Investing 101: Exchange Traded Funds (ETFs)

A good friend of mine (let us call him Tunde) asked how some of his “limited” free cash could be saved. He mentioned that he didn’t want too much risk and was not too bothered about making too much money in the short-term (of course his investment should do that!) and he didn’t want to spend too much on charges. In effect, he wanted to sleep happily without worrying too much, expect his investment to grow (potentially) and not have to spend unnecessary money.

With these constraints, I felt that he should go for Exchange Traded Funds (ETFs). Now, I will try to give a concise gist on ETFs, their characteristics, advantages and disadvantages.

ETFs are essentially a hybrid between buying “individual” company stocks (or shares) and investing in mutual funds so we can’t discuss ETFs without talking about stocks and mutual funds. So what are stocks and mutual funds?

In brief, when we invest in a company by buying a stock (or share), it tells us that we have a claim (or ownership) in that specific company. The challenge is that if the company we invested in doesn’t do well, the stock market participants could react negatively by possibly reducing the value of the stock.

For simplicity, let’s say company X does well and is expected to continue doing well, the stock market participants will believe that it is a good investment which in turn will increase the value of the stock. If the opposite happens, and the company doesn’t do well even if it is for a short time, the stock’s value could actually drop. This causes uncertainties as even the companies don’t exactly know if their operations will work as they plan (not even the experts can say they know how their operations will go) – this is one of the reasons that stocks can go up or down (we call this volatility). With this in mind, we can say that the benefit however is that when stock prices rise, the value of your portfolio rises and when stock prices fall the same happens.

This volatility is termed “risk” to your portfolio. Generally speaking, stocks have a high risk relative to “bonds.” It is important to note that you can manage your stock portfolio yourself or let managers do that for you.

In another case, if you are not just interested in investing in the stocks but also want to invest in bonds and other securities or you want to invest in different securities (to reduce your risk), a mutual fund could be your best bet. Mutual Funds collate money from multiple people and invest their capital for them. If I have just N1,000 monthly for instance (it can be higher or lower), I can comfortably invest all of this in stocks, or in some cases, I could also invest it in bonds but if I say I want to invest in both stocks and bonds and maybe some other securities, it will become difficult.

I need to mention that mutual funds can either be open-ended or closed-ended. A closed-ended fund is one that has a specific number of shares that can be bought and they do not issue new shares to more investors while an open-ended mutual fund is one that doesn’t have that kind of restraint – as such. Either way, the number of shares you can buy is limited to the amount that you are bringing into the fund!

What the mutual fund will do is to get this N1,000 from maybe 50 to 100 people monthly. You see how this has suddenly increased to N50,000 or even N500,000! With this new combined money, a mutual fund will be able to invest in stocks (high risk) and bonds (low risk) together thereby reducing the overall risk of the portfolio. It is more technical than that but that is the general gist of how this should work. The investor will now have a portfolio that he/ she may not have been able to “conjure” because the fund has got more money from other potential investors!

Unlike stock investing where you only need to pay 2% of the value of the investment you want to buy or sell as fees (usually), with mutual funds, you pay some significant amount of fees broken into annual fees and initial upfront fees which together can amount to 7% of the gross value of your investment. Some notorious mutual funds can include some “other fees” which only show up later – so if you want to go down this route, ask them questions (your financial advisor could be of help on this one!). This does not include the taxes that you need to pay when you sell your shares.

Another difference between stock investing and mutual funds is that although you can determine which stocks you have; when to buy or sell as well as what price you want to do these, with mutual funds you don’t get this flexibility. Your money is locked in for a specified period (1 year to 10 years) depending on what was written in the agreement (otherwise called prospectus).

When companies distribute dividends (for stock investors), the investor can either choose to take the cash or reinvest it in the stocks or other stocks. The same goes for mutual funds, they can either distribute dividends or reinvest them, and it depends on what was agreed. However, mutual funds are not limited to dividends as they also invest in bonds for instance – they can also distribute the income received from their investment in bonds also called “coupons”. When they sell off assets that they owned at a profit, they can also distribute the proceeds back to investors and investors can even sell their mutual fund shares to each other at a profit (this is of course dependent on what was said in the prospectus.

Mutual funds differ based on what it is that they choose to invest in – some invest in stocks only, some invest in bonds only while some invest in stocks, bonds and other instruments.

With these clarifications, I can go further. ETFs are essentially mutual funds that are allowed to trade like stocks in the stock market. You can buy ETFs like LOTUSHA15NEWGOLD, and STANBICETF30  in the Nigerian Stock Exchange like any share you would have bought, essentially in the same way you would have bought the stock but you would know that the ETF is invested in not 1 but a group of companies.

The advantages of ETFs:

  1. Since the ETFs invest in many items (stocks, bonds, etc.) they have a lower risk than a single stock
  2. You can buy and sell them as you will
  3. They generally have fewer “fees” than funds
  4. Are less risky than investing in individual stocks directly

The disadvantages of ETFs:

  1. They can have more fees than stocks as they still incur some management fees (it is still a fund after all)
  2. As discussed earlier, holding equities usually gives a better yield than ETFs because if you invest directly in stock, you can take risks that ETFs won’t.
  3. Some ETFs can be limited to large company stocks or assets which may not have good growth potential – investors please confirm the constituents of the ETF before you buy!

These are a few of the advantages and disadvantages of ETFs. However, remember that they are like mutual funds because of the way the underlying company pools money from many people to invest in various stocks, bonds, and/ or securities and they are also like stocks as you can just buy and sell them on the stock exchange.

Bottom-line, ensure that you look through the particular ETF before you buy to ensure that it meets your expectations – whether capital appreciation, income, dividend disbursement etc.

Remember there is no 100% risk proof investment so try to minimise your risk!

Keep investing.