The different types of exchange traded funds explained

The first exchange traded fund (ETF) first hit Australian shores back in 2001, now many years later, they have become one of the most popular investment products. Their growth in popularity has seen a variety of ETFs emerge.

If you are interested in investing in ETFs, we’ve put together a cheat sheet on the different types of funds you may encounter.

Active and passive ETFs

First and foremost, ETFs will generally fall into two categories: active or passive. Initially, exchange traded funds were constructed as a purely passive investment product, essentially the ETF would track or imitate the index it was designed to follow. Today this has changed, investors now have the option to invest in exchange traded funds that are passive and active.

Active investments are actively managed by a fund manager who decides on the investments included within the portfolio and buys and sells assets according to changes in the market. Fund managers are actively trying to beat the market in order to optimise returns. Whereas, passive investments track an index, and therefore cannot beat or under-perform the market. Although, bear in mind, as you are paying for the service of a fund manager, active investments are typically more costly. Additionally, fund managers don’t always get it right and can under-perform the market.

Stock ETFs

Stock ETFs track shares and are likely to be the most common type of ETF you will come across. Stock-based ETFs can replicate a stock index or a collection of stocks grouped by sector, geographical location or by a common feature that is shared between them.  Each individual stock is weighted and their overall performance is tracked. One share in a stock-based ETF will buy you a nominal amount of each company it is tracking and can be an active or passive investment.

Considering online share trading? The table below displays a snapshot of online share trading platforms on Canstar’s database, sorted by star rating (highest to lowest) and with links to providers’ websites. Please note the Star Ratings are based on the casual investor profile (average of 2 trades per month). Always ensure you read the PDS before selecting a online share trading provider. 

Bond ETFs

Traditionally, bonds were often difficult to access for the average investor. There were only two ways to invest in bonds: going directly to the company or through the secondary market. However, just like stock ETFs, bond ETFs can be traded on a centralised exchange – like the ASX. As a result, they can provide investors with exposure to the bond market much easier than before. And, just like a traditional bond, if you invest in a bond ETF you will still receive your interest/coupon payments.

Sector or industry ETFs

Exchange traded funds can also be broken down by sector. For example, if you were predicting a boom in the technology sector, you could consider a sector ETF that tracks a selection of companies just within the tech industry. However, keep in mind that the more granular you go, the less diversified your investment becomes.

International ETFs

If you are looking to invest outside Australia, international ETFs provide an easy-to-access solution.  By investing in an international ETF, you can gain exposure to foreign markets without the need for an international share trading platform. Just like other ETFs, these funds are available on the ASX. But bear in mind, when investing internationally you should take into account currency risk. As the value of the foreign currencies fluctuate against the Aussie dollar, the value of your investment will fluctuate as well.

Commodity ETF

Commodity ETFs are similar to sector ETFs as they single out a certain section of the market, in this case a particular commodity, whether it is gold or oil. One thing to note is the ownership of the commodity, when you invest in a commodity ETF you do not directly own that asset. Rather, these ETF consists of derivative contracts that emulate the price of the underlying commodity.

Factor ETFs

Factor-based funds are a form of active management. They offer the potential to achieve specific risk and return objectives by purposely creating portfolios with a bias towards certain stock characteristics, like: value, size, momentum, quality, dividend yield or low volatility. However, these types of ETFs generally come with significantly more risk than you’d expect to experience with broader stock market ETFs.

Consider the risk involved

Understanding what’s on offer can be a good place to start, but before investing in an exchange traded fund you should also consider the risks involved and always read the PDS.

Cover image: Things (Shutterstock)

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