Chapter 2: Understanding Exchange Traded Funds

Missed Chapter One? Learn more about the importance of your goals when investing in ETFs

What are ETFs?

So, what exactly are ETFs? ETFs are managed funds that, just like the shares of listed companies, can be easily bought and sold on the share market.

As with a managed fund, each unit of an ETF represents an interest in the underlying assets. However, unlike managed funds, ETFs can be traded throughout the day at prevailing market prices, which provides investors with much more flexibility and efficiency.

Depending on their particular investment focus, individual ETF products usually have hundreds, and sometimes thousands, of underlying shareholdings.

For example, instead of buying shares in Australia’s biggest listed companies separately, and paying brokerage on each transaction, it’s easy for any investor to buy units in just one ETF product that invests in all of the 300 largest companies listed on the ASX.

Similarly, there are ETF products on the ASX that offer easy access to thousands of international companies listed on share markets in the United States, Japan, China, and other countries. Other ETFs cover wider regions, such as Europe and Asia, and investments in niche market segments such as property, infrastructure, and commodities.

There are also products providing exposures to more technical trading strategies, such as minimum volatility and value.

For those wanting to balance out their investment portfolio with different asset classes, it’s also easy to buy ETFs that cover fixed income securities (government and corporate bonds) and other asset types such as cash, gold, and other commodities.

Put simply, there’s an ETF product for just about any investment purpose.

That’s why so many investors globally, either directly or through a financial adviser, are using ETFs as the core building blocks of their investment portfolios.

What are Index ETFs?

ETFs have traditionally used an indexing approach that seeks to replicate the returns of a specific market or sector index.

Index ETFs are the most common and they carry all the benefits of traditional index managed funds, such as low operating costs, diversification, tax efficiency and simplicity. They also have some of the benefits of share trading, including continuous pricing, trading flexibility and low execution costs

ETFs are structured so their value can be expected to move in line with the indexes that they seek to track, such as the S&P/ASX 300 Index in Australia. For example, a 2% rise (or fall) in an index should result in an approximately 2% rise (or fall) in the price of ETFs tracking the same index (before fees and expenses).

What are Active ETFs?

While sharing many features and benefits with index ETFs, active ETFs are different to index ETFs, most notably because they do not track indexes. Instead, they use a specific investment approach to achieve a particular outcome, such as outperforming a specific index or minimising the impact of market volatility.

Active ETFs range from factor-based active ETFs that are backed by physical assets all the way through to leveraged ETFs which obtain their exposure through complex trading strategies that offer potentially higher returns, albeit with higher risk.

As the ETF market has evolved, investors now have access to a variety of active ETF products across the risk spectrum. It is important that investors understand how the ETF that they choose to invest gains its exposure to the market as not all products are the same, which is particularly the case for synthetic based products.

How do ETFs really work?

ETFs are traded throughout the day on exchanges at share market-quoted prices, just like individual equity securities.

By contrast, managed fund units are bought and sold directly through a fund company or a financial adviser at the fund’s net asset value (NAV) at the end of each trading day.

Although they trade like individual securities, ETFs – like managed funds – are open-ended investments. That means new units can be created and existing units redeemed daily, based on investor demand. Closed-end funds and individual securities, on the other hand, generally issue a fixed number of units.

The open-ended structure of ETFs means that the normal forces of supply and demand do not determine the value of the ETF.  The fact that new units can be created when there is large demand or redeemed when there is selling means that an ETF should always trade at a value that is close the current market of its underlying assets or Net Asset Value.

How can you use ETFs in your investment portfolio?

ETFs can be a simple and cost-effective way of gaining broad market coverage across a range of asset classes.

The ease, flexibility, diversification, and low cost of ETFs make them an innovative and effective investment solutions that can be used in many different ways including to:

• Construct an investment portfolio—ETFs covering different asset types and markets can be used to build a robust, fully diversified and low-cost portfolio.
• Build the foundations of a portfolio—ETFs can be used to create the diversified “core” of an investment portfolio, which can be complemented by other investments (‘satellites’) like direct shares or more actively managed funds to seek returns above the benchmark.
• Rebalance a portfolio—Over time portfolios can move away from their initial asset allocations as the value of different assets change. ETFs can be used to correct these imbalances quickly, easily, and cost-effectively by buying or selling ETFs in the underweight/overweight asset class.
• Trade in the market—ETFs offer investors the ability to rapidly deploy cash into the market, and gain exposure to market movements while deciding on a more long-term investment strategy.

How can you invest in ETFs?

ETFs can be bought or sold on any share market trading platform, just like individual shares.

To purchase an ETF, investors select the ETF they would like to invest in. 

Using the three or four-letter ‘ticker’ code applicable to the ETF, investors can place an order to buy (or sell) on the exchange. 

Because ETFs are open-ended funds, new units can be created and existing units redeemed on daily basis, based on investor demand which means new (and existing) investors should receive a price close to its current value or 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 comprises the issuer’s responsible entity fee and recoverable expenses including custodian fees (excluding transaction-based fees), accounting and audit fees, index license fees, registry service fees, listing fees, and other administrative expenses. 

The management fee is calculated daily and deducted from the ETF’s net asset value. 

Other associated fees may include brokerage paid on buy and sell transactions, depending on the service provider used.

Quick Bits: Benefits of ETFs

• Low cost – ETFs typically cost less than traditional managed funds, and substantially less than buying individual shares.
• Diversification – ETFs can provide investors with broad exposure to entire markets, asset classes, or multi-asset class investments that offer an all-in-one investment solution.
• Tax efficiency – Due to their ‘buy and hold’ approach, index ETFs generally have a low turnover, minimising capital gains and improving long-term performance and tax efficiency.
• Liquidity – ETFs provide exposure to broad investments in liquid markets. The open-ended structure of an ETF means that it can be as liquid as the underlying securities that it invests in.
• Transparency – Most ETFs are highly transparent investments that provide investors with full visibility of what they are investing in.