What is an Exchange Traded Fund (ETF)?

The popularity of ETFs has grown substantially in the last few years. Active Exchange Traded Funds are expected to boom in coming months.

2019 was a standout year for the Australian ETF industry, surpassing $60B in AUM. 

With increasing talk about this relative newcomer on the investment scene, it might be time to get more acquainted with exchange traded funds.

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.

Prepared by Canstar.

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.

Active vs Passive

As their name would imply, active ETFs are just that: actively managed. A fund manager or team oversee the ETF. Actively managed ETFs offer similiar benefits in terms of liquidity and tax efficiency to passive ETFs and have a benchmark index, but the managers of these funds may deviate from the index in response to market changes or where they see fit. Essentially, the portfolio construction is at the discretion of the fund manager. 

Though it is their goal, it’s important to remember there is no guarantee an Active ETF will outperform a passive equivalent. 

As active managers have the freedom to trade outside the index, shareholders may not always know their portfolio construction. ASIC’s regulatory measures aim to protect traders and investors alike. 

Active ETFs

In December of 2019, after five and a half months of review, ASIC lifted its ban on Active ETFs. The review and initial ban of new Active ETFs originally began largely due to price and portfolio transparency issues. 

According to Alex Vynokur, Chief Executive Officer of BetaShares, “Active ETFs currently represent approximately 7% of the industry, with growing interest from investors wanting to gain exposure to active strategies via an ETF. ASIC has done a commendable job in its review over the past 5 ½ months, and the lifted pause is a significant positive in so far as removing uncertainty. This will no doubt encourage further growth, and broaden the range of solutions on offer for Australian investors.”

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.

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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.

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.

Risks

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.

How to invest in ETFs

As ETFs are traded on the stock market, in order to invest in them you will need a broker or an online share trading platform. Alternatively, if you don’t have a lump sum to invest, many micro-investing apps also invest in ETFs.

To learn more about investing and ETFs, check out Canstar Investor Hub

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