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Are ETFs ideal for inexperienced investors?

I keep hearing business commentators talk about ETFs and wonder what they are and whether they are the sort of complicated investment product that caused the GFC. Are they? And if not, are they good for people who want to invest without experience?

First up, let me say that they were not the derivatives that caused the financial collapse that characterised the GFC. I should say from the outset that not all ETFs are the same. Some are more risky than others, while some are as safe as many good quality shares. But remember, even good quality stocks dived when the market crashed with the GFC.

In a nutshell, a company will create an ETF, say around an index such as the S&P/ASX 200 index, which tells us how the Aussie stock market has performed on a daily basis. The company selling the ETF buys all 200 stocks and so when you buy a unit of the ETF you get all the stocks in the index and the numbers bought will reflect the importance of each stock in the index.

So, if you put $200,000 into such an index, you don’t hold $1000 of each of the 200 stocks, but instead a whole lot more BHP Billiton, Rio Tinto and CBA than you would some smaller company that might be the 199th and 200th biggest companies in the index.

What you also get are the dividends that go with those stocks and so the value of the unit goes up according to movement in the shares’ prices, just like ordinary shares, and you get the dividend payments from the shares you hold via the ETF.

For someone who doesn’t want to pick individual stocks and just wants to read the newspaper or listen to stock reports on the radio, he or she will know whether they have made money or not by simply noting what has happened to the index. So if in one year your index went up 10 per cent, well you would have made a bit less as you do pay fees but they’re not big compared to fund managers’ fees.

Why is that? There’s less work picking and dumping stocks because the company in question buys the index.

One last thing, I reckon index-based ETFs are pretty safe but if the market crashes you lose but as long as you can wait, the market will always come back.

However, if you go for a narrow ETF, say focused on resource stocks, these can promise better returns if resource prices go higher, but they can also be more risky as you’re trying to pick one sector, which means you’re not diversified.

By buying an index of the top 200 stocks, you get a good mix of sectors and it means you’re more diversified. It reduces your overall returns in the short- to medium-term, but it reduces the risk.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Published on: Tuesday, June 28, 2011

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