A Beginner's Guide To ETFs: What You Need To Know

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This post was originally published on my website, at thefrugalstudent.com.

If you've read up about investments, chances are you would've heard of ETFs and noticed that many people/websites recommend investing in ETFs for beginners.

But if you're a newbie investor, you probably have many questions surrounding ETFs like what they are or what's so good about them.

Don't worry, you've come to the right place.

In this post, I will try to explain everything you need to and should know about ETFs, including some common misconceptions.

Disclaimer: For the purpose of this post, "ETF" refers to passively managed ETFs, ie index ETFs, and not actively managed ETFs.

What Are ETFs?

ETF stands for Exchange-Traded Fund, which is an investment tool that traditionally tracks an underlying stock index.

According to Wikipedia, a stock index is defined as "an index that measures a stock market, or a subset of the stock market, that helps investors compare current price levels with past prices to calculate market performance".

Basically, a stock index measures the performance of a group of stocks, and if the index goes up, it means that the group of stocks has also gone up on average, and vice versa.

For example, the S&P 500 is an index that tracks the performance of 500 large companies listed on US stock exchanges, and the Vanguard S&P 500 ETF (VOO) is an ETF that tracks the S&P 500.

What Kinds Of ETFs Are There?

As there are many different indices that track different categories of stocks and other asset classes, there are also many different ETFs.

Indices (and ETFs) often use region, market capitalization, sectors, or a combination of these categories to track stocks and other assets.

For example, the S&P 500 tracks the performance of large US companies - so it is a US large-cap index, tracking stocks by category of region and market capitalization.

This in turn makes the VOO a US large-cap ETF.

Meanwhile, other ETFs like VHT are sector-specific, tracking stocks in the Health Care sector like Johnson & Johnson and Pfizer.

Index VS ETFs

To better understand the relationship between an index and an ETF, cooking can be used as an analogy.

In order to prepare a dish, you will need a recipe, which lists down all the ingredients that are required and the amount of which is needed.

If you want to make the dish, it doesn't make sense to buy the recipe - because what you need are the ingredients, not the list.

However, it could be time-consuming to pick out all the ingredients that you need by yourself, especially if there are many ingredients.

Moreover, it may be expensive to buy all the ingredients - because recipes often call for small, specific amounts of each ingredient, but ingredients tend to be sold in larger, fixed quantities - which makes them more expensive to buy.

A solution to this is to buy DIY meal kits, where all the ingredients are prepared and packaged nicely according to the amounts that they are required, and all you have to do is cook.

In this analogy, the dish that you want to make can be seen as the category to be tracked, ie US large-cap stocks; the recipe for this dish is any index that tracks this category, ie the S&P 500; and the DIY meal kit is an ETF that tracks this index, ie VOO.

It would be very expensive for the average investor to buy all 500 stocks individually due to all the transactional costs involved, as well as the high share price of some individual stocks.

Instead, investors can simply buy VOO, which comes packed with all 500 underlying stocks, held in very close proportion to that indicated by the index.

Essentially, ETFs acts as a liquid, tradable form of the underlying index. It is listed on the stock exchange and can be traded amongst investors throughout the day.

ETFs VS Mutual Fund

As a newbie investor, it may not be clear what the differences between an ETF and a mutual fund are.

However, by nature, ETFs and mutual funds are vastly different.

Liquidity

ETFs are traded on the stock exchange where they can be bought or sold throughout the day.

On the other hand, mutual funds have to be bought/sold directly from the investment company, and can only be done at the end of the day after markets close.

Prices

For ETFs, prices change according to demand and supply - each unit can only be sold at a price that another person is willing to buy at, and vice versa.

This means that it is possible for ETFs to be traded at either a premium or a discount to their net asset value (NAV), ie the total value of shares held by the ETF.

For mutual funds, its NAV will be reported according to its end-of-day holdings and will be the price at which investors can buy/sell.

This means that the price of a mutual fund will usually be a fair value, in that it is priced at its NAV.

Product Structure

Since ETFs are traded on the stock exchange like stocks, all trades occur between investors only - there is no interaction between investors and ETF fund managers.

However, investment companies are directly responsible for the buying/selling of mutual funds by investors, which results in more administrative work involved.

This translates into additional costs that are passed on to investors.

Passive VS Active

Finally, if you compare mutual funds and passively managed ETFs, the investment approach is completely different.

ETFs simply track an index, and stocks are only bought and sold to match the holdings of the index - no additional work is involved to make these decisions.

Meanwhile, mutual funds exercise active management, where stocks are bought or sold according to the fund manager's predictions of the stock's future performance in order to maximise returns.

The work involved in the analysis of stocks and decision-making process, again, translates into costs that are transferred to investors.

All the extra costs involved with mutual funds result in high expense ratios/management fees, often ranging from 1~2%.

ETFs typically have expense ratios of <1% and as low as 0.03%.

1 Index, Many ETFs

If you've tried searching for an ETF, ie an S&P 500 ETF, you would've noticed that there are many different ETFs that claim to be S&P 500 ETFs - so what's the deal?

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While there is only 1 version of any given index, there are often multiple ETFs that track any single index.

For example, for the S&P 500, there are different ETFs for:

• different managing institutions (ie VOO/Vanguard vs IVV/iShares)

• different stock exchanges (ie VOO/NYSE vs VUSD/LSE)

• different trading currencies (ie VUSD/USD vs VUSA/GBP)

Despite there being so many ETFs, since they are all tracking the same index, their performance is largely similar.

There are, however, differences in:

• Net Asset Value: total value of shares held by the ETF

• Expense Ratio: cost of owning the ETF

• Liquidity: ease of buying/selling the ETF

• Cost Per Share: cost of 1 unit of the ETF

• Withholding Tax Rate: tax rate on dividends

• Tracking Error: error between the ETF's holdings and benchmarked index

For the most part, the differences that really matter are expense ratio and withholding tax rate, because these directly affect your overall investment returns.

But even then, these differences are relatively minor, so you don't have to stress too much over them.

ETF Terminologies

Expense Ratio

An ETF's expense ratio is one the most important things to know because it directly translates into the cost of owning the ETF.

The expense ratio refers to all the costs involved in maintaining the ETF, which include management fees by the fund managers and operation costs like trading fees.

These costs are necessary so that fund managers are able to ensure that the ETF is tracking the underlying index as closely as possible.

Naturally, a lower expense ratio is preferred because this means less money is paid as fees.

ETFs tend to have expense ratios of less than 1% and can be as low as 0.03%, as in the case for VOO.

Accumulating VS Distributing

Since ETFs tend to hold many different stocks, there will be some stocks that pay out dividends periodically.

Usually, if you own the stock, you will receive this dividend payment in your brokerage account. But for ETFs, this is not always the case.

Some ETFs prefer to keep the cash received as dividends and reinvest it into the fund, so this cash never reaches you as an investor. These are known as accumulating ETFs.

Other ETFs will collect the dividends from the individual stocks and pay them out to investors as per normal - these are distributing ETFs.

For US-listed ETFs, they will almost always be distributing - because US regulations require at least 90% of income to be distributed to shareholders.

This is important to take note of because of taxes.

When you invest in overseas stock exchanges as a Singaporean, you will often be charged a withholding tax on dividend payments.

This can be as high as 30% for US-listed stocks and ETFs, ie if you were supposed to receive $100 in dividends, you will instead only receive $70 after tax.

Clearly, this high tax rate will eat away at your investment returns.

But there is a workaround for this.

Withholding tax rate is dependent on the country where 1) the ETF is listed and 2) the stocks held by the ETF are listed.

For any S&P 500 ETF, all stocks held are listed in the US, but the ETF itself can be listed in a different country's stock exchange.

This will affect the overall withholding tax, as illustrated below.

Ireland-domiciled ETF:

US-domiciled ETF:

This means that buying an equivalent distributing-type ETF that is listed on the LSE instead of the NYSE is more cost-efficient.

For a more detailed post on withholding tax, check out this post.

What's So Good About ETFs?

Now that you know so much about ETFs, why exactly are they good?

The simplest reason is that it is a cheap and easy way to diversify your portfolio, which generally reduces risk.

ETFs allow people to own a basket of assets at a relatively cheap price as compared to buying them separately.

This results in savings on trading costs and time.

It also removes the concept of stock picking, ie trying to identify winning stocks.

Instead, ETFs promote the idea of buying a basket of both winning and losing stocks, reaping the average returns of the whole basket.

Business cycles tell us that in the long run, markets always trend upwards - so if we are able to own ETFs that resemble the market portfolio, we will be guaranteed to reap returns eventually.

Because of this, ETFs are often thought of as a "sure win" type of investment, which is why they are so highly recommended.

A Caution Against ETFs

ETFs =/= Market

ETFs are highly recommended forms of investment because they are often used synonymously to refer to the market portfolio.

That is when people say "invest in ETFs", what they are really saying most of the time is "invest in ETFs that track the whole market".

The problem here is that there are many types of ETFs - a beginner who is new to investing may not necessarily know this and think that investing in any ETF is good enough.

The concept that ETF investing will produce market-average returns is based on the assumption that the ETF you are investing in is representative of the market portfolio, ie an S&P 500 ETF or FTSE All-World ETF.

If you were to only invest in sector-specific ETFs or other ETFs that are not representative of the market portfolio, you will likely not achieve the market average return and you may not necessarily achieve a positive return at all.

Thus, it is important to understand that if you want to adopt ETF investing as a strategy, you need to be invested in the market portfolio - any other ETFs that you wish to add to your portfolio will simply serve as further diversification.

ETFs Not As Diversified As You Think

While ETFs undeniably help investors to achieve a diversified portfolio, they are not as diversified as you think.

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This is because ETFs tend to be cap-weighted, meaning that stocks are held in proportion to how much they "contribute" to the overall index.

So ETFs hold a larger position in larger companies and a smaller position in smaller companies within the categories that it tracks.

For example, the 10 largest holdings in VOO (out of 500 stocks) make up 28.6% of its total assets - meaning that the remaining 490 stocks only make up ~70%.

This means that while you're technically invested in 500 different companies, a large portion of that goes to 10 companies alone, which may not be as much diversification as you were expecting.

In addition, these 500 companies are US-listed, which results in a lack of geographical diversification - growth in the EU, UK, and APAC region will only be captured minimally due to the global reach of large US MNCs.

Thus, for better diversification, it may be a good idea to include small-cap ETFs and other region-specific ETFs to obtain a portfolio that is more representative of the global market.

To summarise,

ETFs are a great tool that makes investing cheaper and easier for everyone.

With the wide variety of ETFs that are available on the market, it is easier than ever to create a globally diversified portfolio.

By choosing ETFs that minimise losses to expense ratio and withholding tax, investment returns can be maximised and you will be well on your way to a better financial future.

However, before blindly following the trend of ETF investing, it's important to understand the concept behind why ETFs are thought to be an effective vehicle for growing wealth.

Before you jump into investing, also check out this post about things you need to understand before investing.

If you enjoyed this post, share it with someone who's new to investing!

What are your favourite ETFs? Let me know in the comments below!