INSIDE INVESTOR: The power of the ETF

A simple way to create a diversified portfolio is to trade in ETFs, or Exchange Traded Funds. Such funds are based on a basket of investment products and can remove the uncertainty of picking individual stocks.

If you need any evidence of how furious the pace of change is in the business world these days, just consider how acronyms have infected our everyday language. We need to communicate so quickly, almost everything is reduced to a bunch of letters.

Consider the YOY performance of the ASX since the GFC. Shocking! Or think how much time it takes to compare the various PE trends of FMG and BHP to the PCP. It can drive you nuts.

One tool investors can employ to simplify decisions, diversify portfolios and eliminate legwork is the use of ETFs, sorry, Exchange Traded Funds.

An ETF is exactly as its name implies. It is a fund that concentrates on a particular market segment or index that is traded on the stock exchange and in recent years, their popularity among investors here and on global markets has seen a vast array of new funds spring to life, particularly since 2009.

There are more than 60 such funds traded on the local exchange, covering everything from the broad based Australian market to individual sectors, from strategies such as bear market trading to yield plays and debt securities, to commodities of all persuasions and funds that concentrate on global, regional and individual country markets. Want exposure to the South Korean market? It is just a click away.

The market price of ETFs is determined by the stocks, securities or commodities they hold and are closely aligned to the net asset value of the fund’s investments.

Investing in one of these funds provides an instant portfolio, reducing the need to pick individual stocks. Such a strategy reduces risk although at the same time, reduced risk can often be accompanied by lower returns. As a more sober investment, the thrill of picking a winner is missing. But if consistent performance, low management fees and ease of diversification into sometimes difficult to access asset classes are what you require, then ETFs are an invaluable tool.

Their increasing popularity has added to the liquidity of most ETFs, making it easy to enter and exit the market on any given day.

It is worth noting that some funds carry more risk than others. While commodity funds – such as oil, gold or base metal funds – eliminate the need to take delivery of physical product, such as can occur on futures markets, those that invest offshore may or may not be hedged against currency fluctuations. That is something that is well worth checking before taking the plunge. Then there are synthetic ETFs, that trade largely in derivatives that are based on physical markets. These can offer fabulous returns but the trading is more opaque and hence the risks are greater.

While most investors will continue to invest directly in companies, the addition of ETFs into a portfolio can add instant diversification and improved risk management. It is worth taking a look ASAP.

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