Exchange Traded Funds
I will start off by defining an Exchange Traded Fund (ETF). An ETF includes a basket of equities, bonds, commodities or assets which track an index.
Take the Lyxor ETF DAX (DAX FP EQUITY) as an example. If you buy this ETF, you would be getting exposure to the 30 stocks which make up the DAX (being the German market). This means that the performance of the ETF will be very close to that of the index.
In my opinion every portfolio, irrespective of the risk profile of the client should have an exposure to ETFs. However, going through clients’ portfolios, few are those which actually have exposure to these instruments.
So who’s getting it wrong? The following are what investors love and hate about these instruments;
What’ to love?
The first thing that comes to mind is diversification. If you buy a market ETF like the Euro Stoxx 600 (SXAPEX GY EQUITY) in Europe or the S&P 500 (SPY US EQUITY) in the US you have a big part of your diversification process covered for you without you having to go into any of the technical detail. My opinion is that the core of your portfolio should be made up of market ETFs.
The second is that these instruments are traded on a stock exchange and can be bought or sold anytime during the trading session. So if you are worried about a potential negative event in the market which could drive prices lower, you could sell the instrument immediately with no delays.
The third is that your satellite holdings can also be in the form of ETFs. For example, if you are bullish on the auto sector but do not have the time to go through individual valuations you can always refer to the iShares STOXX Europe 600 Automobiles & Parts (SXAPEX GY EQUITY). This index will include all the auto constituents in the Euro STOXX 600 ETF.
The forth is that these instruments are cost and tax efficient. When it comes to buying an ETF, it would cost you the same as if you were to buy any ordinary stock on the market. But in reality if you buy the Euro Stoxx 50 you would be buying 50 stocks. Imagine what costs you would incur to buy all 50 individual stocks!
The fifth is that irrespective of your timing in the market ETF, the probability is that you are still making money. Take the S&P 500 as a case in point. Whether you bought at the peak of the technology bubble in the late 90s or the peak of the property bubble in the 2007, you’d still be making money today. In contrast, if you bought several individual stocks, it could be that you never recovered all of your capital.
What’s to hate?
There are two major drawbacks with ETFs which I can think of.
The first is that an investor likes the excitement of going into individual names and following what is happening. With ETFs (even if they are sector specific ETFs) you lose the excitement of monitoring what is happening with an individual stock.
The second disadvantage is that if you get it right on a stock, the potential upside would be far greater than that of the index itself. Be it the market or even the sector index.
Conclusion
In my opinion, the advantages of ETFs far outweigh the disadvantages and it is important that investors familiarize themselves with these investments. I remain of the opinion that the core of a portfolio should be made up of market ETFs which will limit unsystematic risk in a portfolio and avoid negative surprises due to bad management of portfolios.
This article was issued by Kristian Camenzuli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.