How do ETFs work?
Exchange traded funds (ETFs) are a security that typically tracks a stock index or sector. You can also get ETFs that track a commodity, bond or a range of assets. ETFs are traded on the stock market, when you buy an ETF you are buying shares of a portfolio that tracks the yield and return of its corresponding index or asset.
For example, when you buy into an ETF that tracks the ASX 200, you are in effect purchasing a little bit of each of the top 200 companies traded on the Australian Securities Exchange – see the example below.
An ETF which tracks a sector index, let’s take energy for example, would result in you effectively holding a small part of each of the energy-related companies on the ASX. Essentially, ETFs move in tandem with the assets or index it was designed to follow.
Related Article: Who offers ETFs in Australia?
ETFs vs Managed funds
ETFs are similar to a managed fund, both are pooled investment vehicles that have a fund manager to oversee the investment. With both you can also gain exposure to a wide variety of investment options. As with the examples above, you can invest broadly, such as investing in the ASX 200 market with hundreds of holdings. Alternatively, your investment can be more focused, such as tracking a single sector.
The key difference between the two is an ETF can be traded on the stock market. Allowing you to buy and sell your holdings like you would an individual company stock. ETF investors also typically have a transparent view of their fund’s holdings and investment value, this is not always the case with Managed Funds.
It’s a mixed bag
Initially, ETFs were seen solely as passive investment option as traditionally it only tracked stock market indexes and didn’t have a fund manager to actively manage the investment.
However, in the last few years this has changed. ETFs today can come in many different forms. As mentioned above, ETFs that track commodities, bonds and a basket of other assets are now available. You could, for example, buy an ETF that tracks the investment results of global equities in the healthcare sector. Those interested in ethical investing, may be interested in ETFs that just track the performance of companies that are leaders in climate change.
Some ETFs available now are actively managed – although only a small percentage. Meaning, that they have a fund manager to oversee the investment and who actively tries to beat the market, therefore increasing investors’ returns.
Related article: Active vs. Passive Investing – What’s the difference?
Why invest in an ETF?
There are a number of benefits ETFs can provide to investors, such as:
Diversification – ETFs can provide investors exposure to a number of different asset classes, countries and sectors all in a single trade.
Lower management fees – The management fee for ETFs tend to be lower when compared to Managed Funds, and unlike managed funds, most ETFs do not charge a performance fee.
Liquidity – Because ETFs are traded on the stock market this allows investors to trade ETFs stocks with relative ease, making it a high liquid asset.
Pricing – ETFs trade very closely to their net asset value. Because ETFs are traded on the stock market investors are able to see the price and value of their investment.
ETFs also have a number of risks to be aware of. These include market risk, liquidity risk and currency risk (particularly if you’ve invested in an international or global ETF). Check out this article on common investment risks to learn more.
ETFs do not suit every investor, so before investing be sure to read the PDS, and if ever in doubt seek the help of a professional financial adviser.
To learn more about investing and ETFs check out Canstar Investor Hub.