ETFs (Exchange-traded funds) offer investors a low-cost way to replicate the performance of an underlying index, basket of securities, commodities or other asset classes. For many investors, ETFs also help them to diversify their investment portfolio, enabling them to invest across a wide range of asset classes.
An ETF is a managed fund that’s bought or sold on an exchange. In Australia, they’re sold on the Australian Securities Exchange, with the majority being passive investments that aren’t seeking to outperform their respective performance benchmarks.
How ETFs work
ETFs allow individual investors across varying financial situations to own a bundle of shares or options in a single trade that’s listed on a stock exchange. In recent years, the sector has exploded, growing beyond the original ETFs that were passive index funds. Investors have flocked to them as a means of instantly creating a diversified portfolio, with ETFs allowing investors to own an entire section of a market by default, to which other assets (such as Australian or global shares, foreign currencies, commodities or metals) or asset classes can be easily added. ETFs can be structured to track anything, including specific investment strategies. They’re also of value to investors as they offer management fees, with less taken in the way of broker commissions than if each stock within the ETF was purchased individually.
ETF share prices will change regularly throughout the trading day as the shares within that basket are bought and sold on the market, unlike mutual funds, which only trade once per day after the close of the market hours.
There’s no limit to the number of stocks an ETF can own, with many owning hundreds or thousands of stocks across varying industries. While some funds will focus on country-specific offerings, others have a global or industry/sector outlook.
Each ETF in Australia receives an ASX code, which can be bought and sold by investors in the same way shares are. In order to begin investing in ETFs, the first step is to engage an online broker.
Types of ETFs in Australia and beyond
Physically-backed and synthetic ETFs
As the ETF market has grown in Australia and beyond, so, too, has it evolved to introduce innovative and varied funds to a wide variety of investor appetites. As of 2013, synthetic ETFs were found to be worth over a third of the total market (according to research from Vanguard), following their introduction into Europe in 2001.
Synthetic ETFs allow providers to offer exposure to markets that are difficult to access or, alternatively, to follow strategies that are challenging to implement. Physical ETFs, often called traditional ETFs, look to replicate the results of a benchmark index by physically holding either all or a representative sample of the underlying index’s constituents. In this instance, the portfolio manager manages cash flow from interest and dividend payments and investor transactions based on the ETF’s market prices.
Synthetic ETFs, however, invest in substitute or collateral baskets of securities that can be unrelated to the benchmark. They do so via swap agreements with one, or multiple, counterparties, who make an agreement to pay the return on the benchmark, thereby guaranteeing the synthetic ETF’s return by the counterparty.
As synthetics can come with counterparty risks, the main two reasons investors consider using them are costs, with the TER of synthetics often lower than with physical ETFs, and tracking errors. As synthetic funds are guaranteed by the counterparty, any errors caused by a lack of a full replication aren’t an issue, as opposed to physical ETFs, which have a higher variability of returns the further the portfolio is from full replication.
ETFs are characterised as having either passive or active managers, with Passive ETFs looking to replicate the performance of a broader index.
Actively managed ETFs will not usually target an index of securities. Instead, portfolio managers will make decisions about which securities are to be included in the portfolio. While these funds can offer significant benefits when compared to passive ETFs, they are often more expensive to investors as a result of that active portfolio manager’s activity.
Factor and Smart Beta ETFs
Smart beta is a strategy that aims to combine elements of passive index investing with active fund management in order to achieve transparency, diversification and market-beating returns, all while maintaining a low cost. Smart beta doesn’t pick stocks by their market capitalisation (i.e. how large they are in size), but instead uses a quantitative rules-based approach to pick stocks. Its choices are based on factors such as smaller sizes, high quality, low volatility or high dividend yield.
Smart beta ETFs can be attractive to investors because of their historic higher returns but often offer a more volatile investment option.
Factor investing is a type of smart beta strategy that refers to grouping investments based on a trait or characteristic that leads to influences on performance. This type of investing has gained in popularity in Australia in recent times. Factors include value, low size, momentum, low volatility, high yield, quality or multi-factor.
Factor investing can be a risky form of investment due to a number of inherent risks, including the de-prioritisation of certain factors, increased fees and timing risks. However, factor investing can also save investors time, exposing them to a particular investment strategy without the need to spend hours in research. It can also result in the potential for outperformance, as well as enhancing diversification within any single portfolio.
Structured and synthetic ETFs
Structured ETFs share investment policies in common with ETFs, sharing the passive nature of this strategy. Here, structured ETFs have the advantage of maximising the performance of each strategy, with structured ETFs enabling investors to join benefits typical of an ETF investment with those gained from dynamic management, and reducing the costs of the investor’s portfolio, with access to more complex investment strategies at a reduced cost than a simple tracking of the benchmark index. Structured ETFs also deliver the benefits of periodical proceeds, with dividends or interests collected by the structured ETF able to be redistributed periodically.
What is a derivative?
While derivatives are commonly confused with ETFs, they’re not the same thing. A derivative is a type of financial contract whose value is dependent on an underlying asset, benchmark, or group of assets. Derivatives can be traded on an exchange or over-the-counter, with derivatives used to trade any number of assets.
The prices of derivatives are derived from the fluctuations related to the underlying asset. These forms of financial securities are common within certain markets and are often traded to hedge against risk. Amongst derivatives, common types include futures contracts, forwards, options, and swaps.
Derivatives are considered to be a form of advanced investing. Commonly, underlying assets are stocks, bonds, commodities, currencies, interest rates and market indexes.
Commodity ETFs are forms of ETFs invested in physical commodities. They may take the form of agricultural goods, natural resources and metals. Generally, a commodity ETF is focused on either a single physical commodity, or investments in commodities futures contracts. Alternative forms of commodity ETFs track the performance of a broad commodity index, with multiple individual commodities representing a combination of physical storage and derivatives positions.
Commodity ETFs are popular with investors who are looking to hedge against inflation or achieve a profit within a struggling stock market. As with all investments, commodity ETFs also carry risk.
What you can invest in through an ETF in Australia
ETFs can contain all kinds of investments, with various investment forms able to be held within a single ETF. While some offer U.S.-only holdings, others are international. For example, leading Australian ETFs include:
BetaShares Crude Oil Index ETF - Currency Hedged (synthetic), which has demonstrated a 46.8% return over the past year
Vanguard Global Infrastructure Index ETF, with a 15.03% return of the past year
Magellan Infrastructure Fund (Currency Hedged) (Managed Fund), with an 8.63% return over the past year
With thousands of ETFs (approximately 8,000) available around the world, all kinds of investment strategies and appetites can be catered for. It’s not uncommon for investors to balance investment in ETFs with steady returns at lower risks alongside those that offer higher potential returns with associated higher risks.
ETFs are chosen by investors in relation to their investment goals, as well as their risk appetite in order to achieve their desired returns. As each ETF has its own risk-return ratio, it’s crucial to understand fund offering documents before making an investment decision.
ETFs vs. Managed Funds
To the undiscerning eye, ETFs can look similar to index managed funds. While both forms of investments are useful tools for creating portfolios, there are key differences between them that are necessary to understand.
ETFs and managed funds both deliver asset ownership, diversification, regulation, structure and purpose. Managed funds, however, allow investors to add new funds through regular contributions or deductions, while investors are free to buy additional units in ETFs at any time during the trading day. As brokerage is a fixed dollar amount payable on every transaction, ETFs are often more suitable for investors who are making large or irregular investments.
A key difference also lies in the area of pricing. Orders to buy or sell ETF units are executed throughout the trading day, leading to continuous pricing changes based on current market price. With managed funds, orders to purchase or redeem units are only executed at the end-of-day price.
ETFs also offer more transparency, as information about their underlying holdings is readily available on the investment manager’s website. Managed funds, however, are not under a duty of requirements to disclose their portfolio holdings. Often, only their top 10 investments are listed and visible.
Finally, ETFs come with a familiar environment for investors who are already used to trading on the ASX, appealing to those who want to employ sophisticated trading strategies, such as limit and stop-loss orders. Managed funds don’t offer the same trading opportunities.
Pros and cons of investing in ETFs
ETFs offer many advantages to discerning investors, including:
Diversification: a single ETF can create exposure to a wide range of equities, market segments, or styles. It can also track a broad range of stocks or even work to mimic the returns of a particular country or geographic region.
Easy to access: ETFs have the trading liquidity of equity. This allows them to be purchased on margin and sold short; to be traded at a price updated throughout the day, and to manage risk by trading futures and options in the same manner as a stock.
Lower brokerage fees: For ETFs which are passively managed, they offer lower expense ratios when compared to actively managed funds (as most mutual funds are).
Lower discount or premium in price: There’s a reduced risk of ETF share prices being higher or lower than their actual value, as they trade throughout the day at prices close to the price of the underlying security. As they trade on supply and demand, market makers will effectively capture price discrepancy profits.
Alongside the myriad benefits offered by ETFs, there are a number of cons that need to be considered by the astute investor:
Less diversification: Within certain sectors or across foreign stocks, investors may find themselves limited to large-cap stocks as a result of a narrow group of equities in the market index. This means that potential growth opportunities, derived from a lack of exposure to mid- and small-cap companies, may be missed by ETF investors within their managed fund.
Intraday Pricing leading to potential over-trading: As longer-term investors may have a 10-15 year time investment, they may not benefit from intraday pricing changes, while some investors are likely to trade more due to lagged swings between hourly prices. A high swing within a short time period could induce a trade, whereas pricing that’s set at the end of the day could help to balance fears from getting in the way of a long-term investment objective. As ETFs can be traded throughout the trading day, this can lead to over-trading for investors unclear on their strategy.
Lower Dividend Yields: The yields from dividend-paying ETFs may not be as high as owning a high-yielding stock or group of stocks. As ETFs track a broader market, the overall yield will average out to be lower, even when picking the stock with the highest dividend yield.
What are the main benefits of investing in an ETF in Australia?
One of the most popular benefits of investing in ETF units in Australia is the ability for an investor to build a diverse portfolio, gaining exposure to sectors that suit their investment strategy. They’re also largely viewed as lower-risk investments as they hold a basket of stocks, using high diversification and low costs to form an attractive investment proposition. Investors have the option to buy or sell an ETF in alignment with changing investment strategies, with flexibility another key benefit of exchange trading.
Step-by-step guide to buying an ETF (how to invest in ETFs in Australia)
How to buy and sell units in ETFs
If you’ve ever traded shares before, the process of how to buy an ETF, or selling an ETF, is the same. A broker is required in order to enter your order during ASX trading hours, upon which brokerage is payable. Settlement of the trade will take place 2 business days following the transaction. At this point, during a purchase, legal ownership of the ETF is transferred to you. If you’ve sold units, funds will then be deposited into your bank account.
Moomoo offers easily accessible online trading across a desktop and mobile app, giving investors the tools they need to buy and sell units in ETFs.
Compare the price and NAV
The fair pricing of an ETF can be checked by comparing its price on the ASX with the NAV (Net Asset Value). ETF providers give NAV updates both on the ASX at the end of a trading day and on the ETF provider’s website. It’s advised that the price you buy or sell ETFs at should be close to the NAV per unit, but it’s not uncommon for the ETF price to move away from the NAV.
Check the product disclosure statement before you invest
Each ETF comes with a product disclosure statement (PDS) from the product issuer (which is a legal requirement for any financial product). All investors are advised to review this thoroughly before making purchasing decisions. It’s important to remember that the PDS is not offering any financial advice, and to make informed decisions based on your own strategy.
Pay for your ETF purchase
Your broker of choice will offer payment options within your brokerage account, with the large majority allowing you to set up a linked bank account. Some brokers will require investors to deposit cash into their accounts before they’re able to trade.
Do ETFs pay dividends?
Just like any other dividend-paying stock, the vast majority of ETFs pay dividends. These are typically in the form of cash payouts or issuances of further shares. It’s best to check the PDS of each individual ETF to ensure you understand their dividend policy.
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