Exchange Traded Funds (ETFs) Terminology Explained

With market volatility increasing significantly in recent months, many investors have been looking to capitalise on lower stock prices. One of the common investment themes is to diversify your holdings across a range of shares, but due to practical reasons, this isn’t always easy to achieve.

As a record number of investors take up online share trading for the first time, Exchange Traded Funds (ETFs) have soared in popularity. ETFs are just like a managed fund, however, you can trade them on the ASX. So if you’ve been looking for an efficient and cost-effective way to diversify your share holdings, ETFs allow you to buy lots of companies through one product instead of buying them individually.

Over the last six months, SelfWealth has seen the combined trading value for the three most-popular ETFs bought through our online share trading platform rise nearly four-fold. 

As new ETFs flood the market, investors have also bought a wider range of exchange traded funds. SelfWealth has observed a wave of interest in ETFs that bet against the market, track commodities or feature international shares.

However, it’s not easy to cut through all the information and choose an ETF. If you’ve just started investing in shares, all the jargon can be overwhelming. Fortunately, we have it covered for you. Here are the most important terms to know when investing in ETFs!

The different types of ETFs

Active ETFs: Also known as “ETMFs”, the fund manager actively invests the combined funds of all investors to try and beat the market. Active ETFs do not attempt to mimic an “index” like “passive ETFs”.

Broad Based ETF: A broad based ETF, sometimes called an “index” ETF, tracks a group of stocks that make up an index, like the S&P/ASX 200. The fund has exposure to lots of stocks from different industries. If the ETF tracks an international index, like the S&P 500, it may be called a broad market ETF.

Exchange Traded Managed Fund (ETMF): An active managed fund where the fund manager tries to beat a “benchmark”. They are traded on the ASX, just like normal shares. Unlike managed funds, ETMFs offer investors greater liquidity, transparency and live pricing.

Geared ETFs: Debt (“leverage”) is used to increase a fund’s exposure to the performance of the “index” or assets that it tracks. Make sure you understand the risk of geared ETFs because they are highly volatile and can lead to bigger losses.

Hedged ETFs: An ETF where the fund manager uses “hedging” to cancel out the impact of currency movements on the performance of the underlying “index” or assets.

Inverse ETFs: Looking to bet against the market? Inverse ETFs are a special type of ETF used to short the market. The fund manager uses “derivative” contracts. The performance of the underlying “index” or asset shares an inverse relationship with the ETF price. For example, if the market drops, an inverse ETF will rise.

Passive ETFs: Seek to match the performance of the “benchmark” they track. For example, the SelfWealth SMSF Leaders ETF (ASX: SELF) seeks to track (before fees and expenses) the performance of the SelfWealth SMSF Leaders Index. This “index” is a collection of shares put together through a “rules-based” analysis of SelfWealth’s SMSF portfolio database.

Physical ETFs: Imitate a target “index” by holding some or all of the assets of the index. These ETFs are generally lower risk than “synthetic ETFs”.

Rules-based ETFs: Also known as strategy based ETFs. The fund manager uses their own selection criteria to pick a limited number of stocks to hold in the ETF. For example, the ETF might only consider ethical businesses or stocks that pay dividends.

Sector ETFs: If you’re looking to invest exclusively in a specific sector such as information technology or financials, sector ETFs aim to capture the performance of stocks from a particular sector.

Structured products: A form of exchange traded product which relies on contractual obligations and rights against the “issuer”.

Synthetic ETFs: Financial “derivatives” are used to simulate the performance of an asset. This is useful where it is impractical to physically hold an asset (e.g. oil). Because the fund does not invest directly in the asset, there is “counterparty risk” to synthetic ETFs.

Unhedged ETFs: An ETF that does not use “hedging” to offset foreign exchange rate volatility. The fund’s performance is impacted by currency movements.

ETF third parties

Authorised participants: Financial institutions that create and redeem “units” in the ETF directly from the “issuer”. 

Custodian: A third-party institution that holds ETF assets for the benefit of “unitholders”.

Fund administrator: A third party that helps run the ETF. They might prepare financial reports or independently calculate “NAV” and “distributions”. 

Issuer: Sometimes called the Responsible Entity, an issuer is the ETF product provider.

Market makers: The brokers, banks, or dealers that provide “bid/ask spreads”. They maintain an active market for the ETF by buying “units” from sellers, selling units to buyers and even creating more units for the fund manager. 

ETF investment strategies

Active management: The fund manager actively trades stocks and tries to time the market in order to beat it.

Currency hedged: The ETF has been protected from foreign exchange rate movements. See also “hedging” and “hedged ETFs”.

Hedging: Familiar with the expression to hedge your bets? Hedging involves one asset or financial instrument being bought to offset adverse price movements in another asset or instrument. This strategy reduces investment risk but also limits your potential profits.

Leverage: A practice that many businesses and even homeowners around the country do! Borrowing to invest. Beware, however, leverage can increase your losses if things go pear-shaped.

Buying and selling an ETF

Benchmark: An “index” used to compare the performance of the ETF. 

Bid/ask spread: Have you noticed a difference between the highest price a buyer is willing to pay to buy “units” in an ETF and the lowest price offered by a seller? That right there is the bid/ask spread. You can view it on the order page within your trading account.

Distributions: Australian investors love their dividends! Distributions are the share of dividends or income earned by the fund that a “unitholder” is entitled to.

Distribution yield: The return that an ETF pays out each year in “distributions” compared to its share price. Keep an eye out for a percentage figure.

Franking credits: A favourite among income investors, franking credits are tax credits for shareholders where tax has already been paid by a company. Lots of ASX shares pay dividends that come with franking credits.

FUM: Funds Under Management. The total value of money in the fund.

Indirect Costs Ratio (ICR): An estimate of the total costs associated with the fund’s assets. This figure is expressed as a percentage of the fund’s average “NAV” through a year. It includes investment “management fees”, operating expenses of the fund, as well as performance fees where applicable.

Issue price: The “NAV” of the fund divided by the number of “units” on issue.

Management fee: This fee reflects the fund manager’s costs to manage the fund’s assets. The fee is built into the fund’s daily “NAV” and the ETF trading price, so make sure you weigh this up before you invest.

Management Expense Ratio (MER): An estimate of the total costs of investing in an ETF compared with the average value of its assets under management. This includes “management fees” and operating expenses, but excludes the “bid/ask spread”, broker and platform fees, plus any performance fees. Lower is generally better, however, that doesn’t guarantee the fund will perform better!

Net Asset Value (NAV): The total market value of the assets in a fund, minus the costs, liabilities and other expenses. The value, calculated daily, is measured per unit. You’ll see this listed by the ETF provider, but if you want to calculate it yourself, divide the fund’s total net assets by the number of “units” on issue.

Units: When you buy an ETF, you own units in the fund. The fund owns the shares or assets.

ETF assets and instruments

Asset allocation: How the fund has split investment in different asset classes like cash, ASX shares, international shares, property and commodities.

Call option: This is a financial instrument that provides the option holder with the right but not the obligation to buy an asset at an agreed price up until a particular date.

Derivative: A highly complex contract between two or more parties where the performance of an asset drives the value of the contract. Examples include, “call options” and “futures” contracts, where movements in the price of an asset (e.g. oil) determine the value of the contract. An increasing number of ETFs use derivatives, so read the PDS carefully!

Futures: A financial contract where one party has an obligation to either buy or sell an asset or financial instrument for a specific price at a fixed date in the future.

Index: A group of shares that represent a market or sector of the market. The index may be market-cap weighted, where the weight of each stock is proportional with the value of each company. Alternatively, the index may be equally-weighted, with each stock making up an equal part of the index. Finally, it might be price-weighted, where the influence of each stock in an index is proportional to the movement in its share price.

Trading behaviour of ETFs

Backwardation: Some ETFs trade “futures” contracts to mimic movements in the price of an asset. Backwardation occurs when a futures contract trades at a higher price near its expiry compared with contracts that expire in the future.

Contango: The opposite of “backwardation”. This occurs when the price of “futures” contracts expiring in the future are more than current ‘spot’ price for a contract nearing its expiry. This typically occurs when the price of the asset is expected to increase over time.

Counterparty risk: The risk an institution defaults on its financial obligations under a contract. Because some ETFs use “derivatives” to imitate movements in the price of an “index” or asset, these ETFs are subject to counterparty risk.

Tracking error: In an ideal world, the price and returns of an ETF would perfectly follow the price and returns of the “benchmark” it tracks. However, sometimes that doesn’t happen and the divergence is referred to as a tracking error.

About Jarrod Purchase

Jarrod has extensive experience marketing a variety of products across a multitude of industries and joined SelfWealth, Australia’s fastest growing share trading platform, two years ago. As a new stock market investor himself, he had to learn the ropes and is here to help SelfWealth members and Australian investors alike, in navigating the sometimes-intimidating topic of share trading and investment. Jarrod strongly follows the SelfWealth mantra, “Trade Smarter. Every time.” and this comes out in his love for teaching new investors on how to get started. Follow Jarrod on LinkedIn.