Why ETFs are the darling of the early retirement movement

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There are broadly two types of people: those who say no to barista coffee so they can buy more ETFs, and those who think ETFs are something to do with EFTPOS but aren't too sure.

I was in the second camp at one point.

Then I discovered the joys of ETFs and why they are favoured by the early retirement crowd.

etfs early retirement investing for FIRE

What is an ETF?

Exchange traded funds (aka ETFs) are, in broad terms, a diversified investment vehicle. They are the brainchild of Jack Bogle, who first created Vanguard index funds in 1976.

The premise of index funds is that rather trying to beat the market, it's easier to go along with it by creating a basket of shares that mirror an index.

Danielle Ecuyer, author of Shareplicity, likens buying ETFs to buying a bag of lollies.

"It's a wrapper that reflects an underlying basket of shares that is normally an index - but it can also be thematic, for example, clean energy, cyber security, or financial services," she says.

An ETF is basically the same index fund but traded on the share market.

According to Kurt Walkom, co-founder of share trading platform Pearler, an index fund and an ETF are the same.

But with an ETF, the fund manager decides to list on the share market so that the fund can scale better. People in the FIRE movement typically prefer ETFs over index funds as the fees are slightly lower even though it's essentially the same product.

My ETF journey

I opened my first index fund in 2010. A few years earlier I had participated in a local share trading course. One week, the instructor mentioned something called an index fund that had low fees and a diversified portfolio. I was sceptical: it sounded too good to be true. But intrigued, I began to investigate before starting a Vanguard product with an initial investment of $5000.

When my marriage ended in 2014, I sold the joint index funds to ensure cash during a difficult time. I later started a solo index fund to store savings until the property consent orders were implemented.

Once I got ownership of my own home, I sold the index fund to help pay down the mortgage aiming to create sufficient equity to give myself an emergency fund. More recently, I started reinvesting in ETFs during the depths of the market slump last year.

As my new hubby approaches retirement, we are gradually selling down investment properties and investing into ETFs. We love the ease of ETF investment and I've become a bit addicted to checking our growing ETF portfolio balance online.

ETFs and FIRE

The financial independence retire early (FIRE) movement loves a good ETF.

The FIRE movement, made popular by financial influencers such as Mr Money Moustache aka Peter Adeney is about living frugally and investing prolifically to reach financial independence early, relying on the power of compound interest.

Not all FIRE devotees use ETFs as their investment vehicle of choice, but they are easily the most fashionable.

Walkom says ETFs are popular with those on a FIRE journey because it is easy to track financial independence goals.

"You want to get a passive income that covers your expenses - then you are FIRED," he says.

Ecuyer believes younger people in particular are looking for investment options outside of a low-interest bank account - especially to turbo-charge saving for a home deposit. And younger investors haven't been scarred by the global financial crisis.

"They are saying hey, we can't really afford to invest in property in property at the moment, but we want to do something with our savings so that maybe we can afford to buy a property," she says

Technology has also made ETFs more accessible - and fun.

No longer do you need a stockbroker and a significant lump sum to trade; online share trading platforms that use gamification have made it easy - and cheap - to invest in ETFs. Micro-investing sites such as RAIZ, Spaceship and CommSec Pocketbook also make it easy for young people to invest small amounts in index funds.

Advantages and disadvantages of ETF investing

A key advantage of ETFs is that they offer diversification, which helps reduce risk.

If you only invest in one company, it's a bit like placing all your money on a horse in the Melbourne Cup: if it wins, you will get a big payout but there is a high chance you might not back the winner. In contrast, index funds and ETFs allow investors to back all the horses in the race.

The diversified nature of ETFs also means that you don't need to spend hours and hours researching stocks before deciding what to invest in.

Walkom says that instead of spending time on research, people can channel that time into working extra hours to earn more money to invest into more ETFs.

But buying the basket also means accepting the bad eggs as well as the good; sometimes that can mean an average result despite individual standouts.

According to Scott Phillips, chief investment officer at the Motley Fool, an ETF investment means you get a market return minus some fees.

"For most people, that's enough," he says. "But if you have an appetite for a bit more risk, and you want to beat the market, individual shares are the way to go." He also cautions that in the Australian market, it is difficult to get a truly diversified ETF as the top companies on the ASX are heavily weighted with financial services and mining.

Another key advantage of ETFs is their low fees. But Phillips warns that not all ETFs are the same.

"These days there are more ETFs in the US than stocks," he says. "Nearly every fund manager creates ETFs - and then wants you to buy theirs. Why would someone invent an ETF? They want you to buy it, and if you buy it, you're paying fees." He advises people to understand what they are investing in to minimise this risk.

ETFs have been in Australia for 20 years, and in that time, they have witnessed rapid growth. They are here to stay. With rapid advances in technology, I can only imagine what they will be like when they hit 40.

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Serina Bird is a proud frugalista who has amassed a million dollars through frugal living. Serina's first book, The Joyful Frugalista, is out now. She blogs at The Joyful Frugalista, and her podcast is available on Spotify and Apple Podcasts. Serina is the founder of the The Joyful Business Club.