ETF Meaning and How They Work
An Exchange Traded Fund (ETF) is an open-ended investment fund, similar in structure to a traditional managed fund, but it is bought and sold like any share on the ASX. Most ETFs are designed to closely track the performance of a specific index or underlying asset class, aiming to provide the returns of that index or asset—minus the fund’s operating fees and costs.
Unlike buying a single stock, an ETF instantly provides access to a portfolio of underlying assets in one transaction. This is a simple and efficient way to add instant diversification to an investment portfolio. Given their broad market access and flexibility, ETFs have become one of the fastest-growing investment categories globally.
Key Takeaways
An ETF is an open-ended investment fund that is traded on the ASX, just like a share.
They track the performance of a given index or asset class.
ETFs are known for being simple, transparent, low-cost, and flexible options for long-term investors.
Popularity and Motivations
ETFs are increasingly popular among Australian investors. Recent industry data shows a steady rise in the number of Australians holding ETFs, with new investors often citing diversification as a top motivation. Other key factors include saving time compared to researching and picking individual assets, the ease of buying and selling, and their ability to form a good portfolio core.
Benefits and Risks of ETFs
Benefits
Diversification: They provide exposure to a wide range of investment strategies, geographic regions, and asset classes in a single product.
Accessibility: Investors can buy and sell ETFs on the ASX through standard online brokers and investment platforms.
Liquidity: Because they are traded on the Australian Securities Exchange, ETFs can be bought and sold throughout the trading day, offering convenience.
Transparency: Information relating to the fund, including underlying portfolio holdings and fees, can be accessed at any time via the fund manager’s resources.
Cost-Effective: As many ETFs aim to passively track an index, they avoid the high 'active management' fees typically associated with traditional managed funds.
SMSF Friendly: ETFs are eligible to be held within Self-Managed Super Funds (SMSFs) and are a popular tool for this client base for structuring a diversified strategy.
Risks
The primary risk of investing in an ETF comes not from the fund structure itself, but from the investment risk associated with the asset class or strategy it tracks. For example, if you invest in an ETF that provides exposure to the broad Australian share market, then market-wide movements will directly influence the performance of the ETF. Before investing, always review the relevant fund documentation for detailed information on specific risks.
Understanding the Types of ETFs
With hundreds of funds available on the ASX, investors have ample choice. Established and emerging categories of ETFs include:
Australian Shares and Sectors: Funds providing broad exposure to the local market, specific sectors (like financials), or targeted investment objectives (such as high income generation).
International Shares and Sectors: Funds offering diversified exposure to global developed or emerging market equities, valued for their growth potential and geographical diversification benefits.
Bonds (Debt Securities): These funds bundle up various debt securities, including government and corporate issues, for investor convenience while paying regular distributions.
Cash (High Interest): Funds that invest primarily in deposit products across multiple Australian banks, aiming to track cash market indices and pay attractive, regular income distributions.
Commodities: For investors seeking exposure to assets like gold or resources stocks, these funds offer targeted exposure for diversification purposes.
Foreign Currencies: Funds that allow investors to gain exposure to movements in major global currencies without the complexity of trading in foreign exchange markets.
Diversified Funds: These products offer all-in-one solutions, providing exposure to several asset classes in a single trade at a pre-set risk level. These funds save time as the asset allocation and investment selection is handled by the fund provider.
Property Securities: Funds for investors seeking income and diversification opportunities via property trusts and listed real estate companies.
Passive vs. Active Management
ETFs can be either passively or actively managed, with the former currently dominating in Australia:
Passive ETFs: These funds are designed purely to match the performance of a specific index before fees. They do not employ professional stock-picking or market timing strategies to outperform the benchmark, resulting in considerably lower operational costs. They typically publish all their holdings daily.
Active ETFs: These funds aim to beat the index or achieve a specific return objective by utilizing a higher level of research and trading activity. While they offer the potential for higher returns, they generally charge higher fees. To protect their strategy, they often do not disclose their full holdings daily.
Fees and Costs
Like all managed investments, ETFs charge fees and incur costs. However, they are typically a highly cost-effective managed investment option. The vast majority of index-tracking ETFs do not charge the high active management fees associated with traditional actively managed funds.
Creating an ETF Portfolio
ETFs provide essential building blocks for a wide range of long-term investment strategies:
Core Portfolio Construction: ETFs can be used as the fundamental core holdings in a portfolio, providing broad domestic and global exposure. A sectoral ETF can also be used to obtain simple, diversified exposure to a particular industry such as healthcare or technology.
Core-Satellite Strategy: This involves allocating the majority of capital to diversified, buy-and-hold ETFs (the 'core') and supplementing them with smaller, more tactical positions (the 'satellite' components) for specific regional or sectoral exposures.
Dollar-Cost Averaging (DCA): This involves investing the same amount of money at regular intervals, regardless of current market movements. This disciplined strategy helps to mitigate market timing risk and facilitates gradual wealth accumulation over time.
Understanding ETF Structure
Investors should understand the difference between how an ETF achieves its exposure:
Physical ETFs: These funds directly own some or all of the underlying securities that make up the target benchmark. For example, a fund tracking a major Australian index will own the physical shares of those companies.
Synthetic ETFs: These funds use derivatives (such as futures contracts) to provide exposure to an asset class that may be hard to access and own physically. Due to their reliance on derivatives, they generally have a higher risk profile and face different types of risks than their physical counterparts.
What to Consider Before Buying an ETF
Not all ETFs are equal. Key factors to consider when assessing a fund include:
Reputation of the Provider: Assess the provider’s track record, longevity in the Australian market, and assets under management.
Quality of Exposure: Review the methodology of the index the fund uses. Look for funds that work with established index providers known for their rigorous standards.
Total Cost of Ownership: Compare the complete cost of buying and holding the fund against similar products, including the management fee and typical transaction charges.
Tracking Error: Evaluate how accurately the fund has replicated the performance of the index it is designed to track. Passive funds, due to fees, cannot outperform their index, but their returns should be extremely close.
Domicile: The location where the fund is legally based is important. Australian-domiciled funds can help investors avoid administrative complexities associated with investing in funds domiciled overseas.
Investor Protection
ETFs are regulated unit trusts whose units trade on the ASX. They operate under the highest form of investor protection regulation available in Australia. The assets underlying the funds are held on trust for the benefit of the unitholders and are typically held by an independent third-party custodian. This structure ensures that the ETF assets are legally separate from the product issuer and protected from the issuer's creditors in the unlikely event of a company default.
The open-ended structure of an ETF means its true liquidity is tied to the liquidity of the underlying assets it holds, extending far beyond the trading volume seen on the ASX screen.
Source: https://www.betashares.com.au/education/what-is-an-etf/
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