Investment basics: what is an ETF?
In the previous sections, we discussed what is a stock, dividend, growth and value stocks. But for many people, the actual buying of individual stocks can still be unnecessarily complicated (and as the numbers show, it really is). Thus, thanks to many public appearances by investors and marketing by big brands, many beginners have probably heard of so-called ETFs. One of the most passive, common and simplest ways to invest. But is everything as rosy as it is presented?
What is an ETF?
As always, I'll start with the English name to help you navigate foreign information sources. An ETF is an Exchange Traded Fund. In Czech, it is an Exchange Traded Fund.
An Exchange Traded Fund (ETF) is actually something like a stock, but it incorporates a larger number of "chunks" of other stocks. Sort of like a mutual fund, but publicly traded on an exchange. ETFs usually track an index (Typically like the S&P 500, so the 500 largest publicly traded companies in the US, the 1000 largest companies in the world, etc.)
,asector (so maybe chips, energy, agriculture, etc.), a commodity (metals, crops...). As I mentioned - ETFs can be traded on an exchange.
- An ETF can be described as a basket of securities that is traded on an exchange just like an individual stock.
- The price of an ETF changes throughout the trading day as stocks are bought and sold on the market. This is unlike mutual funds, which are not traded on an exchange and which trade only once a day after the markets close. In addition, ETFs tend to be more cost-effective and liquid compared to mutual funds.
- AnETF may own hundreds or thousands of stocks across different industries, or it may be isolated to one particular industry or sector.
Basic types of ETFs
As I mentioned earlier - ETFs are primarily divided by their focus and scope. However, if you've already chosen your first ETF based on your preferred area or type of investment, there's still a crucial point to address: Accumulation or distribution?
Accumulation ETF: An ETF where all dividends paid by the underlying assets within the ETF are reinvested BACK into the fund by the fund manager at no additional cost. As a result, the value of the ETF increases. Thus, whatever the assets contained in the ETF pay you is immediately reinvested automatically in the ETF. More or less, it then works like a snowballing snowball. It can also be likened to the DRIP method, which I described in the Investment Fundamentals piece as well as the dividend.
Distribution ETFs: Unlike accumulation ETFs, distribution ETFs pay dividends to investors. That means everything goes directly to you, and it's up to you whether you invest that money back into the ETF or take your significant other out to dinner with it.
Which is better?
As always, the answer is that everything has its pros and cons. A distribution ETF pays out any dividends or interest, while an accumulation ETF reinvests those returns back into the fund - so the investor automatically benefits from compound interest.
So, at first glance, an accumulation ETF appears to grow faster than a distribution ETF, which does not reinvest the proceeds. But appearances can be deceiving.
The most common method to ensure a fair comparison between distributing and accumulating ETFs is to assume that all distributions are reinvested back into the ETF. That way, you can compare the growth of the two types of ETFs on a total return basis. However, there will be a deviation in the form of a later reinvestment of the dividend in the distributing ETF. This may seem minor, but it makes quite a splash.
So really, in the end (in terms of growth), the accumulation ETF wins by a small margin. But not as noticeably as it might seem at first glance.
Understandably, however, this is a tax on the lack of cashflow and a sort of "passive" income in accumulation ETFs.
What is the main advantage of ETFs for beginners?
Now for the most important part - is ETFs suitable for beginners? The answer is - probably yes. In fact, data shows that it is one of the "safest" and least demanding investment options. So, although I always say that there is no such thing as safety in investing. In fact, ETFs (typically the aforementioned ETF replicating the SAP500 index) more or less mirror, for example, the economy of an entire country or market. The average growth of the market is then the kind of threshold that investors watch a lot. In fact, beating the average market performance is much harder than it first appears.
Quite often, even actively managed funds can't do it. But some ETFs and broadly diversified instruments usually keep up with the market (if only because they copy it quite often, right). However, if you believe you can beat the market, for example, then picking individual stocks probably won't get you away.
But ETFs are not just the choice of passive investors and beginners. Experienced Wall Strett wolves often choose them for their portfolios as well, as they give them tremendous diversification and exposure to a sector or area in one compact package. Imagine the folly of buying, say, 500 companies from the SAP index....
They can also form something of a "sure foundation" for a portfolio, to which more experienced investors then add smaller positions in individual stocks. But always with the idea that the solid base remains and is perfectly diversified.
The choice is, as always, up to each of us.
What about you, do you choose ETFs, stockpicking, or a combination of both?
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Disclaimer: This is in no way an investment recommendation. This is purely my summary and analysis based on data from the internet and a few other analyses. Investing in the financial markets is risky and everyone should invest based on their own decisions. I am just an amateur sharing my opinions.