Low fees and diversified risk: The case for ETF investing

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Exchange-traded funds (ETFs) are a form of mutual fund which are constructed to match the assets and securities associated with a financial market index and can be bought in the same way as stocks. One of the most popular examples is the SPDR S&P 500, which tracks and invests in the top 500 companies by market capitalization listed on the NYSE, NASDAQ or Cboe BZX Exchange.

An ETF is considered “exchange-traded” as it is traded in the same way as stocks – on an exchange, with prices of a given ETF’s shares changing throughout a trading day. The fees on ETFs are often cheaper than those of index funds (a form of mutual fund which would also allow an investor to spread their investment across a large group of companies).

The combination of low fees and diversification of risk across a large group of securities, rather than several selected stocks, has driven the dramatic rise of the ETF and index fund industry over the past couple of decades.

In 2006, the famous investor Warren Buffet challenged the hedge fund industry, offering to bet $1 million that an index fund would beat a group of hedge funds over a decade once fees were taken into account. By 2018, the S&P 500, Buffet’s chosen fund, averaged gains of 7.1 percent, in comparison to the five competitor hedge funds’ average annual gain of 2.1 percent – not exactly a close race by any stretch. Buffet later donated his winnings to charity.

Investors can access ETFs that cover every major index and sector of the equities market. For Middle Eastern investors looking to keep their money close to home, perhaps the iShares MSCI Saudi Arabia ETF KSA - the largest Middle East and Africa ETF with over $850 million in assets - might appeal. Alternatively, if an investor wants to spread their risk across the region, the WisdomTree Middle East Dividend Fund provides exposure across the Middle East.

There are also specialized ETFs which cover specific industries, such as technology or energy, or a particular market niche, such as commodities or real estate (via real estate investment trusts, otherwise known as REITs). This flexibility gives a potential investor many options when considering where to park their assets.

Passive investing

For an investor looking to fund themselves into their later years, or for those who are looking to save for a large purchase such as real estate, passive investing via ETFs is a worthy course to consider. The goal of the passive investor is to avoid as many fees as possible while limiting trading activities to bring costs associated with making trades down.

A passive investor doesn’t generally need to outthink the market – instead, they invest in the market as a whole. ETF’s play this role – they facilitate passive investing. The simplicity of this investing strategy is one of its strengths.

In contrast, active investing – the ongoing buying and selling of investments – requires constant monitoring and incurs higher costs. Traditionally, active investing is done by an active investment manager, for instance via a hedge fund, and thus comes with a range of fees. An investor needs to pay for the time and expertise of an investment manager – costs which an ETF avoids, as the simplicity of the fund removes the need for active management.

This simplicity also allows an investor to sidestep the need for a financial planner. Entry-level investors can open their own brokerage account with a firm online and begin investing in ETFs without requiring significant market experience, removing another layer of cost.

ETF’s offer not just simplicity, but also higher returns. It has repeatedly been shown that it is very difficult for an investment manager to actually beat the market. Research conducted by Standard & Poor’s as of the end of 2018 showed that the majority of actively run large-capitalization funds have failed to beat returns offered by the S&P 500 for the ninth consecutive year.

Savings accounts

Savings accounts are commonly considered a safe place to park savings, but the power of inflation erodes their value. In the UAE, it is difficult to find a savings account offering more than one percent interest, whilst inflation is expected to hit around two percent for 2019 – effectively wiping out any monetary gains. Meanwhile, the return of the Vanguard S&P 500 ETF, which tracks the top 500 companies in the US, was 10.3 percent over the past 12 months– a significant improvement compared to a traditional savings account.

Of course, the usual investment caveats apply here: if the stock market plunges, then so will investments. However, the advantage of spreading risk over a large group of companies means that an investor only needs to bet that the overall economy as a whole will grow, rather than a few, expensively picked, hand-selected stocks perform.

With central banks across the world looking to cut interest rates, the effect of inflation will likely become even more pronounced. Budding investors should consider alternative methods of value growth and preservation - ETFs are an attractive proposition.