Investment choices - Exchange Traded Funds
April 5, 2007Moving on to your second option of investment: exchange traded funds (ETFs). Generally, a fund is a selection of shares (portfolio) which is managed by a fund manager (that was obvious, wasn’t it?) who earns a living by researching companies and making (your) investment choices.
There is a variety of funds out there, which are commonly categorised as mutual funds and index funds. This same principle applies to ETFs, which are a fairly new investment option having only been traded at the London Stock Exchange since April 2000.
And that’s where the main difference between an ETF and a fund lies: ETFs are traded just like shares on the stock exchange and thus require a lower initial financial outlay. While funds commonly have minimum investment levels of a few thousand pounds, ETFs are much cheaper. That is why Richard Jenkins @ MSN Money claims that you should start investing right away even if you only have $100 (~ £ 50; €75) in your pocket (I disagree, but that’s another story…)
Just like their “big brothers”, ETFs track either an index (like the S&P 500 in the US, or the FTSE 100 in the UK) or a specific sector (oil, pharmaceuticals… you name it!) which gives you the security that comes with diversification (i.e. not putting all your eggs in one basket 
) without the financial investment needed if you were to build up a diversified portfolio yourself.
Tracking an index doesn’t require much active work (ETFs are called “passively managed”), because it is simply a copy of the shares represented by the index/sector. This means ETFs have the lowest expense ratio that is available for funds and therefore annual expenses won’t eat up most of your gains.
The FTSE 100, for instance, represents the 100 largest companies in the UK (technically the “most highly capitalised companies” - see here for more information), so buying an ETF tracking the FTSE 100 gives you almost guaranteed growth in the long run (the FTSE100 was “born” on 3rd January 1984 @ 1000 base points and closed today at 6,395.40).
Let’s sum up the advantages that come to mind:
- low annual costs
- inherently diversified
- no minimum investment limits (other than the price of the share)
- no time-intense research to pick a “good” company - the number of available options is reduced to 669 worldwide
But:
- stock indices represent the economy’s well-being: if the economy is undergoing a recession the index will inevitably fall
- ETFs tracking sectors are as volatile as the sectors they’re tracking - especially commodities like oil or metals can fluctuate quite badly
After we’ve now looked at exchange traded funds, next on my list: index funds and mutual funds.
