Exchange-Traded Funds for Your Investment Portfolio - dummies

Exchange-Traded Funds for Your Investment Portfolio

By David Stevenson

Investing in the UK by picking an individual company or bond introduces specific risks. Perhaps some of your individual bets go wrong, exposing your limited ability to stock-pick individual shares successfully. Or assume that something peculiar happens, such as you buy shares in UK oil giant BP because you think that oil prices are going to rise.

They do, but then – theoretically, of course! – a sudden and catastrophic oil blowout occurs at one of their rigs and reveals systematic management incompetence. Your BP shares fall in value even though your broader bet on oil prices was correct. Such problems are called idiosyncratic risk (which doesn’t suggest that you’re an idiot!).

Thankfully a better way exists of implementing your broader strategic objectives for your portfolio without taking the risk of betting on an individual company or relying on your stock-picking skills. This method involves investing in an index that captures a particular set of companies, bonds or prices. For example, instead of investing in just BP, you invest in a sector index that tracks the fortunes of the world’s leading oil companies.

Or you can simply decide that a better, more diversified choice is to invest in a broader market index such as the FTSE 100 for large British firms or the S&P 500 for big US stocks. By investing in an index, you don’t have to laboriously buy every stock within that index (500 for the S&P 500 and 100 for the FTSE 100); you simply make use of an exchange-traded fund (ETF).

These trackers come in all shapes and sizes but the essential idea is that you don’t buy an individual stock, but invest instead in a broad index that captures your key strategic objective.

Stock market indices have long dominated the world of shares. Every hour or so the factual news radio stations report on how the benchmark S&P 500 or FTSE 100 indices are performing. Investors are trained to think about investing using an index, and ETFs make doing so easier than ever. You just pick up your phone or, alternatively, log onto the Internet, tap in the symbol of the fund you want to buy and click!

You’ve just bought exposure to the S&P 500 or FTSE 100 index. You can then sit tight holding these shares for the next 5 or 50 years or sell them 5 minutes later. The choice is yours, and the ease of trading exceptional. Plus, the underlying costs of these funds are incredibly low.

Most fund managers charge 0.05–0.50 per cent per year for managing an ETF, whereas a manager who actively manages that portfolio of stocks can easily charge more than 1 per cent per year. The cost is lower because managing an ETF is really only one step up from operating a computer.

The fund manager simply makes sure that the composition of the fund tracks the composition of the index. With a little bit of help from a software program and trading technology, this process can be virtually automated. Hence no need to pay for a Porsche-driving fund manager!