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Friday letters are usually dedicated to taking questions from our community. Do you have a question for us? Please feel free to
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Question
Are ETFs also good for long term investments like stocks? If yes, do they offer interests or dividends too?
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Answer
Let’s start with understanding what ETFs are. You should see Exchange Traded Funds as a basket filled with a variety of investments like individual stocks. If you want to invest in the stock market while diversifying your portfolio, ETFs come in quite handy. As compared to mutual funds which are professionally managed and require higher fees, ETFs often offer much lower fees. This is because they are passively managed as they only follow an index. These reasons make them an excellent option for long-term investing, offering several advantages similar to those of stocks, along with additional benefits.
Here is an interesting real life story that proves this. In 2008, Warren Buffett took on a bet to challenge the hedge fund industry who already charged very high. Buffett's contention was that, including fees, costs and expenses, an S&P 500 index fund (which works very similarly to an ETF), would outperform a hand-picked portfolio of hedge funds over 10 years. He backed his bet with two basic investing philosophies against each other: passive and active investing.
The result says “at the end of 2016, Buffett's index fund bet had gained 7.1% per year, or $854,000 in total, compared to 2.2% per year for Protégé's pick—just $220,000 in total.” You can read the story in full here.
There is however a type of ETF that works best as a short-term investment. Infact, you’ll be running into losses if it is invested in for a long-term. They are called inverse ETFs, speculative short-term investments intended to be bought and sold during a single day. These ETFs are used to profit from market declines but can be complicated and risky.
But if they offer interests or dividends, ETF issuers collect dividends paid by the individual company whose stocks are held in the fund and then the issuers pay to the investors either directly or reinvested. This means as an investor, you are getting access to a selection of dividend stocks within a single investment.
In summary, ETFs except inverse ETFs, are well-suited for long-term investing due to their diversified nature and low-cost structure. By investing in a single ETF or index fund like Warren did in S&P 500, you gain exposure to a diversified portfolio of assets, which can help mitigate risk and provide more stable returns over the long term.
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Question:
What do you mean by “in the dollar mutual fund, the principal is not guaranteed”?
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Answer
Mutual funds work pretty much the same as ETFs in that it invests in a pool of funds that offers a diversified portfolio of investment except that they are actively managed and way more expensive.The principal, in the context of investing, is the initial amount you invest into a fund. The principal in this case is a dollar mutual fund, with the expectation of generating returns over time.
Dollar mutual funds are mutual funds that are invested in US dominated instruments like the Eurobonds. A Eurobond is a debt instrument that's denominated in a currency other than the home currency of the country or market in which it is issued. It doesn't mean the bond was issued in Europe or in European currency. This can be significantly affected by factors like inflation, interest rates and foreign exchange rates, thereby affecting the overall performance of your funds.
When it is stated that the principal is not guaranteed in dollar mutual funds, it means there is no assurance or promise that the initial investment amount will be preserved or protected from loss. Unlike certain fixed-income investments like your bank savings accounts that offer principal protection, mutual funds are not immune to market risks and fluctuations. Fluctuations could be as a result of issues like economic conditions, foreign exchange rates which can have a significant impact on the value of your investments.
Please note that this doesn’t mean the dollar mutual funds are inherently risky or unsuitable, especially as you have professionals that actively manage your portfolio and mitigate the risk of that happening. Each mutual fund has its own investment objectives, risk profile, and potential returns, which should align with your investment goals, and risk tolerance.
In summary, the statement that the principal is not guaranteed in dollar mutual funds reminds you of the risks associated with investing. While there is no assurance of preserving the initial investment amount, dollar mutual funds provide opportunities for investors to participate in international markets and potentially achieve their financial goals over time with the aid of professionals managing your funds.
Never forget, MoneyAfrica is committed to provide guidance and support to help you make informed investment decisions. Join our community here!
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