How you may want to consider investing in ETF and index funds

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As beginners learning how and where to invest money in Singapore, we tend to have a unique interest in investment products that offer high dividend yield. This is the reason why many had invested in Reits such as Capitaland Commercial Trust, an associate of Capitaland and Mapletree Logistic Trust, an associate of Mapletree Investments. However, making such investments in single reits or stocks carries a high degree of investment risk. This risk can be mitigated by putting in additional work to understand more about the company and business model. It can also be assessed through a detailed investment thesis where you detail how and why you want to make this particular investment.

However, a major drawback of this method is that it requires a lot of time and effort on the part of the investor. Given a hectic day to day work schedule, it may be difficult to find the time to do the necessary research. Furthermore, the learning curve can be steep. Those who have learned to hunt for the stocks with highest dividend yield will know that there is a lot of investment foundation work to be done.

The Alternative: Index funds/ Exchange traded funds

There is an alternative and that is to either invest in an index fund or exchange traded fund. Index funds and exchange traded funds are different from specific stock investment in the sense that they are passive investments. Index funds invest passively in a basket of securities whereas exchange traded funds invest in the all the securities in the exchange. By investing in a basket which includes all the securities, an investor diversifies his risk.

To better understand why such passive investments may be ideal, it is best to do a thought experiment. Lets assume a basket has 3 stocks; A B and C. On a particular trading day, there was a 10% sell off in C whereas A appreciated in price by 10%. C however, traded sideways. Had you invested solely in C you would have 15% of your invested capital. If you have no idea as to whether to invest in A or C, the index fund or ETF allows you to buy the entire basket. While this may mean that you will have only 5% return, it is a better outcome than had you chosen to put all your capital into A.

It is worth knowing that Index funds and ETFs can also be used for sector or country specific investing. As long term investors you may be keen to increase your exposure in a particular segment of the economy or a particular country, which has optimistic growth prospects. Hence these passive instruments can be a good alternative when you are deciding how you will like to deploy your capital.

Caveat: Index funds and Exchange traded funds are different

While we have been discussing exchange traded and index funds as a type of passive investment, they are not exactly the same. Index funds are also known as mutual funds and are thus created by investment management firms. As they are created by other firms, there are a few main differences:

  1. ETF can be traded anytime as long as the market is open, Index funds can only be traded at specific cut offs
  2. ETF can come at a lower cost compared to index funds due to the additional cost incurred by the firm

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