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Trading the index: why exchange traded funds offer the best of both worlds

ETFs allow investors to diversify over an entire sector in a single investment while managing risk

Index funds, which passively track indices, have actually outperformed actively managed funds over the past decade. Photograph: iStock

Index funds, which passively track indices, have actually outperformed actively managed funds over the past decade. Photograph: iStock

 

Exchange traded funds (ETFs) are investment vehicles structured to enable investors to track a particular index, such as the FTSE 100 or the Nasdaq, through a single, liquid instrument that can be purchased or sold on a stock exchange.

According to the Irish Funds Industry Association, the trade body for the sector, an ETF offers the advantages of an investment fund, such as low costs and broad diversification, together with characteristics more commonly associated with equities such as access to real-time pricing and trading.

As funds that track indices, they provide their investors with an exposure to the securities in an index, while the listing on the exchange means the ETF shares can be bought and sold by investors in much the same way as an equity security. They offer investors the ability to diversify over an entire sector or market segment in a single investment.

“It has never been easier or more cost effective to invest in the stock market in a diversified way through a fund,” says Daniel Moroney, investment strategist with Brewin Dolphin Ireland.

“An exchange traded fund, or an index fund, is just one fund, but under the bonnet are maybe 1,000 individual shares.”

Very many of these low-cost vehicles track an index. If, for example, you wanted exposure to the Nasdaq but didn’t want to have to go out and research it, investing in a fund that tracks it would provide just that.

Today’s retail investors have US investment firm Vanguard to thank for ETFs. It invented them. “As an investor in the 1980s it was much more difficult to be diversified. Vanguard was literally in the vanguard, democratising access to investment funds for ordinary investors and meaning you don’t have to pay an investment manager,” says Moroney.

Though it means you might miss out on putting all your money on one particularly high-performing stock, it also prevents you from picking the single stock that sees you lose your shirt.

“The chances of all 1,000 firms in it going to zero are non-existent. It’s as close as you get to a free lunch in terms of managing risk. By contrast, if you pick one or two stocks, as we know from bank stocks here, they could. These days there is no excuse to put your money in a single stock,” he says.

It doesn’t have to preclude the fun element of stock picking either. ETFs are easy to manage, and if someone has additional savings they’d like to invest, that’s still there for you. “Just remember it’s very important that the size it represents of your overall savings is not disproportionate. No matter how good you think it is, it brings single-stock risk with it,” he says.

Property-based ETFs can offer an alternative to direct investment in property, allowing you participate in the performance of a fund that contains hundreds, if not thousands, of properties under the bonnet rather than sink all your savings into one property, or even a few properties, in the same market. With a property-based ETF, you don’t have to worry about voids either.

One of the advantages of ETFs is their low cost, which might enable you spend more money on expensive investment products such as hedge funds or private equity, Kevin Quinn, chief investment strategist at Bank of Ireland, points out.

Index funds, which passively track indices, have actually outperformed actively managed funds over the past decade too, largely driven by Big Tech. Though past performance is no indicator of what the future holds for tech, in recent years such index trackers have meant “you were participating in the rise of tech without even having to think about it,” says Quinn.