Financial management and investment today is radically different from a century or even a decade ago. Now exotic financial securities such as derivatives and hedge contracts can now be traded as easily as shares of stocks of publicly-listed companies. One of these financial instruments is exchange-traded funds or ETFs.
According to the Chartered Financial Analyst Institute or CFA® exchange-traded funds is
[a] type of mutual fund traded like other shares on a stock market, having special characteristics particularly related to redemption, and general designed to closely track the performance of a specified stock market index.
In laymen’s terms, ETFs are shares of a mutual fund that invests in assets and then sells its ownership shares to the public, who then trades those shares in the exchanges. A unique characteristic of ETFs is that they are usually designed to closely track an index. This means that the stocks you see in the funds’ portfolio are the stocks comprising a stock index. For example, the Dow Jones Industrial Trust is an ETF for–you guessed it–the Dows Jones Industrial index. However, index ETFs is but one of the several types of exchange-traded funds. There is also a commodity ETF, currency ETF and even a bond ETF.
So, how does one exactly invest in exchange-traded funds?
Investing in ETFs is just like investing in ordinary stocks.
First, identify your investment objective. Are you investing in ETFs to minimize risk? Or to preserve capital? Or to gain access to foreign markets? Or are you trying to minimize the impact of recession on your portfolio?
Second, decide on how much you are willing to invest. Personally, in all my investment decisions, how much is decided by how much I am WILLING and can AFFORD to lose.
Third, identify criteria to choose what ETFs to invest in. For example, you may want to invest in ETFs which have shown a compounded annual growth rate (or CAGR ) of 15% for the last 3 years. Or you may want to invest in ETFs which track US exchanges only. These criteria will depend on your risk and reward preference as an investor, and on the investment objectives you have identified.
Fourth, if you don’t have a broker yet, scout for a reliable one. (Author’s Note: how to select a reliable investment broker will be discussed in the next article.) If you are already using a broker or any online stock trading program, devote some time to study the ETFs traded in the exchanges you have access to.
Fifth, identify the ETFs which meet your investment criteria. Then from these selected ETFs, chose the ETFs which you think will most likely help you achieve your investment objectives.
Lastly, now you can buy shares of the ETFs through your broker or the online stock trading program you are using.
In investing in exotic financial assets such as ETFs, it is important that you familiarize yourself with how such securities work and trade, otherwise you could easily lose your hard-earned investment fund.
