Imagine you're at a party, and the topic turns to investing. Someone mentions they've invested in exchange-traded funds (ETFs) and everyone nods approvingly. Now you may not have experienced this exact scenario, but it’s not unlikely given the rising popularity of ETFs. It seems more investors, especially Australian long-term investors, are adding ETFs to their investment portfolios. Their popularity appears to be increasing at a faster rate than more traditional methods like individual stock and mutual fund investing. But why?

Though no asset is perfect for all investors, in this article, we’ll explore why ETFs have grown so popular. We’ll also look at how they compare to individual shares and their role in a long-term investing strategy . Whether you're new to the investing party or you’ve been around a while, understanding the drawcards of ETFs can help you make informed decisions. Plus, you can contribute valuable insights to your next investing conversation. So let's get you clued up on ETFs.

What are exchange-traded funds?

For those new to the investing scene, let us introduce you to ETFs and how they work. An ETF is a type of investment that's traded on an exchange, like the Australian Securities Exchange (ASX) . They work like individual stocks, but instead of investing in one company, exchange-traded funds hold a collection of assets. These assets might include shares, bonds, or other securities across asset classes – similar to a mutual fund . An ETF can be traded like a stock during trading hours, whereas a mutual fund can only be traded at the end of the trading day. ETFs and mutual funds have a lot of similarities, however, it's worth noting many mutual funds are actively managed which can result in higher fees than ETFs.

Investing in an ETF offers a simple way to achieve diversification. When you buy an ETF, you’re effectively buying a small piece of many different investments. This spread of investments can help reduce risk compared to buying individual shares.

There are various types of ETFs, just as you can invest in different varieties of a mutual fund. Some track major market indices (index ETF), like the ASX 200. Others focus on specific sectors (sector ETF), like technology or healthcare. There are even ETFs that invest in bonds ( bond ETF ) or commodities (commodity ETF). You can also choose between actively managed ETFs (active ETFs) and passively managed ETFs (passive ETFs).

ETFs can be an efficient way to invest in a broad range of assets. They also aim to offer simplicity, flexibility, and a direct path to diversification. These are just some of the reasons long-term investors are drawn to this investment type versus investing in an individual stock or mutual fund.

Why have ETFs become more popular with long-term investors?

ETFs have become a favourite among long-term investors for several reasons. They offer unique potential benefits that cater to those looking to build a stable and diversified portfolio. These benefits include:

• Diversification
• Lower costs
• Flexibility
• Liquidity
• Transparency
• Access to different markets and sectors

Each of these features makes investing in an ETF a potentially attractive option for investors committed to the long-term vision. Now, let's look at these features one by one.

Diversification

Investing in an ETF provides diversification by holding a variety of assets in one investment. This spreads risk across many investments, potentially reducing the impact of any single asset performing poorly. This can mean greater stability and potential for steady growth.

For example, consider an ETF that tracks the ASX 200 . When you invest in this ETF, you’re investing in the top 200 companies listed on the Australian Securities Exchange. If one company faces a downturn, the overall impact on your investment is lessened. That’s because it’s balanced by the performance of the other 199 companies.

Lower costs

As a passive investment, ETFs are known for their comparatively low costs, which can be an advantage for long-term investors. They typically have lower expense ratios and management fees compared to other investments, like actively managed funds . This means more of your money stays invested, helping you build wealth over time.

For instance, an index ETF might have an expense ratio of 0.10%. This means you pay $1 for every $1,000 invested per year. In contrast, a managed fund could have an expense ratio of 1%, costing you $10 for every $1,000 invested. Over time, these cost differences can add up, significantly impacting your overall returns.

Flexibility

You can buy and sell an ETF throughout the trading day at market prices, just like individual stock. Some other investments, like a mutual fund, can only be traded at the end of a market trading day. The flexibility of ETF investing allows for quick adjustments to your investment strategy when needed.

For example, if you hold an ETF that tracks the technology sector and see an opportunity in healthcare, you can sell your tech ETF and buy a healthcare ETF in the same trading day. This flexibility enables you to respond promptly to market changes or shifts in your investment goals.

Liquidity

With buying and selling an ETF, there have historically been many buyers and sellers. This means you can trade them easily without significantly affecting their price. This is particularly useful if you want to quickly adjust your portfolio, or if you need to access some of your investment funds for an unexpected expense. Selling an ETF is generally straightforward, and you can typically have the cash in a few days. This ease of access can make an ETF a convenient option for long-term investors who need occasional liquidity.

Transparency

An ETF fund manager will regularly disclose their holdings, unlike a mutual fund which will sometimes only disclose holdings quarterly. The regular disclosure of an ETF means you always know exactly which assets you own. This openness helps you make informed decisions and understand your investment better.

For example, most ETFs publish a daily list of their holdings. If you invest in an ETF that tracks the ASX 200, you can see a detailed breakdown of all 200 companies in the fund. This level of transparency allows you to monitor the fund's performance and ensure it aligns with your investment goals.

Transparency also builds trust. Knowing exactly what you're invested in can help reduce uncertainty and provide peace of mind. It can also allows you to track your investments more effectively and feel confident in your long-term strategy.

Access to different markets and sectors

By investing in an ETF, you can diversify your portfolio across various industries and regions without the complexity of managing multiple individual investments.

For example, if you want to invest in international markets, you can buy a total global ETF that includes shares from companies around the world. This gives you exposure to global economic growth and can reduce the risk of being too concentrated in one country's market.

Or if you're interested in renewable energy, you can invest in an energy ETF focused on clean energy companies. This allows you to tap into growing sectors that might be difficult to invest in individually.

What about individual stock? Are they still popular?

Investing in individual stock remains popular among many long-term investors. However, ETFs have seen a significant rise in popularity over recent years. Many investors still value the potential high returns and control offered by individual shares. Even so, the simplicity, diversification, and lower costs of ETF investing have made them increasingly attractive, especially for long-term investing strategies.

Individual stock investing offers unique advantages, but also comes with specific challenges.

Advantages of individual stock

• Potential for high returns : Investing in the right company can lead to significant gains. Successful companies can provide substantial returns over time.
• Active management and control : Investors can choose and manage their own portfolio. This allows for a personalised investment strategy tailored to individual preferences and beliefs.
• Dividend income : Some individual shares pay dividends, potentially providing a regular income stream in addition to potential capital gains.

Challenges of individual stock

• Higher risk and volatility : Individual stock can be more volatile. The performance of a single company can, therefore, significantly impact your portfolio.
• Time and research : Managing a portfolio of individual stock requires extensive research and ongoing monitoring. This can be time-consuming and requires a deep understanding of each company.
• Lack of diversification : Holding individual stock can lead to a less diversified portfolio, increasing exposure to specific risks.

How do ETFs compare to individual stock?

To understand the distinct advantages and challenges of individual stock compared to ETFs , it's helpful to examine them side by side. The table below highlights key differences between these two investment options for long-term investors.

Feature	ETF	Individual stock
Diversification	Broad diversification with a single purchase	Requires multiple purchases for diversity
Cost	Generally lower fees	Can involve higher trading and management costs
Flexibility and liquidity	High, traded throughout the day	High, but depends on the specific stock
Transparency	High, regular disclosure of holdings	Variable, depends on company reporting
Access to markets/sectors	Broad, easy access to various sectors	Requires individual stock selection

Choosing between an ETF and individual stock

Deciding whether to invest in an ETF or individual stock depends on your goals and risk tolerance.

Your investment goals determine what you aim to achieve. Are you saving for retirement, a home, or your children's education? Long-term goals usually span over several years or decades. ETF investing can be beneficial for these goals because they offer diversification and stability. For example, if you're saving for retirement in 20 years, an ETF that tracks a broad market index can provide steady growth with lower risk. (It's important to note, however, that all investment strategies bear risk – including long-term investing in ETFs.)

Risk tolerance is your ability and willingness to endure price movements. If you have a high level risk tolerance, you might prefer individual shares. They can offer higher returns, but come with more volatility and risk. For instance, if you're comfortable with the ups and downs of the stock market and want the potential for significant gains, investing in individual tech companies might suit you. But remember: gains are never guaranteed in any asset class.

But if you prefer stability and comparatively lower risk, ETF investing could work for you. An ETF spreads risk across many assets, potentially reducing the impact of any single investment's poor performance. A balanced ETF portfolio can provide consistent returns without the stress of constant market monitoring.

Roles in long-term investing

The different features of an ETF versus individual stock can make them complementary investments in a long-term investor’s portfolio. Many long-term investors use a core-satellite approach , combining ETFs and individual shares. The "core" of the portfolio consists of ETFs, providing a stable foundation with broad market exposure and diversification.

The "satellite" portion involves selecting individual stocks to complement the core. These shares can target specific opportunities for higher returns or focus on particular sectors or companies of interest. This approach allows investors to benefit from the general stability and simplicity of ETF investing while still pursuing the potential high rewards of individual shares.

For example, an investor might hold an ETF that tracks the ASX 200 as the core of their portfolio. To enhance this, they might add individual shares in a promising tech company or a high-dividend utility company. This blend of ETFs and individual shares can offer a balanced strategy, combining broad diversification with targeted investments.

While ETF investing provides many benefits for long-term investors, individual stocks still hold significant appeal. A core-satellite approach can effectively integrate both. It takes advantage of the strengths of each to create a strong, diversified investment portfolio.

Bring it back to your goals

ETF investing has gained popularity among long-term investors for many reasons. As we covered, they can offer diversification, low costs, flexibility, transparency and access to various markets and sectors. These benefits make them attractive for building a stable and diversified portfolio. Individual shares also continue to play a key role in long-term investor portfolios, and can complement an ETF-based strategy if they align with your risk tolerance.

As an investor, you have the power to choose what works well for you. Take the time to assess your needs, explore your options, and build a portfolio that suits your long-term vision.