Exchange traded funds – or ETFs – are a popular investment option in Australia. According to Vanguard Investments, ETFs are so popular with investors that in the first half of 2019, an additional $10 billion was invested in them, growing the market to a total size of $50 billion. Stockspot's chief executive and founder, Chris Brycki, has predicted that the ETF sector will continue to grow over the next few years, possibly reaching $100 billion by 2022.
What is an ETF?
An ETF is an investment fund which can be bought and sold as units (like shares) on a stock exchange such as the Australian Securities Exchange (ASX). One reason they are increasing in popularity is because they’re a relatively easy way to invest in a broad range of assets such as shares, commodities and currencies.
How does an ETF work?
ETFs are either passive or active, but most that are available on the Australian market are passive. A passive ETF tracks a market index or asset class, and its value increases or decreases just as the index or asset class does. For example, you can invest in an ETF that tracks the S&P/ASX 200 (an index that measures the performance of the largest 200 companies listed on the ASX). If those companies improve in performance, the value of the ETF also increases.
An active ETF is managed by a fund manager who selects investments by continually buying and selling assets for the fund as the market changes. The manager’s goal is to maximise returns for investors by outperforming a benchmark index or the market.
ETFs are different to managed funds because they are easily bought and sold on the sharemarket, making them a more flexible investment option. Whereas a traditional managed fund is only accessible through a fund manager.
Types of ETFs
Equity ETFs are the most common variety. They track a specific set of shares, based on an index (such as the S&P/ ASX 200 or NASDAQ Composite), sector (such as banking), location (for example, Australia), or a number of other factors. For example an equity ETF could track the ASX 300 (an index of the largest 300 companies on the ASX) or the FTSE Australia High Dividend Yield Index (comprised of blue chip Australian companies that have historically paid above average dividends).
Bonds are issued by companies or governments to raise money. By investing in bonds, you’re effectively loaning money to that company or government. Bonds can be quite tricky for individual investors to access, but bond ETFs make it much easier to invest in this asset class. A bond ETF could track the performance of the Australian fixed rate bond market.
focus on certain industries. This type of ETF gives you access to an industry on a broader scale rather than picking one or a portfolio of shares on your own. An industry ETF could give exposure to gold mining companies around the world or offer access to a number of companies involved in battery technology and lithium mining.
These types of ETFs track single commodities, such as gold, energy or livestock; or a collection of commodities within the one ETF. For example a commodity ETF could offer exposure to the current price of four precious commodities—gold, silver, platinum and palladium or enable you to invest in gold via the ASX.
Currency ETFs track the value of a particular currency against other currencies. For example, you might invest in a currency ETF that tracks the US dollar relative to the Australian dollar.
Through international ETFs, investors to access foreign markets without using an international share-trading platform. By investing in an international ETF you gain exposure to foreign indexes such as the Nikkei index in Japan or the S&P 500 (an index measuring the performance of the largest 500 companies listed on US stock exchanges). Keep in mind that these investments can carry a currency risk (so changes in the value of the Australian dollar might impact on the value of your investment) and that foreign taxes may apply.
The advantages of ETFs
You can diversify your portfolio
Instead of only investing in one or two companies (as many investors do when investing on their own), ETFs allow you to gain exposure to multiple companies in a single trade. Having a diverse portfolio is widely recommended as it allows you to spread the investment risk.
They can be cost-effective
Many managed funds demand a high minimum investment, whereas buying ETFs on the ASX only requires $500 plus a brokerage fee to start.
Management fees also tend to be lower than managed funds (although this may not be the case for active ETFs as you’re paying for a fund manager’s services).
They carry many of the same perks as shares
ETFs can offer many of the same benefits as shares, such as regular dividends. They can also be tracked and traded throughout the trading day.
The disadvantages of ETFs
They don’t perfectly match what they track
Your ETF will closely match the index or asset that it is based on but returns will never exactly match – this is known as a ‘tracking error’. The extent of this error depends on the ETF’s fees, taxes and investment strategy.
Also, if the ETF is not traded often (or is illiquid) this will influence the degree of tracking error. Some issuers engage ‘market makers’ to create a market for their ETF to try and keep the price close to its net asset value (NAV), which is the value of the fund’s assets minus its liabilities. This helps to make the ETF more liquid and reduces tracking error.
They still carry risk
Like investing in shares, ETFs do bear risk. Even though some offer a diversified investment, they are still vulnerable to changes in the market and there is always a chance of incurring a loss.
There are also some unique risks that can arise from trading in ETFs including:
- Liquidity risk: If an ETF has a small number of buyers and sellers there can be problems getting out of the investment.
- Counterparty risk: ETFs that use derivatives or lend their underlying assets are also open to the risk of loss if the counterparty defaults.
How to buy and sell ETFs
While ETFs are traded just like shares, there are some additional things you should do before you trade in them:
- Check to see if the price is close to the latest NAV. The market price of the ETF should be close to the NAV, otherwise you might be buying for a price that is more or selling for less than the ETF is actually worth.
- Remember to place orders to buy or sell ETFs when the market for its underlying asset is open and at least 30 minutes after the sharemarket opens if the ETF is tracking shares.
Start investing in ETFs with ANZ
If you’re ready to start investing in ETFs you can open an ANZ Share Investing account in a few easy steps (Applications for ANZ Share Investing accounts will close on 1 July 2022). Find out more about ETFs and learn about ANZ Share Investing in our frequently asked questions on our website or in the Education Hub within the ANZ Share Investing platform.