Saving, Investing and Growing Money · Lesson 5 of 9 · 13 min

Diversification, index funds, ETFs and the cost of fees

You cannot control what markets do, but you can control how spread out your money is and how much you pay in fees. Both matter more than most people realise.

Diversification: not all eggs in one basket

The FCA describes diversification as spreading investments across different products and markets so you rely less on any single one.
Its example is an ice-cream van that also sells umbrellas: whatever the weather, something sells, so income is steadier.
Investor.gov explains that spreading money across asset classes, and across many holdings within each class, can offset losses when one investment does badly.
The FCA is clear that 'Diversification can't totally eliminate risks', and for a while a single company's shares may perform as strongly as a diversified mix.
The FCA suggests that even experienced investors who accept more risk limit high-risk investments to about 10 per cent of their portfolio.

Funds, index funds and ETFs as concepts

A fund pools money from many investors to buy many investments; each share of the fund is a slice of the whole portfolio, Investor.gov explains.
A market index measures the performance of a 'basket' of securities meant to represent a market. You cannot invest in an index directly.
An index fund 'seeks to track the returns of a market index', usually by holding the securities in that index, according to the SEC.
An exchange-traded fund (ETF) is a fund whose shares trade on a stock exchange during the day; many ETFs are index funds.
Actively managed funds try to beat the market and depend heavily on the manager's skill; index funds follow a passive strategy and simply aim to match the index before fees.

What index funds cannot do

The SEC warns that an index fund is subject to the same general risks as the securities in its index: if the market falls, the fund falls too.
The SEC notes index funds may trail their index because of fees, expenses and trading costs, and may not match it exactly (tracking error), for example when they hold only a sample of the index's securities.
A narrowly focused fund (one sector or one country) may not diversify you much. Investor.gov suggests checking funds' top holdings, for example to make sure two funds you own are not holding the same things.
The SEC also cautions that not every index fund is cheaper than every actively managed fund, so always check the actual costs.

Why fees matter: worked example

Fund fees are usually taken from the fund's value each year, so you pay them indirectly and may not notice them.
The SEC's own example: 100,000 dollars for 20 years at a 4 per cent return grows to about 208,000 dollars with 0.25 per cent yearly costs, but only about 179,000 dollars with 1 per cent costs.
Our dirham example: AED 10,000 left for 30 years at an assumed 6 per cent a year before fees becomes about AED 57,435 with no fees.
With a 0.2 per cent yearly fee (net 5.8 per cent) it becomes about AED 54,271; with a 1.5 per cent fee (net 4.5 per cent) it becomes about AED 37,453.
That 1.3 percentage point difference in fees costs about AED 16,818 over 30 years, more than one and a half times the original AED 10,000.

Questions to ask about any fund

What does it hold, and in how many countries and sectors?
What is the total yearly cost, and are there extra charges to buy, sell or hold it on a platform?
Is it Shariah-compliant, if that matters to you?
Convert any percentage fee into a money amount, as the SEC's fee bulletin does: a 0.25 per cent fee is 25 dollars a year for every 10,000 dollars invested, and a 1 per cent fee is 100 dollars.

Practise in real life

Tick each one off when you have done it.

Look up the meaning of 'expense ratio' or 'ongoing charges figure' and write a one-line definition in your own words.
Use an online calculator to compare AED 5,000 over 20 years at 5 per cent with fees of 0.25 per cent versus 1.25 per cent.
Draw your own 'ice-cream and umbrellas' example of diversification for a small business you know.

Remember

Diversification spreads risk but cannot remove it.
Index funds aim to match a market index; they still fall when the market falls.
ETFs are funds traded on an exchange; many track an index.
Small yearly fee differences compound into large sums over decades.

Note: This lesson is general education, not personal financial advice, and it does not recommend any product, firm or app. Past performance does not guarantee future returns, and all worked examples use simple assumed rates, not predictions. Our fee example uses a simplified method (return minus fee each year); real fund charges are calculated slightly differently, which changes the figures by a small amount. The ETF definition is general background; the SEC bulletin we used confirms that index funds can be structured as ETFs.

Check yourself

1. What does an index fund aim to do?

2. Can diversification remove all investment risk?

3. In the SEC example, 100,000 dollars over 20 years at 4 per cent grows to about 208,000 dollars with 0.25 per cent costs. Roughly what does it become with 1 per cent costs?

4. What happens to an index fund when the market it tracks falls sharply?

5. AED 10,000 for 30 years at 6 per cent before fees. Roughly how much does a 1.5 per cent fee leave compared with a 0.2 per cent fee?