What you need to know about ETFs and why you should consider investing in them

 What you need to know about ETFs

This is Part 1 of the ETF series. Learn about the different types of ETFs here.

What the heck is an ETF?

You can think of Exchange Traded Funds (ETFs) as a basket of companies that are related in some way. ETFs are traded like individual stocks—that is to say, you can trade in and out of them throughout a normal trading day—but are made up of many companies. The idea of an ETF is to invest in a specific area, without taking any stock-specific risk.

Until recently, mutual funds were the most popular vehicle to diversify away from stock-specific risk. But when people realized that they could get just as much diversification while paying lower fees, there was a huge flow of money away from mutual funds and into ETFs.

Pros of ETFs

  • Easy to trade through any brokerage account (liquid)
  • Low fees compared to other passive investments (e.g. mutual funds)
  • Huge selection
  • Limit stock-specific risk
  • Can invest thematically

Cons of ETFs

  • Not diversified outside of specific sector/category
  • Miss out on stock-specific outperformance
  • Many ETFs do not track a specific index so it is not as easy to measure relative performance

A simple example that shows the benefits and drawbacks of investing in an ETF

In 2005 the world was a different place. Beyoncé ran the world (ok fine, she still does) and Dell computers were the best thing since sliced bread (and they were bigger than a bread box too!). Google was mostly a search engine, and YouTube had just been created.

Let's say you decided to buy Dell stock at the beginning of 2005 (Dude, you’re getting a Dell) and you held it until the company was taken private in October 2013. The price over this time went from $42.14 to $13.65 for a -67% return, or a -8% annual return.

Now let's say you decided to invest in a Technology-focused ETF over that same time period (We'll use the XLK, which is composed of ~75 of the largest technology companies in the world). The price went from $21.11 to $33.61 for a return of 59%, or a 5% annual return.

Comparing Dell to XLK: By diversifying away from a specific stock (in this example, Dell) you would have returned 13% more each year!

On the other hand, what if you had bought Google stock instead? The price over that time went from $96.49 to $507.99 for a return of 426%, or a 36% annual return!

This example illustrates the trade-off you get by investing in an ETF. You run the risk of missing out on huge gains (like Google) but you also reduce the risk of picking a dud (like Dell). This brings us to the moral of the story.

Investment return (%)

Notice how Google outperformed the XLK over this time period and Dell underperformed the XLK. In hindsight, it's easy to see that Google was the right pick. But unless you are confident that you can consistently pick winners, it's much safer to invest in an ETF.

The moral of the story is this

Dell and Google were both cool in 2005, so there were probably many everyday people who bought one or both of these stocks. In hindsight, we can see that Dell would have been a bad pick, while Google would have been a great pick. But unless you are confident that you can pick winners consistently, there's no reason to take stock-specific risk! In this scenario, buying the Technology ETF (XLK) would have given you a solid return of 5% per year (with lower risk), while also giving you more peace of mind and time to focus on your passions (or to find funny cat videos on YouTube, I mean it was 2010).

Ok, so now you know the basics on ETFs. Want to learn about the various types of ETFs to understand how to select ETFs for your portfolio? Check out Part 2 here.