An exchange-traded fund (ETF) is a security that tracks the performance of an index, sector, commodity or theme.
What are ETFs?
ETFs combine a set of securities into a “basket” to achieve this goal. Importantly, investors are able to trade ETFs like shares through brokers on a stock exchange, which makes them liquid. Generally, investors can invest in equity, bond, multi-asset class or commodity ETFs. An example of an equity ETF is the Satrix FINI, which invests in the 15 largest financial services companies in SA. This means that if you believe the environment is favourable for financial sector companies, you gain exposure to the 15 biggest ones without having to analyse or “stock pick” specific companies to find the winners.
In addition, EasyEquities has a wide range of SA’s growing number of JSE-listed ETFs available on its platform that are focused on local and offshore assets.
Advantages and disadvantages of ETFs
While buying one share exposes you to the risk of a single company, an ETF provides exposure to multiple companies in a single transaction, which reduces risk. For example, this means that when one company suffers a sell-off in an equity ETF, it would only be a small percentage of the fund. This is especially useful in a portfolio of ETFs which includes different sectors or asset classes. Other advantages include improved liquidity (as it trades like a share) and low cost due to ETFs being a passive, rather than active investment.
As with any investment, there are risks involved. When investing in ETFs, investors take on market risk, which implies that if the index being followed declines in value, then the basket of securities – which tracks the performance of the index – will also decrease in value.
Choosing the ideal ETF
An ETF with a simple investment process and lowest possible cost is key. In addition, ETFs that can be included as part of a tax-free savings account (TFSA) are also highly beneficial as it enables you to maximise the tax-free portion of your savings and interest.
Importantly, the ideal ETF should also suit your risk, capital and time profile. Simply put, higher-risk ETFs are probably more suitable for investors with a high-risk tolerance and a large amount of capital to invest over any time period. In SA, where the savings rate is low and retirement savings are key, we would be inclined to recommend ETFs that are easy to understand, cost-effective and can form part of a TFSA with a view to investing over the long term.
Finally, we recommend that investors choose an ETF with a diversified ETF portfolio or total portfolio in mind. This would enable you to choose ETFs most closely aligned to your available capital to invest, risk profile, time horizon and investment goals.
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