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What is ETF? Meaning, function and why you need it

The first exchange-traded fund (ETF) was launched in 1993.

Fast forward to date, and the global ETF assets stand at a whopping $9.1 trillion.

In 2020 alone, investors poured more than $730 billion into ETFs.

So what makes ETFs so popular among investors?

Exchange-traded fund (ETF)

Exchange-traded funds (ETFs) are tradable securities that track an index, commodity, sector, currency, or other assets. They are called exchange-traded funds, as they are traded on the stock exchange, just like stocks. And that allows investors to buy and sell ETFs, like stocks.

To understand ETFs better, imagine you’re grocery shopping. Now, you can either fill your basket with the essentials by walking down the aisles of the supermarket, finding each of the items, and adding it to your basket. Or you can simply buy one of those pre-filled baskets that have all the essential groceries.

ETFs are just like these pre-filled baskets, but for stocks. And unlike mutual funds, ETF shares can be bought and sold using your brokerage account, just like you would do with stocks.

ETFs can be structured to track anything from the price of a commodity to a collection of tradable securities. To do this, the fund will own the assets it is supposed to track. When it comes to tracking indexes, ETFs work almost the same way, as a low-cost index fund.

For example, if an ETF needs to track the performance of the S&P 500, the fund will buy stocks of all the companies in the S&P 500 and allocate them accordingly. So if you buy a share of this particular ETF, you’ll have invested in all the companies in S&P 500.

ETFs can have hundreds of assets in their holdings, to track stocks across various industries. Or it can focus on a particular industry or sector.

A very popular exchange-traded fund in the US is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index.

The popularity of Exchange-traded funds

As you can tell from the chart, the popularity of ETFs has risen rapidly over the years.

So what makes ETFs so popular?

Ease of use

ETFs are especially popular among newer investors. Most of them would start with a broad market ETF like SPY rather than picking individual stocks.

Why? It’s an easy choice.

Having to go through each individual stock deciding whether it’s the right choice for them, is intimidating to most newer investors. Whereas with ETFs, you’re instantly investing your money in the largest companies in the market.

ETFs trade on exchanges with ticker symbols similar to stocks. That makes it really easy to find them with a brokerage account.

Diversification

Investing in ETFs brings in immediate diversification.

As we’ve discussed earlier, ETFs are a basket of stocks. So buying a single ETF share will ensure that you’re investing in multiple companies. And if it is a broad market ETF, your investment will be spread across companies in different sectors and industries. That helps in decreasing volatility.

Because it’s highly unlikely that companies across all sectors will go down at the same time.

Also, for someone who picks individual stocks, ETFs can help in getting exposure to a certain sector, they might not be familiar with. For example, if you believe that the marijuana industry has significant room for growth, but you’re not quite sure which company to pick, choosing an ETF that focuses on marijuana stocks can save you time, and still make sure you don’t miss out on the industry winners.

Passive investing

Another advantage of ETFs is that you don’t need to frequently intervene with your assets. You can invest your money in a broad market ETF and forget all about it, and still grow your portfolio.

In many instances, these constant interventions and changes are the reason people lose money in the markets.

And the fund itself is passively managed. Meaning ETFs are generally automated to imitate changes in the underlying index/asset it tracks. Often, that results in having almost the same performance as that of the underlying index.

Having said that, there are also actively managed ETFs. These are run by professionals who make changes to the fund’s holdings more often. As a result, the fees tend to be higher when compared to passive ETFs. ARK Innovation ETF (ARKK) is an example of an actively managed ETF.

In general, most ETFs tend to be passively managed.

Low cost and commissions

This is a major factor in the wide popularity of ETFs. It’s cheap to invest in them.

The thing with investment vehicles is that they’ll charge you a substantial amount, for allowing you to invest in them. Actively managed mutual funds, for example, charge anywhere from 0.5% – 2% of your investment, annually.

But not ETFs.

On average, ETFs tend to charge anywhere between 0.02% – 0.75%.

You might wonder why we’re fretting over such a small percentage difference. After all, mutual funds are managed by finance professionals – they must know what they’re doing.

Well, think again.

A study by Vanguard found that only 18% of active mutual fund managers beat their benchmarks over a 15-year period. And, of these outperforming managers, 97% of them experienced at least five years of underperformance.

So basically, when choosing to invest in a mutual fund, you’re paying them huge sums of money every year, only to underperform the market.

With ETFs however, that’s not the case.

Sure, you might not beat the market. But you’ll likely match its performance every year. And believe me, you’ll be far ahead of most investors out there.

Different types of ETFs

As I said, there are ETFs for almost every asset, sector, and industry. Let’s look at some popular types.

Stock ETF

These are baskets of stocks that focus on a specific industry or sector. This also includes broad market ETFs such as SPY, which tracks the S&P 500, thereby tracking the performance of the 500 largest companies in the US. As illustrated before, stock ETFs have lower fees when compared to stock mutual funds.

Industry ETF

These ETFs are also stock-based. However, industry ETFs focus on a particular industry or sector (known as sector ETFs) rather than the broad market. This helps investors in getting exposure to an industry, which they might not be familiar. Especially with high-growth industries like technology, investors might be confused as to where they should invest.

So instead of looking for a specific company, they can invest in an ETF that focuses on major technology companies out there, making sure they don’t miss out.

Bond ETF

It’s what the name says – an ETF for bonds. Bond ETFs hold various kinds of bonds such as treasury bonds, corporate bonds, and municipal bonds. Their income distribution depends on the performance of their underlying assets. Investors generally choose bond ETFs, when they are looking for regular income from their investments.

Commodity ETF

These ETFs track the price of a commodity like gold or crude oil. These funds can be used to hedge your portfolio from downturns in the stock market. It is also far better than owning the physical commodity, as it involves a lot of complications. Commodity ETFs invest in all kinds of commodities.

For example, the popular coffee ETF in the US is iPath Dow Jones-UBS Coffee Subindex Total Return ETN (JO).

Inverse ETF

This is a different kind of ETF. While most funds are trying to capitalize on the price appreciation of underlying assets, inverse ETFs do the quite opposite. They aim to earn gains when the underlying asset goes down. This is done using something called shorting.

ETFs vs Stocks 

ETFs and stocks are inseparably linked.

ETFs have lots of similarities with stocks; how they can be bought and sold, ticker symbols, etc. More importantly, the majority of the ETFs are made of stocks.

As for which of these is the better investment choice, I would say that’s entirely up to you.

ETFs can be helpful if you’re a complete beginner and don’t know where to start. Or if you do not have the time to spend picking individual stocks, ETFs might be the ideal choice for you.

You may also choose ETFs as a way of getting exposure to industries that are unfamiliar to you. Thereby enhancing your portfolio and ensuring diversification.

ETFs vs Mutual Funds

Cost

To iterate what we have discussed before, ETFs have several advantages over mutual funds.

ETFs are certainly cheaper. On average you’ll be charged anywhere between $75-$200 a year, for every $10,000 you invest in mutual funds. Whereas in ETFs, you’ll only be charged $2 – $20 a year, for the same investment.

This is because mutual funds are actively managed by a finance professional who is constantly in the pursuit of beating the market. Yet, over the past 15 years, only 1 in 13 managers have succeeded in doing so.

Tax Efficiency

And ETFs are more tax-efficient than mutual funds.

Generally, when you sell shares and realize the gains, you’ll incur capital gains taxes, which will be taxed depending on how long you’ve held the assets.

ETFs are passively managed. So buying and selling within the fund is less. However, as mutual funds are actively managed there are more buying and selling shares. This can incur taxes.

This means, even if you don’t sell any mutual fund shares, you might still incur taxes due to the nature of how mutual funds work.

Bottomline

ETFs are your go-to choice if you are a complete beginner, or if you don’t have the time to do due diligence in individual stocks. ETFs allow you to get started with investing. And for someone who has a portfolio of individual stocks, it helps you in diversifying your assets and getting exposure to different sectors.

However, it is important to know that your returns will be average. You might never beat the market.

But if you can put aside 20 mins a day, you could potentially generate substantial returns and beat the market year over year, by choosing individual stocks.

Check out the workshop to learn more.

Coffee ETF: Is it the right choice for investing in Coffee?

Coffee is inarguably one of the most consumed beverages in the world. Being one of the ‘breakfast commodities’ along with orange juice, the rich aroma of the brewed coffee has made it equally popular among the old and the new generation. Over 2.25 billion cups of coffee are consumed in the world daily. Over 90 percent of coffee production takes place in developing countries—mainly South America—while consumption happens primarily in industrialized economies[1]. Coffee is the most valuable and widely traded tropical agricultural commodity and 25 million smallholder farmers produce 80% of the world’s coffee[2].

Growth in the world of coffee consumption

The worldwide coffee consumption has risen from 146.98 million 60 kilogram bags(the standard measure for coffee) in 2012/13 to around 165.35 million 60 kilogram bags of coffee in 2018/19[3]. The United States is the largest consumer of coffee in the world, with nearly 500 million cups a day. The US consumed a total of 27,430,000 60kg bags in 2019/20[4]. However, if you look at the average per capita consumption of coffee, the Netherlands tops the chart with 8.3 kg per capita, whereas in the US it is 3.5 per capita.

However, there are countries where coffee consumption is not prominent. China, the most populated country in the world has one of the lowest coffee consumption rates with an average of just one cup a year[5]. However, the coffee consumption rates are growing at 30% per year, compared to the international rates of 2%[6].

Investing in Coffee

coffee beans

There are different ways by which you can invest in the coffee market. Like any commodity, there are a number of products and services that are dependent on or associated with coffee. Coffee plantations are an example of direct investment. However, since the majority of coffee production is concentrated in a few countries, factors such as climate change could potentially affect the investment.

Soft drink manufacturers and other companies that sell coffee-based products are another option to consider. Companies such as Nestle who sell coffee-based products such as Nescafe and Nespresso are a good investment option if you don’t prefer directly investing in coffee production.

Coffee ETFs

There is only one kind of exchange-traded fund or ETF when it comes to coffee. These coffee ETFs track an index that holds coffee futures. One such ETF is the iPath Dow Jones-UBS Coffee Subindex Total Return ETN (JO).  Another ETF that tracks the performance of the coffee futures index is the iPath Pure Beta Coffee ETN.

An ETN is different from an ETF. While equity ETFs own the stocks in the index that it tracks(if the ETF is tracking S&P 500, then it will own stocks of all 500 companies), an ETN does not provide the ownership of the securities to the investors. They only pay the returns of the index they track. Hence, ETNs are similar to debt securities.

iPath Dow Jones-UBS Coffee Subindex Total Return ETN (JO)

The iPath Dow Jones-UBS Coffee Subindex Total Return ETN tracks Dow Jones Coffee Index by holding coffee futures contract in the most nearby month. The fund also has cash collateral invested in US Treasury bills and includes the rate of interest earned. The expense ratio of the fund is 0.75%. There is no dividend yield since the fund’s holdings are futures contracts. The total assets value over $100 million.

The iPath Pure Beta Coffee ETN (CAFE)

The iPath Pure Beta Coffee ETN tracks the Barclays Capital Coffee Pure Beta Total Return Index. Similar to JO, this too holds coffee futures contracts but differs in its investment strategy. Similar to JO, this fund also has an expense ratio of 0.75%. However, the totals assets value at only $5 million.

It is to be noted that, climate changes, political upheaval, and changes in supply and demand make the coffee futures volatile.

 

Coffee ETF, Coffee companies, and ‘Coffee the commodity’

coffee plants

With coffee ETFs, note that you won’t essentially own any coffee companies by investing in these funds, as these track an index and hold coffee futures contracts, which is a commodity.

When it comes to investing in coffee as a physical commodity, there are a number of factors that need to be considered. Since the majority of coffee production is limited to a few countries, factors such as climate change and political upheaval can affect the prices quickly. Another factor is the demand. Since coffee is not a necessary staple like wheat or rice, the demand largely depends on discretionary income and spending patterns. Commodities, including coffee, are traded in US dollars. A strong US dollar can depress the coffee prices and a weak dollar, well, is good for prices.

Investing in coffee companies is another.

 

Biggest coffee companies in the world

starbucks coffee cup

Some of the biggest companies in the coffee industry or make coffee-based products include Starbucks, Nestle, Restaurant Brands, Dunkin’ Brands, and Coca-Cola.

Starbucks

Starbucks is one of the most popular names when it comes to coffee and coffee shops. They are the world’s largest coffee house chain, with more than 30,000 locations spanning across 70 countries[7]. Even though Starbucks is primarily a coffee shop, it serves diverse products such as teas, hot chocolates, smoothies, iced drinks, and a wide variety of food items. Starbucks has a market capitalization of $115 billion. Their net revenue has risen from $14.9 billion in 2013 to 26.51 billion in 2019. The highest portion of the revenue came from the US with $16.65 billion[8].

Dunkin’

Dunkin’ is the second-largest coffee company in the world. With approximately 12,900 locations in 42 countries, the company is also one of the largest donut shops in the world[9]. Their products include donuts, bagels, coffee, and munchkins donut holes. Initially acquired by Baskin Robin holding company Allied Domecq, the company was bought by Inspire Brands in 2020. Dunkin’ Brands generated approximately 1.37 billion U.S. dollars in revenue in 2019, up from 811 million U.S. dollars in 2015[10].

Tim Hortons

Tim Hortons is the third-largest coffee house in the world. With more than 4,846 restaurants in 14 countries[11], the Canadian multinational fast food restaurant chain is another name in the neighborhood when it comes to coffee. The company was purchased by Restaurant Brands International, which also owns similar brands such as Burger King and Popeyes. Their revenue for 2019 was approximately 3.34 billion U.S. dollars[12].

Why do we like Starbucks?

 

starbucks coffee shop

Besides the fact that they are one of the largest coffee companies in the world, there are certain aspects that make Starbucks one of our favorite companies. Many believe that Starbucks is too expensive. They are right, in a way. $5 dollar for a cup of coffee is a little too much, but is that really what we are paying for?

Over the years, Starbucks has become the go-to place for meetups, dates, and informal meetings. Rather than a coffee shop, it has become a place where you can spend time with your friends, family, or even colleagues, considering that many business meetings are also organized at Starbucks. Also, as the number of remote workers is increasing, more people are changing Starbucks into their workspace.

So, the answer is, they are not paying $5 for a cup of coffee, they are paying for the experience and ambiance that comes with it.

Here are some other factors that indicate that Starbucks is built to stand tough times.

Brand Loyalty

Starbucks is one of the brands that know how to treat their customers just right and make them come back again and again. The added food options and the ambiance of the shops make the customers think of Starbucks when they think of getting a coffee. Apart from this, they have a pretty impressive loyalty program for their customers. It allows them to order ahead of time and also provides free refills of hot coffee or tea in-store. Getting to the top of the loyalty tier will get you free snacks and food as well.

This will keep them coming back.

Prior Experience

If we look at how Starbucks handled previous recessions, they focused on winning back their customers’ trust. They started with a survey with questions about the customer experience. Seeing the huge response, they implemented many of the recommendations given by the customers. This helped them sail through a hard time. Even though this does not guarantee that they will perform the same way in future recessions, their focus on customer satisfaction will go a long way in handling tough times.

Diversification

To make most of the brand loyalty and recognition they already have, they began selling their coffee in supermarkets. They also partnered with many delivery companies and have been expanding their drive-thru and mobile ordering platforms. All of these will enable customers to interact with the brand using these diverse options.

Starbucks is one of our top 20 stocks to own for the next 20 years. You can find the other 19 in our bestselling book The 8 Step Beginner’s Guide to Value Investing.

Malox: Understanding the Global Allocation Fund by BlackRock

What is Malox?

The BlackRock Global Allocation Fund (MALOX) is a mutual fund offered by the world’s largest asset management company, BlackRock[1]. Under the category, world allocation, the portfolio of the fund consists of equity, debt, and money market securities. The size of the fund is $25.8 billion. Launched in 1989, the multiasset class fund has a size of $9.16 billion[2]. The current fund managers are Rick Rieder, Russ Koesterich, and David Clayton. Share classes in the fund are divided into Class K, Class R, Institutional, Investor A, and Investor C.

 

BlackRock Global Allocation Fund (MALOX)

exposure breakdown of malox' portfolio

The fund mainly holds equities and bonds, with the remainder in cash. Equities account for 67.3% of the fund, with the top holdings by weight being APPLE INC (2.21%), MICROSOFT CORP (1.99%), AMAZON INC (1.70%), ALPHABET INC CLASS C (1.43%), ISHARES RUSSELL 2000 ETF (1.23)[3]. Technology and consumer discretionary are the major market sectors with 15.89% and 9.80% of the portfolio respectively.

Fixed income (bonds) accounts for 24.15% of the funds with the top holdings by weight being CHINA PEOPLES REPUBLIC OF (1.28%), CHINA PEOPLES REPUBLIC OF (1.26%), and  ISHARES IBOXX $ HIGH YIELD CORP (1.19%)[4]. Government bonds account for 12.31% of the fund.

It pays a dividend of 1.84 %. The dividend is distributed semi-annually. The last four dividends paid were $0.143888, $0.11537, $0.154039, $0.067173 per share.

 

How has it performed?

The below table shows the average annual returns of Malox and the benchmarks

Time Period Malox S&P 500 FTSE World Index
1 year 21.12% 18.40% 16.33%
3 years 9.66% 14.18% 10.68%
5 years 9.29% 15.22% 12.82%
10 years 6.80% 13.88% 9.92%
Lifetime 9.93% 10.62% 7.78%

 

Will MALOX outperform in the future?

With any mutual fund, past performance doesn’t matter as much as future performance. So let’s look at the 2 active managers involved to determine how much of a likelihood that is.

Rick Rieder & Russ Koesterich

Rick Rieder heads up Blackrock’s Fixed Income division. In his owns words, he sees the current debt securities market environment as being conducive to emerging markets and higher yield assets. Russ Koesterich runs the Global Asset division and has a 20-year background in the field.

Expense ratio and loading fees

The expense ratio of Malox is 0.8%. There are no loading fees for Malox. However, you need to pay a transaction fee of $49.95 when you buy or sell funds.

If you had invested $10,000 into this in 2011, you would have…

 

hypothetical growth of $10,000
Source: fundresearch.fidelity.com

If you had invested $10,000 dollars to Malox fund in 2011, you would have $19,307 today. If you had invested in an FTSE world index fund, you would have $25,757. If you had invested $10,000 dollars in an S&P 500 index fund, it would have been $36,700.

 

What we like better than Malox?

Basically, we prefer ETFs over any mutual fund.

Here’s why;

  1. Expense ratio: Mutual funds generally have a higher expense ratio than ETFs. The average expense ratio for actively managed mutual funds is between 0.5% and 1.0%. Rarely, they exceed 2.5%. For passive index funds, the typical ratio is about 0.2%[5]. This essentially means, you would pay a minimum of $50 dollars for an investment of $10,000 in a mutual fund, whereas you will pay only $20 for the same amount in an ETF.

In addition to these costs, investors in mutual funds may also have to watch out for sales commissions, too, which can quickly eat up your principal before you’ve even invested your money.

2. Annual returns: The average annualized return for mutual funds is about 9.5%, well below the average for 2020. For ETFs, the average annual returns are 12.6% 

The numbers given above show, by choosing to invest in mutual funds, you are paying a lot of money only to underperform the market by 40-50%.

3. Active vs Passive: Mutual funds are actively managed, which is essentially what incurs the expenses. You are paying for active fund management to beat the market, not inflation. However, information from a 2018 report from S&P Dow Jones Indices suggests that more than 92 percent of active fund managers in large companies were unable to beat the market over a 15-year period.

In passive investing, they are not looking to beat the market, they are trying to be the market, which essentially produces better returns.

4. Tax efficiency: Taxation is another huge advantage ETF has over mutual funds. In ETFs, the taxes for capital gains incur only when you sell them, whereas in a mutual fund since the shares in the fund are traded throughout the life of the investment, they incur taxes, as and when there are capital gains.

5. Commissions and minimum purchases: When it comes to commissions, ETFs wins, no doubt that. Most of the major brokerages have cut down the commissions to zero on ETFs available on their site. So it won’t cost anything to buy or sell these funds. With mutual funds, some charge sales commissions of 1 or 2 percent of your money. Brokerages may also charge a fee for trading the funds.

As for minimum purchase for an ETF, most brokerages require you to buy at least one share of the fund, even though, nowadays, many brokerages allow you to buy fractional shares as well. When it comes to mutual funds, some may require you to purchase at least $2,500 to get started. Some charge early redemption fees if you sell your position in less than 30 days.

Most importantly, the investment process is a lot simpler when it comes to ETF. Buying or selling an ETF can be done the same way you would do with stocks on an exchange. Even though it is not a complicated process when it comes to mutual funds, it does take some effort, and since they are priced at the end of the trading day, you won’t know what you are paying till the transaction is complete.

Our ETF recommendations:

We are recommending these ETFs, because similar to mutual funds, you can also invest in stocks and bonds using these ETFs, only more efficiently. VIG and VYM hold stocks and VGLT holds bonds.

  1. Vanguard Dividend Appreciation ETF (NASDAQ: VIG)

This is ETF tracks the Dividend Achievers index. It consists of 182 companies. VIG’s biggest holdings are currently Microsoft, Visa, and Procter & Gamble. Some of the other major holdings include Walmart, McDonald’s, and Johnson & Johnson. It has returned 350% over a 10-year period. $10,000 invested in the fund a decade ago would have turned into $35,000 by now. Best of all, VIG charges a low fee of just 0.06% per year and their dividend yield is 1.8%.

       2. Vanguard High Dividend Yield ETF (VYM)

Vanguard describes VYM as a high yield ETF. the ETF tracks the FTSE High Dividend Yield Index. VYM holds 426 dividend-paying companies across all industries. Currently, financials and healthcare account for the largest holdings. The biggest holdings of the fund are Johnson & Johnson, Procter & Gamble, and JPMorgan Chase. Other holdings include AT&T and Intel for some higher yields. VYM currently yields 3.59%, and the expense ratio is the same as VIG, 0.06%.

        3. Vanguard Long-Term Treasury ETF(VGLT)

VGLT is primarily a bond ETF, specifically a US Treasury Bond ETF. 99.9% of the holdings are in US government treasuries with a weighted average of 10-25 year maturity. VGLT currently yields 1.39%. Between March and September 2020, VGLT returned 25.38% compared to 6% for the S&P 500 on a YTD basis. VGLT has monthly distributions of $0.14 per share (roughly a two percent annual yield), which is great if you want more frequent payouts. Its expense ratio is just 0.05% as compared to similar funds that charge anywhere from 0.07% up to 1%.

Bottomline

To sum it up, for the individual investors, we prefer ETFs over any mutual fund, including Malox. Similar to mutual funds you can use ETFs to invest in stocks and bonds. Only with benefits such as tax advantages, low commissions, and the low expense ratio, more liquidity, and most importantly, better returns.

If you would like to know more ETFs and Dividend Growth Investing, check out our new book here.

The book features 13 great dividend-paying stocks to help you achieve a target income of 8% per year!