ETFs are “Exchange Traded Funds” and they’re awesome for FIRE portfoilios.
Here’s a simple primer to ETFs and why they’re a big part of most FIRE strategies – such as in my 2021 FIRE campaign plan.
Investing in shares and bonds comes with risks. There’s a risk that the company falls on hard times and the share price drops, right at the time you’re trying to sell and set sail on the seas of financial independence. There’s a risk that they go bust and you lose all your money.
Oh, and there’s the risk that the company you thought was going to be a superstar unicorn turns out to be a donkey with a carrot on its head, limping along while every other share you could’ve bought zooms on past. Basically, not doing something is an opportunity cost, so putting your money into a company that sucks comes at a missed opportunity of buying that Amazon Mark II share.
So, how might someone mitigate these risks?
Diversification is key – the basics of a fund
“Diversification” in simple terms is owning enough different assets that something does well and compensates for losses of others. Hopefully, by diversifying, you make a net gain by having more growth than loss.
This is where a “fund” kicks in and ETFs appear.
Different types of fund exist in the world. My pension uses a lot of mutual funds, for example.
ETFs are a type of fund. They are slightly different to mutual funds because you can buy them on an Exchange (such as the London Stock Exchange), and they trade like a share. Their price is based on the value of what the fund owns.
If you search for FIRE investing tips on the web, you’re going to read a lot of comments about ETFs. This is because you can buy them in an ISA. ISAs are tax-exempt accounts, so you absolutely 100% want one for investing.
Funds exist so that you can buy into one fund and the fund holds a big collection of shares. A classic fund type would be a “FTSE 100” index fund, which would own a bit of all the top 100 companies on the Financial Times/ London Stock Exchange index.
[Do I get brownie points for explaining what FTSE is?]
This means that if I buy funds, I’m getting a ton of diversification in one purchase. If I buy £100 of a FTSE 100 index fund, my £100 is spread among the whole lot of the FTSE 100. Sure, some of them might go bust, but all 100 of the top 100 public companies in the UK going bust is significantly less likely, right?
Now imagine if I spread this around the world, in a global fund… Significantly less likely. Plus, if the whole world goes bust, money will be worthless anyway in the post-apocalyptic wasteland.
Active and passive funds
Funds behave according to rules. They tell you in their fund summaries and Key Information Documents what those rules are.
Funds are typically either active or passive.
Active funds
These have a fund manager who buys and sells things to make the fund do what it claims to do. Fund managers can seize opportunities and take advantage of markets to bag a bargain or shield the money when economic hardship is coming.
The downside is that the fund manager is a human and needs to get paid. As a result, the fees for active funds are higher than passive funds.
In recent years, there has been a lot of evidence to suggest that active funds don’t actually perform any better than passive funds. Clearly, there are exceptions, but how will you know if you’ve picked an exceptional fund until the results are in and it’s too late?
Passive funds
Passive funds track an index – basically, a pre-selected category of something.
There are different indices out there, all doing different things. Famous indices include the FTSE 100, FTSE 250, FTSE All-Share, Standard and Poors top 500 (S&P 500), MSCI World Index… the list is infinite, as there’s nothing to stop a company generating its own index.
A passive fund will play by the rules of the fund and buy everything available on the index. An S&P 500 fund with a 5% cap on any one asset, for example, will invest £100 among the top 500 companies in proportion to the size of the company, as long as no more than 5% of the money (e.g. £5) is paid into any company. An S&P 500 index fund without this rule, on the other hand, will just pay into all 500 companies based on their proportionate size on the list.
Passive funds are generally cheaper than active funds, as the fund managers don’t participate much except to check that the robot/ computer managing the fund is doing what it’s supposed to.
There are exceptions to this, such as for ethical investing, where a passive fund might charge as much as a cheaper active fund. However, generally, passive funds are cheaper.
What can a fund buy?
A fund can technically buy anything. Shares, real estate, bonds, commodities like gold or oil, foreign currencies – whatever the rules say the fund can own, it can.
ETFs tend to be more focused. You will generally see a mix of equity funds (i.e. funds that buy shares), fixed income funds (funds that buy bonds), blended funds (that but shares and bonds), or real estate (that buy shares in REITS – a topic for later). There are also Exchange Traded Commodities and some ETFs buy a mixture of these.
Accumulating and distributing funds
ETFs that buy shares and bonds will be listed on a stock exchange as “accumulating” or “distributing”. This is because of dividends or bond yields from the shares and bonds that the fund has bought. You’ve bought the fund, you have a right to your share of the money.
An accumulating fund automatically reinvests your dividends or your bond yield payments back into the pot. A distributing fund pays these back to you. Seriously, that’s it.
I saw this bond on the London Stock Exchange, but it’s in US$ or Euros…
Doesn’t mean you can’t buy it. However, the fund will increase by (say) 7% a year over inflation, but the money it’s in might devalue against the £, which might make this more or less impressive.
For example: you buy a $100 fund for £80. You sell it for $120 (hooray!) but since the time of buying it the pound has gotten stronger against that dollar, and your $120 is now worth the same $80. Balls.
On the other hand, the pound might crash against the dollar, and your $120 might buy you £150. Who knows?
Unless you’re buying into a niche index or active fund, most funds offer you options to buy in £, $ or Euro anyway. That said, if you’re buying a fund that trades in other currencies – such as an S&P 500 fund that buys US shares in $ – you might find that a lot of currency fluctuations are priced in anyway, and studies suggest that it doesn’t matter over a long term.
I’m a long way from being an expert on currency markets and this tends to get quite technical for short-term investors, but over my time horizon I’m choosing not to worry too much about currency risk.
Market risk
You can buy ETFs that cover the whole world, or combinations that cover every geographical area of the world with a stock exchange. This is called geographical diversification . I’m a big fan – I can be pretty confident that someone is making money somewhere in the world!
You can even buy ETFs that are diversified by industry, or own combinations of ETFs that cover all the industry types you want. These are usually called “thematic” ETFs and I own a couple for industries that I think are going to do well.
There is also market risk. This is the risk that people just stop investing in something, and the value drops across all types of asset in that class. For example, during March 2020 the COVID-19 pandemic made all stock markets drop dramatically, by around 30%. This is market risk: some shares did rebound and hit new highs straight away, but the whole market was subdued as panicked investors pulled or their money out of the stock markets.
Market risk can also be reduced by diversification. Geographical diversification helps a bit, but having a mixture of shares, bonds, commodities, cash, real estate and maybe even cryptocurrency can help to reduce market risk.
With the exception of crypto funds, which are no longer available in the UK, most of these can be bought as ETFs for a portfolio to reduce market risk.
Why ETFs are a huge chunk of most good FIRE stragtegies
ETFs are great investing tools for FIRE.
As a retail investor, your average FIRE person is going to be paying in small amounts each time. Sure, £1,000 might seem like a lot to you, but in the big scheme of financial markets it barely makes a dent.
By using an ETF, you can diversify easily and cheaply. This means that you can take lots of risks at the same time, reasonably confident that your money will grow.
It also means that you don’t need to read into the specifics of individual companies too much. If one company out of 1,000 fails, your portfolio will barely decrease.
Companies fail all the time. Remember Woolworths? However, buying ETFs across a large chunk of the market means you’re more in line with the average. That’s a good thing! World stock markets are believe to have given 10-year returns at an estimated annual rate of 9.2% on average over 140 years.
Can your cash savings do that?
The humble ETF then allows FIRE portfolios to reduce risk and still generate pretty decent results, without much knowledge.
What I’m using ETFs for
My pension uses mutual funds, which work a lot like ETFs but aren’t on an exchange. I choose them for this because they’re cheaper on my platforms; no other reason.
My ISA is mainly ETFs. I’ve been using a robo-investor that chose these for me, but now that I’ve upskilled myself I’m choosing my own. I am remodelling my portfolio at the time of writing, but the core of it will be a world index ETF, based on Environmental, Social and Green or Socially Responsible Investing filters.
Nothing against war, booze or porn – I just don’t like funding oil companies!
Jokes aside, ETFs have come a long way and allow you a fair but of control without sacrificing diversification. I already own a video game ETF, for example, that buys shares in any company involved in video games manufacturing. It’s doing well!
Using a small number of ETFs is also good for cost averaging, which is a technique for another post. To start with, I won’t have too much to invest, so cost averaging is going to be difficult if I can’t concentrate my money on a small number of things.
