Exchange-traded funds (ETFs) can be a healthy addition to an investment portfolio, but they can also work well as a stand-alone investment. Offering diversification in one trade while having generally lower fees than managed funds, ETFs are becoming a popular choice with investors.
As such, there are many ETFs available on the ASX that provide exposure to a range of markets and sectors.
Factors influencing your ETF
As a passively-managed investment, ETFs can have lower fees than actively-managed investments such as managed funds. This is because they don’t need to factor in the costs of the services of a strategic fund manager.
However, ETFs have other costs, including the management-expense-ratio (MER) and the bid-ask spread. These costs can still take little bites out of your returns.
These costs vary between funds, so you should always take note of how much you’re paying in fees and compare ETF providers to see if you’re getting the best deal.
When you execute a trade, the actual executed price can be different from the price you expected. This difference is known as slippage and occurs more during times of high volatility. Like stocks, ETFs are traded on the ASX, and are subject to slippage.
The liquidity of an ETF is important, as lower levels of liquidity can cause greater bid-ask spreads, more slippage and a decreased ability to trade profitably.
Factors influencing ETF liquidity include:
- The composition of the ETF
- The liquidity of the individual securities within the ETF
- The trading volume of the ETF
- The investment environment (for example, if many investors are trying to buy in a particular sector, an ETF representing this sector might suffer temporary liquidity issues).
Large-cap ETFs can be more liquid than small-cap ETFs. In a similar way, ETFs with fewer actively-traded securities can be less liquid and may have a greater bid-ask spread.
As ETF issuers can create more units in an ETF pretty easily, liquidity issues can be short term. In general, ETFs are considered to be more liquid than managed funds.
Larger ETFs might be able to offer lower fees, higher liquidity and more protection against major swings in the price of the fund, but this isn’t always the case.
Counterparty risk refers to the risk that another party fails to fulfill their financial obligations. Synthetic ETFs are more exposed to this risk than physical ETFs, since synthetic ETFs don’t actually hold underlying assets – instead relying upon swap agreements.
Don’t forget about the importance of the people involved in delivering ETFs to investors. They are responsible for ensuring the ETF performs the way it should. Consider the quality, usefulness and experience of the implementation team, market makers and key participants.
ETF providers have a duty to match the benchmark index they track while handling the costs of turnover through an efficient investment process. High turnover in a portfolio, where lots of buying and selling is taking place, can lead to higher tax and trading costs. These costs can be passed on to investors.
High turnover is okay, so long as it creates higher returns. While turnover is usually low for ETFs, high dividend and strategic beta ETFs can have higher turnover due to their rebalancing requirements (for example, removing a stock with a reduced dividend yield and buying a stock with an increased dividend yield).
Before you invest
It is worth noting that ETFs are considered by ASIC to be complex financial products. Some are more complex and risky than others. For more information on ETFs and risks associated with them, see ASIC’s Moneysmart website.