An exchange traded fund (ETF) is a managed fund that is traded on the stock exchange. When you purchase ETFs you are buying a basket of shares or assets. They are a low-cost way to earn a return similar to an index or a commodity and they can also help to diversify your investments. Units can be bought or sold though a stockbroker, the same way that you buy and sell shares.
ETFs come in different shapes and sizes including, shares or bonds, domestic or international, small cap or large cap, hedged or unhedged. They can also be sector specific products such as commodities, property, gold, oil and banks. There are even diversified ETFs that offer low-cost access to thousands of securities across a wide variety of asset classes in a single trade.
How do ETFs work?
In Australia, most ETFs are a passive investment that don't try to outperform the market. The roll of the fund manager is to track the value of both an index, for example the ASX200 or S&P500, and a specific commodity, such as gold. The value of the ETF rises or falls with the index or asset they are tracking.
Types of ETFs
ETFs can be either physically-backed or synthetic.
Physically-backed ETFs invests in all of the securities in the index or a sample of the securities in the index.
In relation to financial assets, a security is an investment such as shares or bonds that can be traded in financial markets.
Synthetic ETFs hold some of the underlying assets and use swaps to copy the movements of an index or asset. If an ETF is synthetic, it must use the word 'synthetic' in its name. Synthetic ETFs have an additional risk that the counter-party in the swap agreement could fail.
In a swap agreement, a counter-party agrees to pay the difference between the value of the ETF's assets and the value of the assets or index it is designed to track. When a synthetic ETF enters a swap agreement, this creates counter-party risk.
When you invest in an ETF, you don't own the underlying investments. You own units in the ETF and the ETF provider owns the shares or assets.
Advantages of investing in ETFs
Diversification: ETFs allow you to buy a basket of shares or assets in a single trade. This can help to diversify within an asset class. ETFs allow you to invest in markets or assets it can be difficult or expensive to access. You can also diversify across ETFs so there's less chance of loss if an ETF provider collapses.
Transparency: ETFs publish the Net Asset Value (NAV) daily on the ASX. This can help you track how the underlying assets are performing and if the price of the ETF is close to the NAV.
Low cost: Many ETFs have a low management expense ratio (MER). They're usually cheaper than most actively managed funds.
Easy to trade: You can buy and sell ETFs during the trading hours of the exchange.
Disadvantages of investing in ETFs
Market or sector risk: While ETFs can help you diversify, the market or sector the ETF is tracking could fall in value. For example, if the ASX200 declines, the value of your ETF investment will also fall.
Currency risk: If the ETF invests in international assets, you face the risk of currency movements impacting your returns. Some ETFs are 'currency hedged' which removes this risk.
Liquidity risk: Some ETFs invest in assets that are not liquid, such as emerging market debt. This can make it difficult at times for the ETF provider to create or redeem securities.
Tracking errors: An ETF's price can move away from the value of the index or asset it's designed to track. This can be due to illiquidity of the underlying assets, fees, taxes and other factors. This means you could buy or sell when it's not trading at the NAV.
Fees and costs
ETFs are generally a low-cost investment and substantially lower in cost than investing in the same exposure of individually purchased shares. An ETF's management fee is made up of the issuer's responsible entity fee and recoverable expenses. The management fee is calculated daily and deducted from the fund's NAV. There may be other fee and costs charged within the ETF, so check the product disclosure statement before you invest. In addition to this, brokers fees are charged when you buy or sell an ETF to cover the cost of completing the transaction on the stock exchange.
A product disclosure statement (PDS) contains a lot of information you'll need to know about an ETF. It includes information on what index, sector or asset the ETF returns aims to replicate, the fees and costs, the risks of investing in the ETF, and how to complain if you have a problem with the ETF.
Choosing between ETFs and traditional index managed funds
Your decision will ultimately depend on which type of investment best suits you. Here are some factors to consider:
ETFs
Comfortable trading on the ASX
Make large or irregular investments
Require hands-on control of the price you trade
Managed funds
Prefer to access a single unit price for investing
Make ongoing, small contributions
Want to set up an ongoing automatic investment plan
We hope this article has helped you to make sense of what ETFs are. If you still have some questions, send through an email with as many questions as you've got and we'll do our best to share some more helpful insights.
