What Are ETFs (Exchange Traded Funds)

What are ETFs?

An ETF is an investment fund that is traded on a stock exchange, similar to how shares are traded on a stock exchange. It is a portfolio of stocks usually tracking an index. ETFs are passive, aiming to replicate the performance of an index of a specific asset class. This means that if the index goes up then the ETF will go up, conversely if the index falls the ETF will also follow it down.

ETFs are usually focussed on one particular asset such as domestic Australian share, international shares, fixed income products, foreign currencies, property and infrastructure, precious metals and commodifies. Passive ETFs will follow the benchmark index up or down, replicating the performance of the benchmark as closely as possible.

Physical and Synthetic ETFs

ETFs can be synthetic or physical. A physical ETF will hold the actual stocks – the underlying securities – from their chosen benchmark in the portfolio. The manager will adjust the portfolio weightings (how much of each stock is in the portfolio in comparison to the others) to align with the benchmark to replicate the performance of the actual benchmark as much as possible.

Synthetic ETFs are different in that instead of owning the underlying securities, managers will use derivatives e.g. swaps to follow the performance of the index. As a result, Synthetic ETFs face counterparty risk although steps are taken to ensure it is minimised. Despite this, Synthetic ETFs tend to reward investors for taking on additional risk by charging lower costs.

Tips for Buying and Selling ETFs

The value of a physical ETF investment can rise and fall on a daily basis, usually according to the index it tracks.

Here are some tips on what to look for before you invest.

Checking the buying and selling price

You can check if the ETF is priced fairly by comparing the offer price (if you're buying) or the bid price (if you're selling) provided by a broker, with the latest net asset value (NAV)* information available for the ETF.

* The value of assets minus liabilities, often shown as a per unit or per share value.

Price gaps

The market price for the ETF unit should be close to the NAV per unit of the underlying assets. If the offer price quoted by the broker is a lot higher than the NAV, there is a risk that you might be paying far more for the ETF than it is worth. If the bid price is far below NAV, there is a risk that you could sell for less than the value of the investment.

ETF tracking error

ETF prices will not exactly mirror the price of the index or investment they’re tracking due to fees, taxes and other factors.

Timing for market-tracking ETF trades

For an ETF price that reflects the value of the underlying asset more closely, buy or sell units at least 30 minutes after the share market opens, which is 10AM Sydney time.

It is better to buy or sell ETFs when the market is open, as this may help minimise discrepancies between the ETF and the price of the shares that it holds.

Advantages of ETFs

ETFs are often used to diversify a portfolio as they are an easy option to gain exposure in certain asset classes that may be more difficult to gain entry to e.g. international shares which would normally require the services of a specialised broker.

Instant diversification

ETFs are an easy way to diversify across a broad range of assets. Most ETFs track a market index, allowing you to access the performance of an entire market in a single trade. And with ETFs now available for Australian and international shares, property, fixed interest, cash, and more, you can combine multiple ETFs to create your own precisely adjusted asset mix. For more information, click here.

Low costs

Because most ETFs track an index, their investment decisions can be automated, without the need for highly paid human managers. For investors, that means lower management expense ratios (MERs). For example, a broad-based ETF tracking the US S&P 500 typically charges around 0.07% pa in fees, compared to 1%-3% for an actively managed fund.

Liquidity

ETFs can be bought and sold on the ASX like shares. Each ETF has its own market maker - a large financial institution responsible for ensuring there is a matching buyer for each seller, making it easy to access your money whenever you're ready.

Flexibility

You can buy and sell ETFs through the broker of your choice, at the same low brokerage rates as a normal share trade. ETF prices are transparent, instantly available and set by the market. In contrast, investors in a traditional unlisted managed fund can only buy and sell through the issuing fund manager, with the price set by that manager once a day.