What is an exchange traded fund (ETF)?

If you’re reading this, you’re probably wondering what an exchange traded fund, or an ETF, is.  Perhaps you’ve heard of them before as part of some financial news report, but you’re not entirely sure what makes them different to other financial products.

Exchange-traded funds (ETFs) are another form of investment option. Their main attraction is that they offer investors the ability to diversify over an entire sector or market segment in a single investment. How?  Essentially, like a managed fund, an ETF pools your money with other investors, which provides you with wide diversification.

The investment purchases and sales are overseen by a professional fund manager. However like a direct share, an ETF is a highly liquid investment, being listed on the ASX and bought and sold, either through a stockbroker or via your own online trading account.

Exchange-traded funds work by tracking indexes like the NASDAQ-100 Index, S&P 500, Dow Jones etc. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its native index. What this means is that if you, for example, buy into an ETF that tracks the SAP/ASX 200, you are in effect purchasing a little bit of each of the top 200 companies traded on the Australian Stock Exchange.  An ETF which tracks a sector index (energy for example), would result in you effectively holding a small part of each of the component energy-related companies.

An ETF trades like a stock but looks like a managed fund. Because ETFs are designed to track an index, they are considered to be passively managed. This is in contrast to some managed funds which are actively managed.

Exchange traded funds are considered by ASIC to be complex financial products, which is worth keeping in mind. Nevertheless if your financial adviser suggests ETFs you may decide that they offer several benefits over both managed funds and shares. Investing in an ETF allows you to invest in potentially hundreds of companies with a single trade, keeping brokerage fees down, while your management fees are typically lower than a comparable managed fund.

However, whereas in a managed fund the individual fund manager actively decides what assets to invest in, most ETFs currently in Australia aim to track as closely as possible a particular index – a grouping of publicly traded companies that conform to a particular style or sector. They are what is called a “passive” investment, with the underlying assets determined by the index – although it is worth noting that there have been several new ETFs launched in recent times which are moving away from an index approach.

ETF’s may be cheaper than other comparable investment products. When you invest in an exchange traded fund, you do not directly own the shares or other assets the fund has bought.  Instead you will own shares in the fund itself.

Disclaimer

ETFs are considered by ASIC to be complex financial products. Some types of ETF are more complex and risky than others. For more information on ETFs and risks associated with them, see ASIC’s Moneysmart website at https://www.moneysmart.gov.au/investing/complex-investments/exchange-traded-products

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