Explain that a fund unit is a share in many companies, and say where its return comes from.
Get a pen and write down, in a single sentence, your answer to "what do you own when you buy an ETF?" Put it somewhere in view, on a sticky note or at the top of your page, because you will come back to it at the end.
People tend to answer "a stock", "a product from the bank" or "something that tracks the market". Nadia, who has just started investing, answered "a ticker on an app". Each of these is true as far as it goes, yet none of them tells you what could happen to your money. To get that far you need three things clear before you pick any fund: what a fund unit is, how the fund earns its return, and which risks owning many companies covers and which it leaves with you.
A fund pools money from a large number of investors and spends it on a big collection of investments on their behalf. The collection may be shares, bonds, or a mix of the two. In return each investor gets units. A unit is an equal slice of everything in the fund, and all units carry the same claim, whether a thousand people have invested or a million.
You don't choose the individual holdings yourself. Nadia puts S$5,000 into a fund with 500 companies in it (example figures), and she selects none of them. Whenever new money arrives, hers or another investor's, the fund manager adds to every holding in the proportions the fund's rules set out. What Nadia owns through her units is a share of the entire basket.
Running the fund is the manager's job, but the manager doesn't own the shares inside it. Usually the assets sit with a separate custodian or trustee, held apart from the manager's own business. For how custodian and trustee arrangements work for unit trusts in Singapore, see Lesson 1.1, "A unit trust is a pool you own a slice of", in the course "Unit trusts, robo-advisors and managed money compared".
An ETF is a fund with units that are traded on a stock exchange the same way a share is. You place orders to buy or sell them with your broker while the market is open. Module 4 goes into how ETF trading works and how an ETF chooses the companies it holds.
Part of your return comes from changes in value. Every trading day the market puts a price on the shares the fund holds. When those holdings rise in value, so does each unit, and when they fall, each unit falls with them.
The other part is income. A lot of companies pay dividends, which the fund receives. A fund may hand these to investors as cash a few times a year, or it may reinvest them inside the fund, in which case the unit price goes up instead. Both ways, the dividends count towards your return. Lesson 4.4, "Read one ETF factsheet and find six facts", teaches you to check which approach a given fund takes.
Running costs are subtracted from the return. Each fund charges a yearly fee, taken out of the fund's assets. You won't receive an invoice for it, yet it lowers what you end up with. Lesson 5.3 looks at what this fee does to your money over decades.
Diversification is holding many companies at the same time. Its main purpose is to keep a single company from ruining your result.
Take Nadia's S$5,000 again and two ways she could invest it. In the first, it all goes into the shares of one company. If that company collapses, she could lose most of her money or all of it. In the second, it goes into the fund of 500 companies, held in equal amounts, and one company collapses. Her loss is S$5,000 / 500 = S$10, which is 0.2% of what she put in (S$10 / S$5,000).
Real funds don't hold equal amounts. The biggest companies get a larger slice, for reasons set out in Lesson 4.1. Even with uneven weights, a single company failing makes only a small dent in the fund.
This protection is genuine, and it is the main reason a fund is a sensible first investment. You don't have to know in advance which company will do well, and a single bad pick can't sink you.
Spreading money across companies deals with the risk that comes from individual companies. It does nothing about the risk that the whole market falls at the same time. During a recession, a financial crisis or a pandemic, most companies drop together, and a fund full of them drops as well. How many companies you hold makes no difference once the entire market is falling.
Suppose the market as a whole falls 30% (an invented example). Nadia's S$5,000 goes down to about S$3,500 (S$5,000 x 0.70). Holding many companies shielded her from any one of them failing, but did nothing for her in a bad year for the market. Market-wide falls are the reason Lesson 2.1 kept short-term money out of shares, and Module 7 shows what such a fall looks like in your own account.
With a broad fund, one company can't do you much harm, but the market as a whole still can, for a while.
Go back to the sentence you wrote at the start and see how much of the above it already covered. Then, before you go on, try explaining a fund in plain words, the way you would to a friend who has never invested. If you can say what you'd own and what could make its value fall, you're ready for the exercise that follows.
In two sentences of your own, explain what you would own if you bought a fund holding 500 companies.
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