Question

James and Sarah, a married couple of are looking at investing some of their money in the stock market. James has a list of fifteen stocks he think can generate high returns. He wants to trade stocks aggressively when opportunities present themselves. Sarah says that she would prefer investing the money in the S&P 500 etf and holding it.

1. Sarah’s strategy would best be described as a

A. Active strategy

B. Market timing strategy

C. Passive strategy

D. None of the above

2. Which is the advantage of Sarah’s strategy:

A. Lower trading costs

B. Lower fees

C. Diversification

D. All of the above

Answer 1

1. ETFs just mimick the index they are linked to. Hence, investing in ETFs is a passive strategy, as the constituents and their propostion in the fund will just follow the index.

So, Sarah's strategy is Passive Strategy (Option C)

2. Since, ETF's just follow an index, hence, change in portfolio happens only when there is a change in the index, which doesn't happens frequently. Hence, no. of changes happening in the fund's formation is low, so lower trading and hence lower trading costs.

Also, Since ETF's don't need special skillsets for managing them, hence, lower fees.

Since the ETF would be based on S&P500 (constituting 500 stocks from wide range of industries), hence the fund will benefit from wide diversification.

Hence, option D is correct.