Exchange-traded funds are a great way for investors to diversify their portfolios at low fees, if they know what they are buying.
As relatively low-risk, simple instruments that allow small investors to own a diversified portfolio at low cost, exchange-traded funds (ETFs) are popular among small investors worldwide. The number of ETFs is growing fast, with almost 8,000 products to choose from. Some of them track a major market index, but there are ETFs linked to a given portfolio of equities, bonds, commodities and property markets.
The first ETF fund was launched in Canada in 1990. The original concept was to create portfolios of shares replicating a stock market index, such as the S&P 500. The main difference between a plain index-tracking fund and an ETF is that as the latter is listed on a stock exchange, where investors can buy and sell it easily. Unlike conventional investment fund certificates, ETFs can be traded all day long and their price moves intraday with the underlying product.
ETFs and self-provision
In the US, ETFs are strongly linked to pension savings accounts, said András Somi, head of retail research at KBC Securities. In Hungary, this could work with retirement savings accounts (Nyesz), too, as certain ETFs can be part of a conservative, long-term investment strategy.
“With an easy and cheap transaction, I can ‘buy’ into the entire US stock market by investing in the SPY fund,” Somi noted. The SPY fund represents ownership in an investment trust holding a portfolio of equities that comprise the Standard & Poor’s 500 Composite Stock Price Index. “Compared to picking individual stocks, this transaction does not need time, energy or expertise,” he added.
“I would be very happy to see ETFs crowding out unit-linked products in the self-provision market, primarily because the related costs are ridiculously low,” Somi said. While ETF fund management fees are at around 0.5% and can be as low as 0.1% in case of the largest funds, those of unit-linked products vary between 5% and 7%. In addition, spreads are also insignificant, he noted.
“This is a big challenge for us, as we have to outcry those large networks that focus on selling unit-linked products,” Somi said. Unfortunately, several investors have been pushed into buying unit-linked products they did not even need, he added. “An ETF might not be a product suited for everyone, but most potential investors could consider using them in their long-term savings.”
Choosing the right ETF
“Our clients have shown an openness to trade in foreign ETFs with a trading volume of well over HUF 10 million on the very first day of trading,” Somi said. The service to trade in ETFs online was introduced to the approximately 25,000 customers of KBC Equitas on November 1. “According to our experiences, there is a smaller group of customers who are not only aware of what an ETF is, but often know exactly which particular product they want to buy, but most of them are still learning what an ETF is,” he added.
“The most popular products were those tracking the US banking sector, which is not really surprising seeing the volatility of this market segment,” Somi said. Even the VIX index of volatility attracted a couple of customers. VIX is also known as the “fear index”, because a high VIX represents uncertainty about future prices. Clients also bought the SPY fund.
Choosing the right ETFs depends on the investors’ own strategy, Somi said. Conservative investors typically buy ETFs mimicking large indexes, such as the SPY. There are specialized products for investors with a more active or aggressive strategy, such as biotech or clean technology ETFs. Intra-day traders prefer riskier, highly volatile products, such as funds linked to the banking sector, which currently shows very high volatility, or more innovative funds.
ETFs that need caution
As a portfolio of assets backs most ETFs, they are no riskier than other instruments traded on the stock exchange, Somi said. However, there are trickier products, which fortunately account for only a fraction of the market. He warned that these carry special risks that investors should be well aware of.
What are these products? As a rule of thumb, if you do not understand a product, you should not buy it. There are, for instance, leveraged ETFs which amplify the return on a given index and inverse ETFs which go down when a benchmark goes up, and vice versa, as well as leveraged inverse ETFs.
The riskiest products include “synthetic” ETFs as well as exchange-traded notes (ETNs) and exchange-traded vehicles (ETVs). These funds do not own assets like shares, bonds or commodities. Instead, they mimic the behavior of ETFs by arranging a derivative deal with an investment bank, which guarantees to deliver the return of the targeted benchmark. Thus, they face counterparty risk, too.
In order to educate its clients, KBC organizes investment courses and meetings on a regular basis and encourages them to establish an investment strategy that matches their risk preference and economic outlook, before investing in anything.