How ETFs can boost your wealth, and why legendary Warren Buffet is a big proponent.
What Are ETFs?
More commonly known as ETFs, Exchange-Traded Funds are a spinoff of mutual funds. The latter is a company that combines the capital of individual investors to invest in securities collectively. Investors buy shares of the mutual fund, as they do any stock. Unlike investors’ placing all their eggs in one basket of a company’s stock, the mutual fund spreads investors’ risk into an array of companies.
ETFs launched in 1993, enabling investors to buy and sell index portfolios just as they would corporation stocks. Again, the benefit for investors is that they could spread their risk over many companies within the same purchase size.
The first ETF was the Standard & Poor’s Depository Receipt, abbreviated SPDR, and affectionately nicknamed “the Spider” (ticker: SPY).
So, how did Spider improve on existing mutual funds? Investors had access to purchase mutual funds only at the end of the trading session when the Net Asset Value (NAV) could be calculated, and investors were able to buy SPDR throughout the session. To reach the Net Asset Value, you divide the total value of cash and securities in the fund’s portfolio, after subtracting liabilities, by the number of outstanding shares. This calculation provides the intrinsic value of each share.
The Spider was a trailblazer that led many other such products. Examples include the ETF of the Dow Jones Industrial Average, referred to as “Diamonds,” based on its ticker DIA. an ETF based on the Nasdaq 100 Index was launched, with the ticker QQQ, also called Qubes (pronounced “cubes.” World Equity Benchmark Shares, also called WEBS, are shares in portfolios of foreign stock market gauges.
By 2004, nine years after SPDR, the first ETF made its debut, there were roughly 300 ETFs in three classifications: broad American benchmarks, narrow industry, or “sector” portfolios, and international gauges.
ETFs provided a more flexible means to diverse risk than mutual funds offered. As aforementioned, investors had to wait for markets to close before buying or selling shares of the fund after the fund’s net asset value could be calculated. On the other hand, ETFs enable continuous trading, like a stock.
ETFs allow short selling, which mutual funds do not. Traders can also buy them on margin, which mutual funds do not avail.
Electronic Traded Funds also allow investors with more flexibility regarding taxes. When many investors redeem their shares, the fund is forced to sell securities to honor the redemptions. This action can trigger capital gains taxes, which are passed through to and must be paid by the remaining shareholders. Conversely, ETF traders can redeem their shares by selling them to other traders without forcing the fund to sell any underlying portfolio assets.
Electronically traded funds are also cheaper to transact than mutual fund counterparts.
The discrepancy is because investors buy ETFs from brokers, whereas they must buy them directly from the fund when buying mutual funds shares. Therefore the mutual fund spends money on marketing, the cost of which it transfers to investors. ETF funds usually avoid that.
However, ETFs also have a disadvantage over mutual funds. Earlier, we criticized the latter’s limited trading due to the need to calculate net asset value at the end of the trading day. However, that limitation also provides a benefit. Given that ETFs trade as securities, their prices could potentially deviate from the net asset value (like when a stock’s price does not agree with its inherent value).
Investors can buy shares of electronically traded funds at net asset value with no expense from no-load funds (a mutual fund sold directly by the investment company without sales charges or commissions). In contrast, brokers charge fees for selling ETFs to investors. Finally, investors pay a bid-ask spread when purchasing an ETF.
Legendary Warren Buffet enjoys a net worth of more than $117 billion as of March 2022, placing Buffet as the world’s sixth-wealthiest person. Dubbed the “Oracle of Omaha,” Warren Buffet is considered one of the most successful investors. Buffet has long advocated the merits of purchasing the S&P 500 low-cost ETF. First, there has not been a five-year period in market history when the S&P 500 did not provide positive results. Second, Buffet is a strong proponent of risk diversification. Buffet puts his money where his mouth is. He instructed his wife’s trustee to allocate 10% of the cash in short-term sovereign bonds and 90% to a very low-cost S&P 500 Index fund.
There are two types of ETFs. There are passive ETFs, also known as index funds. These track equity benchmarks, such as the S&P, as mentioned earlier, 500 Index. Therefore, this type of ETF’s objective is to match the gauge’s performance it tracks.
Active ETFs include portfolio managers, who intend to beat an index’s performance.
Investors pay ETFs fees called the expense ratio, listed as an annual percentage. For example, a 0.2% expense ratio costs $20 in fees for every 10'000 invested. Therefore, a lower expense ratio saves more of the invested money, which Warren Buffet was referring to in his instructions to his wife’s trustee. The money saved with low expense ratios or annual management fees potentially generates exceedingly superior results over time, as the saved money compounds in the investment account.
Dividends and DRIPs
Most ETFs pay out dividends. Investors can choose to cash out ETF dividends or have them automatically reinvested through a dividend reinvestment plan or DRIP (Dividend ReInvestment Plan).
How to invest with ETFs at Swissquote
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