ETFs Explained – What Are ETFs and Are They a Good Investment?

Welcome to ETFs Explained – Today I’ll be covering what they are, how they work, the pros and cons of ETF investing, the commonly used ETFs by Aussies chasing financial independence and how you can invest in ETFs.

ETFs Explained – What Are They?

An ETF is firstly a fund (the ‘F’), and therefore holds multiple assets in it. Secondly, it is exchange traded (the ‘ET’), meaning that you can buy and sell the same ways as with shares via a stockbroker. This is opposed to unlisted funds, which you must buy direct from the fund manager.

Long-term investors often choose ETFs, as they provide a convenient way of diversifying investment portfolios. This is due to ETFs tracking market indexes. Market indexes can encompass hundreds or thousands of individual assets.

Diversification

ETFs Explained - Diversification

Diversification is a strategy employed by investors to spread their investment portfolio across different sectors, commodities, industries and assets. The reason people diversify is to mitigate the volatility of the stock market. For example, a portfolio consisting entirely of stocks aimed towards mining could rapidly expand or drop its value depending on the availability and accessibility of specific minerals and natural resources. Similarly, if you only invested in shares contained within Australia and there was a market crash in this country, you would bear the full impact of that crash as opposed to someone whose profile consists of shares distributed among 15 countries.

The amount and type of assets contained within an ETF can vary depending on the type you choose. Some ETFs track a specific country’s market such as the Vanguard Australian Shares Index (VAS) which tracks the top 300 companies in the Australian Securities Exchange (ASX). Other ETFs track a particular sector such as the iShares S&P Global Healthcare Sect (IXJ) which exclusively holds companies within the healthcare industry. In a similar bane, different forms of ETFs focus on commodities, bonds, precious metals, currencies and a plethora of other forms of assets.

ETFs Explained – The Good: 

ETFs Explained - The Good

ETFs have several perks that separate them from other forms of investing. The first one is diversification. Because ETFs can hold hundreds and in some instances, thousands of different investments, it’s a very cost-effective way of diversifying your portfolio without having to pay brokerage 100 + times on individual shares. 

They typically have lower management expense ratios (MER) than other diversified investments like mutual funds. This can provide significant long terms gains due to paying less in fees over a long period.

They are less volatile than individual shares, due to the immense diversification. Companies can run into unforeseen circumstances that can lead to significant financial hardship. A new competitor can come out with a superior product, another company may offer a similar service at a cheaper rate, they could receive new management that hinders progression and the list goes on. By having a diversified portfolio, you mitigate the impact of one of your holdings performing poorly as you have others to rectify the losses.

Because they are already diversified, you don’t need to frantically analyse them. It’s a very set and forget type of investment that you can continuously add towards. You don’t need to look at PE ratios, follow the latest news articles, worry about daily fluctuations etc. Simply find an ETF or several that cover multiple countries, sectors and asset types and add to them when you can. It can take a lot of stress out of investing and can save you time and money in the long run.

ETFs Explained – The Bad:

ETFs Explained - The Bad

Like all things, there are some downsides to ETFs. The main one being market and sector risk. If you decide to invest in a particular sector or market such as VAS and the Australian market declines, the ETF will trace that pattern. Meaning that even with diversification, no plan is foolproof and your ETF can still underperform or lose money, especially over a short period.

International ETFs can be impacted by fluctuations with currencies. For example, if you purchase $10,000 worth of units in an ASX-listed ETF that tracks a US share market index, you would own the US equivalent of shares based on their dollar. If the Australian dollar buys $0.75 US dollars, that means you would end up with $7,500 USD worth of units. The risk here is that when you sell, a change in currency can alter the amount of profit you ultimately make for better or worse. If this is something you are worried about, several ETFs offer currency-hedged versions to mitigate against this risk.

Another thing to consider with ETFs is that while some funds offer relatively high dividend yields, numerous individual stocks offer higher yields. If you are exclusively a dividend investor, ETFs while a typically safer option may provide lower yields than individual shares on the ASX.

Lastly, as ETFs track a particular index or sector, they are limited to the overall growth of whatever the fund is tracking. While this diversification increases the likelihood of solid returns, if you have a great deal of knowledge in individually picking stocks, you may be able to profit more by allocating your money towards individual stocks. It should be notated that many industry professionals struggle to consistently do this and that for the majority of people, an ETF will typically outperform handpicked stocks, however.

I am not a financial adviser and as such, I can not assess your individual needs and tailor a particular ETF/ETFs that suit your financial goals. However, in my experience from talking to other investors chasing FIRE, I can reveal commonly mentioned ETFs used in the FIRE community that may give you a starting point. The most common ETF investments that I have observed from people seeking financial independence include but are not limited to: VGHD, VGS, VAS, VEU, VTS, VGE, VAE, VGB, IOZ, IWLD, IOO, IHWL.

As with all investments, conduct your own research to decide on the best investment for reaching your financial goals. This does not constitute financial advice and is designed to provide a guide on what ETFs are prevalent in the Australian FIRE Community, they may or may not be suited for your individual needs and desired outcomes.

ETFs Explained – Summary

ETFs are a very cost-efficient, passive form of investing that enables diversification. You can pick a variety of different ETFs that track different markets, assets, sectors and countries to further enhance your diversification. As with any investment, there are inherent risks such as that market or sector crashing and currency fluctuations. However, the low fees, consistent growth throughout history and the diversification offered by ETFs make them a great option for people on the path to financial independence.

Looking for More Information on ETFs?

I have reviewed two diversified ETFs in detail in the following two links:

VDHG Review
DHHF Review

Alternatively, if you would like a more in-depth explanation of the benefits of ETFs and investing in mutual funds, I have found the following books to be very useful guides

The Simple Path to Wealth
The Australian ETF Guide
The Little Book of Common Sense Investing

Want to Purchase ETFs but Don’t Have a Brokerage Account?

If you would like to invest in any of the aforementioned ETFs, I recommend using SelfWealth. As it offers the lowest flat-rate brokerage fees among any CHESS-sponsored trading platform in Australia. For more information, you can find my in-depth review on SelfWealth Here.

If you would like to sign up and receive 5 free trades during your first month, you can also use my referral link.

3 Comments on “ETFs Explained – What Are ETFs and Are They a Good Investment?

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