pick one and the manager does all the work, while you enjoy your leisure time. If you bought a broad-based ETF that tracks the S&P 500 Index, you would’ve earned an average return of 9% over any 10-year period within the past 100 years. The last 10-year average return is much better at 14%. A dollar invested 10 years ago turns into US$3.7. The best investors like Warren Buffett and Ray Dalio’s long-term average annual return on ETFs is 20% to 30%.

If you do not like to cut your losses, buying stocks can be dangerous and costly. No matter how big and successful a company is, the share prices can go down and down. General Electric and ExxonMobil were the biggest companies in the world and now they are a shadow of themselves. Buying a broad-based ETF like Vanguard S&P 500 is different – you are not relying on a single stock to do well.

It is a good idea to hang on to a broad-based ETF during a bear market. Indeed, you are probably wise to buy more in a bear market. The US stock market has always bounced back given enough time. The S&P 500 Index has gone up almost seven times since the low of 2009.

BETTER THAN MUTUAL FUNDS
If a bank or an insurance company is selling you a fund, it is almost certainly a mutual fund, not an ETF. Most mutual funds are active funds. The fund managers actively try to pick good stocks to outperform indexes. Most ETFs are passive funds where the fund managers simply buy the stocks in an index. Media darling Cathie Wood, an American investor and founder, CEO and CIO of investment management firm Ark Invest, runs a few active ETFs. Her funds greatly outperformed the S&P 500 Index last year but have underperformed so far this year. This is typical of active funds; they can outperform for a period of time but underperform subsequently. Many academic studies have shown that, overall, active funds do not perform better than passive funds in the long term.

A mutual fund charges an expensive upfront fee of 3% to 5%, while ETFs do not charge an upfront fee at all. Mutual funds also charge higher management fees, usually in the range of 1% to 1.5% yearly. Buying mutual funds is like using a landline phone to make an overseas call – it is very expensive and the result is no better.

This year, the asset under management (AUM) of ETFs has surpassed mutual funds. There is a global shift over the past decade from mutual funds to ETFs. Many investors are starting to realise that ETFs are a better deal.

Benjamin Graham, the so-called father of value investing, once said: “To achieve satisfactory investment results is easier than most people realise; to achieve superior results is harder than it looks.” His protégé, Warren Buffett, advised his wife to put most of her wealth in a passive fund that tracks the S&P 500 Index. Next time you want to invest in the stock market, buy ETFs not stocks.

DB resident Boon Tiong Tan (CFA) has worked as a trader with banks like HSBC and Morgan Stanley for over 20 years, and he is the author of A Stock Investment Book For The 99%. For information about the one-on-one courses (money management, stock investment, options trading and chess) that he provides for both adults and kids, email [email protected].

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