Why I Prefer Investing in ETFs: A Guide to Smart Investing

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In today’s fast-paced financial world, making the right investment choices can seem like an overwhelming task, especially if you’re new to the game. However, I have a simple yet effective strategy that I’ve been using for years: I invest primarily in Exchange-Traded Funds or ETFs. Let me break down why I believe they’re the way to go and how you can benefit from them too.

What is an ETF?

The definition from investopedia[1]:

An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.

ETFs are traded throughout the day on stock exchanges, just like individual stocks. This brings us to the first advantage of ETFs:

1. High Transparency and Liquidity

One of the key benefits of ETFs is their transparency and liquidity. You can easily buy and sell ETFs during market hours, just like regular stocks. All you need is the ETF’s ticker symbol, such as SPY for the S&P 500 ETF or QQQ for the Nasdaq 100 ETF. You can check their prices in real time and execute trades instantly. In contrast, mutual funds are priced once a day, making them less flexible for active trading.

2. Cost-Efficiency

ETFs generally have lower costs compared to mutual funds. They typically come with lower management fees, often well below 1%. For example, the VOO ETF has a management fee of just 0.03%[2]. On the other hand, mutual funds can have high upfront fees, often reaching up to 1%[4], along with additional management fees and minimum investment requirements.

ETF Details of VOO

3. Diversification

Imagine you’re a chef preparing a meal. You have a choice of various ingredients, including vegetables, meats, and spices. However, you’re not sure which ones will make the perfect dish, or perhaps you want to create a variety of flavors for your guests.

In this culinary scenario, ETFs are like pre-packaged spice blends or seasoning mixes. Instead of individually selecting each spice and herb, you can choose a seasoning mix tailored to your desired flavor profile. These seasoning mixes are carefully crafted by experts to provide the right balance of flavors, making your cooking experience both convenient and flavorful.

Similarly, in the world of investments, there are countless options, such as stocks, bonds, and commodities, each representing a financial ingredient. If you’re unsure about creating the perfect investment recipe or want a diverse portfolio, ETFs offer a ready-made mix of assets. They allow you to enjoy the benefits of diversification without the need to handpick each financial ingredient, just like using a seasoned spice blend in your cooking.

Why ETFs Are Great for Beginners

If you’re new to investing in stocks, ETFs are an excellent starting point. When you invest in an ETF, you’re essentially investing in a diversified basket of stocks without the need to select individual companies. All you need to know is the ETF’s investment objective, the index it tracks, or the industry it represents.

Most people buy ETFs with a long-term investment horizon in mind. However, don’t be mistaken; ETFs are not just for beginners. Even investment experts like Ray Dalio use ETFs to diversify their portfolios and manage risk effectively.

ETFs Types

1. Index ETFs: Also called passive ETFs. These track major market indexes like the S&P 500 (SPY), and Nasdaq 100 (QQQ).
2. Industry or Sector ETFs: These focus on specific industries or themes, such as Semiconductors (SOXX), Travel Tech (AWAY), or Oil & gas (PXJ).
3. Active ETFs: Unlike passive ETFs that follow indices, active ETFs are actively managed by fund managers who pick and choose individual stocks for the portfolio. A notable example is the ARK ETF series. In general, there are higher management fees compared to the Index ETFs. (For example, the management fee of ARKK is 0.75% annually)

My Personal ETF Portfolio: Index ETFs

I follow a simple yet effective strategy when it comes to ETF investing. I mainly invest in Index ETFs that track a specific index (the performance of the market), like the S&P 500, which represents the 500 largest companies in the US. When you buy an index ETF, such as VOO, you’re essentially investing in all 500 of these companies. This strategy reflects your confidence in the growth and development of those companies.

Over the past 30 years, these companies have delivered an average annual return of approximately 10%[3]. What’s even more reassuring is that the top holdings in the S&P 500, including giants like Microsoft, Apple, Amazon, and Facebook, are household names known for their stability and growth potential.

Advantages of Index ETFs

1. Long-Term Growth: Despite occasional market fluctuations, indexes like the S&P 500 tend to trend upward in the long run. Inflation and abundant global capital inflow contribute to this growth. However, do note that this may not apply to all countries; Japan, for example, has faced economic challenges for several decades.
2. Risk Diversification: By investing in a basket of stocks, you spread the risk. No one can predict when a particular company’s stock will plummet, but diversification helps mitigate this risk.
3. Low Costs: Index ETFs typically have management fees of less than 1%, making them cost-effective. For instance, QQQ and SPY require an investment of just below $500 per share.
4. Staying Power: If a company within the index ETF goes bankrupt, your investment remains relatively safe because you’re not relying on a single stock. Indexes have mechanisms for removing weak companies, ensuring that only strong performers stay in.

What I Will Consider When Buying ETFs

While ETFs offer numerous advantages, it’s essential to be mindful of potential risks and factors that can impact your investment:

1. Fees: Compare the management fees of different ETFs. Passive ETFs generally have lower fees, while active ones may charge more. For me, I would not invest in an ETF that exceeds 1% in terms of the overall fees.
2. Fund size: Invest in ETFs with substantial fund size. A larger fund size indicates that more investors trust the ETF, which is a sign of confidence. It was suggested not to invest if the fund size is less than 5 billion. Also, in general, larger funds tend to have higher liquidity, so that we don’t need to worry about the bid/ask spread.
3. Issuer Reputation: Choose ETFs from reputable issuers with a track record of managing funds effectively. Well-known ETF issuers include Vanguard and iShares. I prefer choosing the ETFs issued by these two organizations first. They have low default risk in general.
4. Top 10 Holdings: Examine the top 10 holdings of an ETF. A concentrated top 10 may lead to higher risk and return volatility. It’s essential to understand these holdings and whether they align with your investment goals. Normally, I won’t buy ETFs with top 10 holdings weight larger than 50%. They have a relatively low ability for risk diversification.

How to check the Top 10 Holdings?

We can go to https://www.etf.com/ to see the proportion of the constituent stocks. For example, the top 10 holdings weight of:

• VOO: 30.77%
• ARKK: 61.86%

Therefore, VOO has higher risk diversification than ARKK. It can spread the risk across different sectors and stocks when there is a bear market. (Luckily I did not buy ARKK before =])

The Ways I Buy ETFs

There are two strategies for purchasing ETFs:

1. Buy Low and Hold

This approach involves trying to buy ETFs when you believe they are at their lowest point, often during market downturns or corrections. After buying, you hold onto the ETFs for an extended period, ideally until they appreciate significantly. This strategy aims to capitalize on market cycles and maximize returns.

It has the potential for higher returns if you can accurately time the market and buy low. However, it requires the ability to predict market movements, which is challenging.

2. Dollar-Cost Averaging

Dollar-cost averaging is a systematic investment approach where you commit to investing a fixed amount of money at regular intervals, such as monthly or quarterly. Over time, this strategy aims to reduce the impact of market volatility on your overall investment.

This can promote disciplined investing and eliminate emotional decision-making. But you may miss out on potential gains if the market experiences a prolonged rally.

Conclusion

ETFs offer a straightforward yet powerful way to invest your money. They provide transparency, cost-efficiency, diversification, and access to various markets and industries. While I primarily focus on index ETFs, there are many types of ETFs catering to different investment strategies.

Whether you’re a beginner or an experienced investor, ETFs can be a valuable tool in your portfolio. They simplify the investment process and offer an excellent way to achieve your financial goals. So, consider adding ETFs to your investment strategy and watch your wealth grow steadily over time.

Reference

[1] https://www.investopedia.com/terms/e/etf.asp

[2] https://investor.vanguard.com/investment-products/etfs/profile/voo#

[3] https://www.lazyportfolioetf.com/etf/vanguard-sp-500-voo

[4] https://www.nerdwallet.com/article/investing/mutual-fund-fees-what-investors-need-to-know