WHAT ARE ETFs AND HOW DO I START INVESTING?

WHAT ARE ETFs AND HOW DO I START INVESTING?

In my latest post 6 TIPS TO BECOME FINANCIALLY INDEPENDENT, I mentioned that investing in Exchange Traded Funds (ETFs) can be a great way to diversify your wealth. This post will outline what ETFs are, two investment strategies and how to get started.

What are ETFs?

Exchange Traded Funds are a form of security that holds an array of other securities, which tracks an underlying index such as the S&P 500 and can be bought or sold on an exchange such as the Australian Securities Exchange (ASX). The purpose of investing in an ETF is that it is a low cost barrier to gain exposure to the stock market and helps limit the amount of volatility in your portfolio. Instead of purchasing units into every company in the S&P 500 (which would cost you a lot of money, plus all the brokerage fees) an ETF provides you with a very small allocation into each company at a fraction of the price. 

ETFs are passive investments that aren't intended to outperform the market e.g. if the S&P 500 goes up 2% in a day, you would expect an ETF tracking the S&P 500 to go up around the same 2% as well. Although limiting yourself to the gains from the overall market, you reduce your risk of high volatility by investing in individual stocks that have the potential to fail and have a large drop in price. 

There are also ETFs that can track specific indexes rather than just the S&P 500. For example, if you're interested in Australian listed Real Estate Investment Trusts (REITs) you can invest in VAP (Vanguard Australia Property Securities Index ETF) or if you're intrigued by high dividend yield companies you can invest in VHY (Vanguard Australian Share High Yield ETF). There's even some that track the complete opposite of the market like BEAR (BetaShares Australian Equities Bear Hedge). All of the listed examples above are listed on the ASX but there are alternative options for those of you investing in other global markets.

There are a vast array of ETF issuers that you can invest in, however, I personally tend to lean towards:

• Vanguard
• iShares
• Schwab
• State Street SPDR

As always, you should do your own research to ensure that you're investing in the right ETF that will help achieve your financial goals. Research could include dividend yield comparisons, past performance (although this isn't an indicator for future performance) and most importantly, comparing the ETF performance against the index that it is intended to track. An ETF that is underperforming against it's intended index might not be a worthwhile investment.

Two ETF Investing Strategies

The way I see investing is you have two broad strategies investors can adopt:

• Capital Growth Investing
• Dividend Yield Investing

Both have pros and cons but each have their purpose when aligned with your financial goals for the future. Let's break down each one with investing in ETFs.

Capital Growth Investing

This strategy involves investing in ETFs with the purpose of a raise in share price in order to make a gain. The objective may be to track the overall performance of the S&P 500 and attempt to gain a substantive increase in share price year on year.

For example, investing in an ETF such as VAS (Vanguard Australian Shares Index ETF) when it is trading at $80.96 per share with the intention of holding until the share price increases to a higher figure, resulting in a capital gain. The advantage of this strategy is that you're able to see significant increases in share price when the market is performing well and sell shares at a higher price than when you purchased in order to make money. However, this is also it's largest disadvantage. If the market falls and the ETF along with it, you're placed into a position where you can either;

• Sell your position (not recommended in most circumstances)
• Hold long-term and be patient for when price eventually rises again; or
• Use it as a buying opportunity and purchase more shares

Overall, this can be a great strategy for investors looking for a relatively consistent gain compared to investing in individual companies.

Dividend Yield Investing

A dividend is a sum of money that is paid to shareholders (frequency determined by the company) out of its profits. As you can receive money by just owning an ETF, some investors seek to invest in high dividend yielding ETFs in an effort to obtain regular returns from their investment and to also continually invest so that compounding works in their favour. 

Finding how much an ETF pays as a dividend can usually be done through websites such as Yahoo! Finance or even on Google. Using an example of IDV (iShares International Select Dividend ETF), which currently has a yield of 7.36% and is trading at $26.61 per share as of November 11 2020. Simple equation of $26.61 x 7.36% ($1.96 per share) can provide you with a rough indication of how much of a return you can expect to receive annually per share owned. By investing consistently in these ETFs you will be less influenced by share price but rather the dividend yield as your return will continue to grow as you invest more money.

Advantage of utilising this strategy is you're able to receive cash flow every year from your investment and have the potential to also make capital gains if the share price does go up (win win!). A disadvantage however is that dividend investing takes time to show noteworthy results. Returns will start very small, but if you're willing to be patient and continually invest, your annual income from dividends will continue to grow into the future.

How to invest in ETFs

ETFs are treated just like any other stock or security on the market. Simply having a brokerage account with available funds is enough for you to be able to make an investment in an ETF. That is the great aspect of investing in ETFs, it provides an easy path for investors to make their first investment in the stock market without the fear of investing all their money into one specific company. 

Once you've begun, that's the hardest part out of the way! As most of you have heard before, time in the market always beats timing the market and consistent investments can prove to be very beneficial to your portfolios.

Summary

Hopefully this post has provided you with a better insight into ETFs as a whole and how you can utilise them to pursue your financial goals. There are countless amounts of ETFs available on the market so make sure to conduct your own research before making an investment. REMEMBER that if you fail to plan, you plan to fail.

Let me know your thoughts in the comments or contact me at thesleepinginvestor@gmail.com or on Instagram @thesleepinginvestor.

Cheers,

TSI