The more complicated features there are in an exchange-traded fund (ETF), the more the managers can charge in fees and the more hidden risks you face when investing in ETFs
Exchange-traded funds (ETFs) are a low-cost, efficient way of investing in the stock market. But here’s a good general rule to follow when investing in ETFs.
Simple is better.
The easier an investment is to explain and understand, the less likely it is to harbour hidden risks and costs that can only work against you. As the old investor saying goes, “Stick with plain vanilla.”
10 Best Practices of Successful Investors
What is the right number of stocks for you? When is the right time to sell? Should you try and imitate Warren Buffett? There are answers to these and many more questions in this report packed with vital investment tips—this is how successful investors get that way.
For some investment firms, the rule works in reverse: The more complicated, the better. Each new feature provides a profit opportunity for the institution that sponsors the investment. It’s particularly important to keep this in mind with exchange-traded funds (ETFs).
These investments generally offer lower fees than actively managed mutual funds [link to what is a mutual fund]. Instead, ETFs aim to mimic the performance of a market index, by holding the same securities in the same proportions used to calculate the market index.
This simple arrangement yields only modest profit margins on “plain-vanilla” ETFs. So some ETF managers try to offset their low fees with high volume.
Each new hedge means more profit for the ETF sponsor
However, adding more features (sometimes referred to as “wrinkles” or “bells & whistles”) can make investing in ETFs attractive to a wider range of investors. Adding features also adds profit opportunities for the sponsoring institution.
For example, consider a typical ETF that gives you exposure to movements in an index of stock prices in an emerging market. This may appeal to investors who are thinking of investing in ETFs or other stocks in that market. But conservative investors may hesitate to buy [link to how to buy ETFs], because they worry about currency movements in the emerging market. So the financial industry has come up with “hedged” ETFs.
The sales pitch is that you can profit from growth in the stock market of the emerging economy, but you avoid foreign-exchange risk because the ETF operator hedges against it. This conveniently overlooks the fact that hedging costs money.
Hedging costs will vary, depending on conditions in the foreign-exchange market, and on how an ETF carries out its hedging program. These fees can double or triple the typical 0.30% to 0.70% ETF management fee.
You’ll need to dig deep to find out how much you pay for an ETF’s hedging feature. But you can be sure that the placing of each new hedge provides a profit opportunity for the ETF sponsor.
Our view: simple is better. If you want to invest in something like emerging-economy stocks, limit your stake to a point where you can accept the associated foreign exchange risk. If you buy an ETF, choose a “plain vanilla” unhedged version.
Or, to adapt yet another old investor saying, “If the foreign-exchange risk on your emerging-market investments keeps you awake at night, sell down to the sleeping point.”
Investing tip: Use our three-part strategy
No matter how you invest for retirement, you should take care to spread your money out across the five main economic sectors: Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.
By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.
You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.
Our three-part Successful Investor strategy:
Invest mainly in well-established companies;
Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities);
Downplay or avoid stocks in the broker/media limelight.
Have you started investing in ETFs? What have you learned? Please share your thoughts in the comments.
Note: This article was originally published in Februay 2015 and has been updated.
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