🎙 How do you become a millionaire on autopilot? You invest in ETFs and hold on for the long haul. This is a super simple and effective way to build wealth, and reach FIRE. ETFs have been gaining in popularity over the past few decades - but what are they and how do you invest in them? 🤔
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Hey, friends! And welcome back to Girl on FIRE, the financial independence podcast for independent women.
My name is Priya, I’m a Chartered Accountant, an analyst and the creator of Paper Money Co.
I’m also a fierce financial feminist and the host of this podcast. I believe that a woman who is in control of her money, is in control of her life.
This week, we’re talking about the ultimate lazy girls’ way to get rich and make millions.
And no, I’m not exaggerating. We’re talking about ETFs, which are exchange traded funds.
We’ll go over what they are and how they work. And we’ll talk about how to invest in them and why they’re such a great option, especially for newbie investors.
Before we get started, I want to remind you to head to my website — papermoneyco.com — to sign up and receive your free copy of my Investing Starter Guide.
It’s totally free, you just need to enter in your email address and I’ll send it to you. And then I want you to start working through it.
It’ll give you a plan to follow, step-by-step instructions to get ready to start investing and building real wealth.
If you’re really serious about learning to master your money, then it’s the perfect guide for you, and I’d hate for you to miss out on it.
As always, Girl on FIRE is about learning, so whip out your favourite notebook or journal and get ready to take some notes.
If that’s not your thing, you can always find the transcript on my website — papermoneyco.com.
Okay, so that’s the end of my shameless plug — let’s dive in!
What are ETFs?
So, let’s start with the basics — what are ETFs? An ETF is an Exchange Traded Fund.
Now, I want you to think back to episodes 15 and 16 when we were talking about investing in shares and stocks.
In those episodes, we were talking about investing by buying stocks in individual companies. So, maybe you buy stocks in Apple, and then in Commonwealth Bank and then in Woolies.
You’re going around picking and choosing what you want to buy. You’re making all these individual trades buying what you want to invest in.
Now, an ETF is a prepackaged collection of stocks or other assets. So, instead of choosing all these individual stocks, you might buy a basket labelled tech stocks, or top 200 Australian stocks, or clean energy stocks.
Think of it like a Christmas hamper. You can either buy all these individual things — the shortbread, brandy, pudding, bon-bons, fruit cake, chocolate covered nuts — and put them in your own little basket.
Or, you can buy one of those done-for-you hampers that are already assembled with the Christmas goodies, wrapped up in cellophane with a big red bow on top.
So, think of ETFs like that done-for-you Christmas hamper. Total side note here — a few years ago, I created a Birthday Basket for myself that was like a little Priya hamper.
I bought books, stationery perfume, candles, beauty products and chocolate — of course, chocolate — for myself and created my own little basket. So, that was fun.
But getting back on topic, these ETF hampers are created by fund management companies like Vanguard or Black Rock or Beta Shares and sold to investors on the stock market.
But let’s take a minute to understand the purpose of ETFs. The goal of an ETF is to track an index. And an index is essentially a segment of the stock market.
So, for example you could have a sustainability index that’s made up of companies that produce clean energy.
Or you can have an index of the largest 200 companies in the stock market. Or maybe an index of all the tech companies listed on the exchange.
So, what your ETF tries to do, is match the performance of that underlying index, whether it’s performing well or not. It’s trying to mirror it.
What’s the difference between index funds and ETFs
Now, it’s important here to clarify the difference between an index fund and an ETF. Because an index fund does the same thing.
It’s a basket of securities that reflects an underlying index and it aims to match the performance of that index.
One of the key differences between an index fund and an ETF is that an ETF is traded on the stock exchange throughout the day just like stocks.
But an index fund is traded at the end of the day at the closing price.
How do ETFs work
Okay, so let’s take a closer look at how ETFs work and how the stocks of individual companies are packed together in the ETF hamper.
What stocks are included in an ETF?
An ETF holds the same stocks that are in the underlying index that it’s trying to track.
So, it’s going to depend on what the ETF is trying to track. So, for example A200 is an ETF created by Beta Shares.
And it’s an ETF of the top 200 companies listed on the ASX, the Australian Stock Exchange.
So, the purpose of A200 is to track the performance of the top 200 companies on the ASX, regardless of whether that performance is good or bad.
Now, those top 200 companies include things like Commonwealth Bank, ANZ, BHP, Westpac and Woolworths.
A200 will always, always, include the top 200 companies, no matter what they are. It has no loyalty to a particular company, it’s always just the top 200 companies.
So, let’s say Woolies has a really bad year, they can’t keep up with ALDI anymore. And they’re not making bank the way they used to.
Their financial performance falls and they’re no longer one of the top 200 companies on the ASX. Maybe they fall down to position 210.
Think of it like a leaderboard. Woolies has dropped down to the 210th spot, which means all the other companies have moved up one spot.
And because of that, there’s now a brand new company in the top 200. The one who was previously in 201st place, is now in 200th place.
So, because the A200 ETF tracks the top 200 companies, it’s no longer including Woolworths. It’s including this new kid in town, instead.
Now, to be clear, not all ETFs are like this. Remember what I said before — it depends on what the ETF aims to track.
There could be an ETF that tracks all the auto companies on the exchange, or the ones that have a strong policy against slavery and underpaid workers in developing countries.
So, when you’re researching ETFs, it’s super important to look at the portfolio holdings — what does the ETF track? What’s in the hamper?
It might say it’s a hamper of delicious chocolate and nuts, but what kind of chocolate and nuts? What’s specifically in the hamper?
How do ETFs determine what portion of stocks they hold?
Okay, so now we understand that an ETF holds the same stocks that are in the underlying index that it’s trying to track.
Another important thing to note here is that the ETF is holding these stocks in the same proportion as they appear on the underlying index.
So, for example, if Commonwealth Bank makes up 5% of the top 200 companies on the ASX, then 5% of the value of the A200 ETF is made up of Commonwealth Bank.
And because the ETF is tracking the index, when the proportion of companies changes, the ETF aims to match that as well.
Understanding the costs when you invest in ETFs
Now, I mentioned earlier that ETFs are traded on the stock exchange throughout the day just like shares are.
And that means your trades to buy and sell ETF units are executed by a broker. We talked about how to choose a broker in episodes 3 and 4.
So, when you trade ETFs, you may also have to pay brokerage fees and commissions. And you may also have to comply with minimum initial investment values set by your broker.
An important thing to note here is that these aren’t the only costs involved with investing in ETFs.
ETFs also charge a management expense which is called a management expense ratio or MER, and it’s expressed as a percentage.
So, for example, if an ETF has a MER of 0.1% that means, it charges a management fee of 0.1% of the value of your holding.
This is a fee that the company who created the ETF uses to cover their costs of operating and managing the ETF.
The MER is a broad measure of how expensive the ETF is for an investor. So, the lower the better, because these fees can add up and eat up into your returns.
MER is a funny word. It sounds like what a bougie cow would say instead of moo.
And we’ll talk about how this cost compares to other investment options a bit later in this episode.
Why you should invest in ETFs
Okay, so now that we know what ETFs are and how they work, let’s talk about why they’re so popular. Their popularity has really exploded in recent years.
And they’re a great option for all investors, especially beginners and people who don’t have hours to dedicate to researching, analysing and choosing individual stocks.
So, why are they such a good investment option?
First, ETFs give an investor instant diversification in one trade. So, if you remember from episode 14, diversification is how investors spread their risk among their portfolio to lessen the blow.
It’s the idea of not putting all your eggs in one basket. Now, think of the A200 ETF we talked about before. In one single trade, you can get exposure to 200 different companies.
That’s 200 different companies of different sizes, in different industries and with different business models and different risks.
If you wanted to do that yourself, you’d have to make 200 trades. If you were building that hamper yourself, that’s 200 trades and thousands in brokerage fees.
But by buying that ETF hamper, you’re diversifying your portfolio in a single trade and in a very cost effective way.
Invest in the whole stock market in one trade
Another benefit is that you can maximise your returns and create a balanced portfolio by investing in the whole stock market in one trade as well.
Instead of choosing individual stocks, which can take a lot of effort and time, you’re investing in the entire stock market in one go.
And if you remember when we were talking about stock market returns in episode 15, that’s an average annual return of 8-10% with one trade.
Earn passive income through dividends and capital gains
Moving on, you also earn dividends and capital gains by holding ETF units. When the value of the underlying index increases, the value of the ETF increases.
And that means that the price of the ETF increases, and if it increases to a point higher than what you paid for it, you’ll make a capital gain.
Similarly, when the stocks which the ETF holds pay dividends, that dividend is passed on to investors.
So, you can earn passive income through capital gains and dividends when you’re invested in ETFs.
Low cost investment
Now, all of this instant diversification and passive income comes at a cost. You will pay brokerage fees and possibly a commission as well, depending on your broker.
You’ll also have to pay a management expense which is deducted from your returns.
But ETFs are actually a low cost investment compared to some other options. For example, a mutual fund is a pretty expensive investment.
Because there’s an actual human fund manager who needs to sit there analysing and picking stocks to invest in. It’s actively managed.
And that fund manager needs to get paid, so the cost gets passed on to investors. That doesn’t happen with ETFs because they’re passively managed.
There’s not a lot of picking involved so the costs are much lower. Now, the MER can change from ETF to ETF depending on what that ETF includes and how that basket is packaged.
Something like the A200 will have a relatively low MER compared to other ETFs. It’s made up of the top 200 companies. There’s no picking involved, it is what it is.
But an ETF that tracks sustainability companies might have a higher MER, because it takes more work to add and remove and adjust the holdings.
So, what’s a good MER? According to Investopedia, for a passively managed fund, the MER is typically about 0.2%.
But there are many ETFs out there that have a higher MER or have a much lower MER.
Now, there have been studies that show that most of the time when a person tries to pick and choose stocks to out perform the market, they actually end up on average underperforming.
Because no one can see the future, so why try to out perform when you can at least be guaranteed to match it.
Risks of investing in ETFs
Now, in this next part of the episode we’re going to talk a little bit about the risks of investing in ETFs.
But before we do that, I need to ask my Girls on FIRE for a favour. If you’ve listened this far into the episode, then you’re clearly enjoying it!
I’d love it if you’d just hit pause for 30 seconds, go over to Apple Podcasts and leave a rating and a review for Girl on FIRE. There’s a link that will quickly take you over there right at the end of the show notes.
Your feedback helps me improve the content that I share and it helps other women out in the internet wilderness find us and become Girls on FIRE as well.
And it’d also make me really happy, which is a nice bonus!
Okay, so back to the risks of investing in ETFs. When you’re learning how to invest in anything, it’s super important that you understand the risks that are involved.
One of the most common risks with ETFs is the risk of tracking error. Now, we talked about how an ETF aims to track the performance of an underlying index.
Tracking error is the difference between how the ETF performs and how the underlying index performed.
So, it’s a measure of how accurate the ETF was in doing it’s job of tracking the index. The lower the tracking error, the better.
The last thing you want as an investor is to purchase an ETF that can’t track the index it’s supposed to mirror.
Potential to pay high brokerage and commissions depending on your broker
The next risk that a lot of investors face, especially at the beginning, is that you could potentially spend a crap ton of money investing in ETFs.
You have to pay brokerage and commissions like you do when trading any stocks. But you also have to pay that management expense we talked about earlier.
And there could be other costs associated with a particular fund that investors have to pay as well.
And those costs add up over time and they can really eat into your returns. So, it’s important to keep those costs as low as you possibly can while still managing your risk.
Still face risks that you face with shares e.g. political risk, market risk
Another thing to keep in mind is that an ETF is a Christmas hamper of individual stocks. It could also contain other assets, but for our purposes, we’re talking about stocks.
And that means that your ETF will face the same risks that stocks face, and that includes things like market risk and political risk.
If you need a refresher on the risks of investing in the stock market, go back and listen to episode 16 after you finish this episode.
How to trade and invest in ETFs
Okay, so next, we’re going to talk about how to invest in ETFs. As I said before, ETFs are traded on the stock exchange just like stocks.
That means you need to buy and sell them through a brokerage account. Now, everything that’s listed on the stock exchange has a code, it’s called a ticker.
It’s just a form of abbreviation to identify a company. So, for example Apple has the ticker AAPL.
Don’t ask me where they got the extra A from, I have no idea but I think it’s weird.
So, when it comes to investing, you’ll choose a brokerage account for yourself using the advice in episodes 3 and 4.
Then, you’ll search for an ETF by the ticker code and decide how much you want to buy.
Now, how do you decide what ETFs to invest in? That’s going to be your choice depending on your investing strategy which we talked about in episode 14.
You’ll need to consider your risk tolerance, your time horizon and your desired returns.
How do I invest in ETFs in Australia
I highly recommend you spend some time Googling companies like Vanguard, Black Rock and Beta Shares.
These are financial services companies that create ETFs. They’re not the only ones, but they’re some of the most popular.
Vanguard and Black Rock are American companies with an Australian presence so that you are able to invest in foreign market ETF’s like the American stock market.
Beta Shares is actually an Australian fund manager. But you can buy ETFs for international securities through Beta Shares as well.
I’ll leave them linked in the show notes for you to check out. Have a sticky beak around their websites and see what kinds of ETFs they offer and what kind of MER’s they charge.
What do those ETFs consist of? What type of companies are included in those ETF hampers? What kind of expense ratios do these ETFs have?
Get yourself familiar with doing this kind of research and looking though the different ETF options you have to invest in. It can be a fun game trying to find the fund that tracks the most stuff while charging the lowest MER.
Priya’s investment strategy with ETFs
Now, for me personally, I invest in both domestic and international shares. Keep in mind that what I’m about to share is just for education purposes and I’m in no way providing prescriptive financial advice.
This is just what I choose to invest in based on my investment strategy. So I have 3 main ETFs in my portfolio.
I invest in VTS, which is the Vanguard US Total Market ETF. I also have VEU, which is the Vanguard All-Word Excluding the US ETF.
And then I also have A200 which is an ETF of the top 200 companies in the ASX by Beta Shares.
So, with these three ETFs, I’m invested in the entire US stock market, the largest companies in the Australian stock market and then all the stock markets in the world, excluding the US.
Now, I make an investment every single month after I get paid. It’s the best time of the month. I’m like a kid in the candy store.
And I’ve had a little bit of fun experimenting with other funds here and there, but these are the ETFs that make up the core of my portfolio. This is how I execute the investing strategy I created for myself to reach my goals.
Now, to keep my costs low, I invest in one ETF at a time. So, this month, I might buy more A200. Next month, I’ll buy more VEU and the month after that, I’ll buy more VTS.
This way, I’m only paying brokerage once per month. And because I use SelfWealth, I pay only $9.50 in brokerage per trade.
So, each month, I’m paying $9.50 in brokerage instead of almost $30 by investing in one ETF at a time, instead of splitting my money among all three.
Of course, that’s personal preference and based on your individual investing strategy. You don’t have to do that, I’m just telling you what I like to do.
How much should you invest in ETFs
Now, when it comes to how much you should invest in ETFs - that’s going to depend on your circumstances.
You’ll need to consider how much you have available to invest and how much extra money you can find for investing in your budget.
And then you need to consider your goals as well. I’m still hoping to retire early and my emergency fund is fully funded, so I’m putting as much money as I can towards investing.
Now, if I continue investing, and the market keeps giving me an average return of 8-10%, I’ll become a millionaire by the time in 45, which is when I wanted to retire.
Next weeks’ episode
And that’s all I have for you Girls on FIRE today!
My challenge for you this week is to head to papermoneyco.com and get your copy of my Investing Starter Guide, if you haven’t done so already.
It’s totally free, you just need to enter in your email address and I’ll send it to you. And then I want you to start working through it.
It’ll give you a plan to follow, step-by-step to get ready to start investing and building real wealth.
On next weeks’ episode we’re going to taking a deep dive into bonds, which are another passive option that a lot of investors choose for their portfolios.
We’ll cover what they are, how they work and how they can help you reach your financial goals.
It’s going to be a super interesting episode so you’re definitely not going to want to miss it.