by Siew Cheng Hoe

Created on: February 16, 2009   Last Updated: August 26, 2009

Diversification is key to reduce risk. You do not want your hard earned money to vanish into the air. You can enjoy the benefit of diversification when you invest in ETF.

What is ETF? What are the benefits of investing in ETF?

ETFs, which are short for Exchange Traded Funds, work in a manner similar to mutual funds. ETFs generally track indexes, be it the broad-based index like S&P 500 or industry-based index. Large block of shares are bought and chopped into smaller pieces and offered to you in the open market.

ETFs provide diversification for the investors at a low cost. For example, instead of buying into each and every company in the Nasdaq-100 index, the investor can now buy from the ETF that track the Nasdaq-100. So a single transaction can achieve the diversification that formerly need 100 transactions.

ETFs reflect the market risk in the broad-based index or industry/sector risk in the industry-based index. Investors who are considering ETFs that track international indices or a specific country index, do take note that there are additional risks in the form of economic and political instability occuring in many countries.

In a sense, while ETFs reduces risk in the form of diversification. It is not a risk free investment. Do not be fool by the term "safe investment".

There are 2 major differences between ETFs and mutual funds:

a. ETFs have no loads, since they are tracking the indices, and have low expense ratios. In mutual funds, we are looking at the expertise of fund managers to pick stock. A lousy fund manager may perform much worse than index. ETFs do not have this kind of problem;

b. ETFs are continuously priced in the market. It provides more transparency than mutual funds. Investors find it easier to buy and sell ETFs.

However, beware of the ease of buying and selling. Investors who are tempted to buy and sell frequently may end up paying more in transaction costs.

Now let us talk about the disadvantages of ETFs.

Some folks are so familiar with a particular industry that they can pick up the King of the kings and Lord of the lords. They do not need the diversification provided by ETFs. They are much better off putting their money into the best company.

Some folks with very long time horizons also do not need the ease of buying and selling feature of ETFs. If they are only going to buy and sell once in every 30 years, it is best that they invest time and effort to seek out the King of the Kings, Lord of the Lords and invest in it.

So dear folks, know yourself and your investment needs first before making your investment. May you make tons and tons of money out of your investment!

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