What Is An ETF (Exchange Traded Fund)?

Why have ETFs become so popular?

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Last updated: February 22nd, 2024

what is an etf

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Last updated: February 22nd, 2024

Reading Time: 10 minutes

ETF is an abbreviation of exchange traded fund, meaning the fund can be bought and sold on a stock exchange. In 2024, around 20% of individual investors in Australia included ETFs in their portfolio, an increase from 15% in 2020.

Younger people with less cash on hand are particularly attracted to ETFs because of their affordable and low-maintenance entry point into the world of investing

Are you interested in exchange traded funds but not 100% sure how they work, how they differ from mutual funds, bonds and stocks, and whether they offer diversification benefits to your portfolio?

Read on to get a solid grasp of ETFs.

What Are ETFs?

An ETF is an investment product that pools the money of multiple investors – both retail and institutional – to buy a collection of underlying assets.

These can include stocks, bonds, commodities, or cryptocurrencies.

An ETF share represents a single entry point to a range of financial markets.

Key features of exchange-traded funds:

  • You can buy or sell units of ETFs on a stock exchange via a stockbroker or an online brokerage, just like you would company shares. You can go long or short.
  • The ETF issuer owns the assets that translate to the ETF’s performance on the market.
  • ETFs are open-ended funds, meaning the number of available units can change daily in response to investor demand. The ETF issuer controls supply and demand by creating or buying back units. (I’ll tell you why it’s important below).

Important!

ETFs can be active (aka managed) or passive. Most are passive and attempt to track a particular index such as the S&P/ASX 200 Index (ASX: XJO). However, active ETFs have shown strong growth throughout 2023 (see graph below).

Is The Appetite For ETFs Rising?

ETFs were first created in the 90s and have grown in popularity ever since — in line with the emergence and strong uptake of online share trading platforms

Prior to that, people usually invested through managed or mutual funds run by professional investment firms and not listed on stock exchanges.

ETFs have gained a lot of ground in 2023, luring in nearly $588 billion in investment this year (while mutual funds continue to wilt).

Above: A record number of actively managed funds have launched this year.

How Do Investors Make Money From ETFs?

Think of ETFs as baskets. Each basket holds securities.

For example, a bonds basket can be packed with a collection of government or corporate bonds.

As an ETF investor, you can buy as much – or as little – of the basket as you want, potentially profiting from the assets’ movements.

  • Investors purchase ‘units’ in the fund that reflect their proportional share of the total assets, receiving a share of returns (e.g., capital gains from rebalancing the portfolio, interest, dividends) from the underlying investments.  
  • Investors profit from increases in the ETF’s day-to-day price per unit and income from the securities in the underlying index.

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Key ETF Terminology You Need To Know:

You’ll come across this jargon when trading ETFs:

  • NAV: Net asset value is the amount of money a fund’s total underlying assets would be worth if sold, minus the fund’s liabilities. The NAV per unit value is also a common metric — calculated by dividing the NAV by the current number of available units.
  • MER: Management expense ratio, also called a management fee. A fancy term for annual expenses the ETF issuer charges, expressed as a percentage. 
  • Bid/Ask Spread: Bid refers to the highest price buyers are willing to pay, while ask is the lowest value the seller will accept. For individual investors, the difference between these values is a helpful guide to the disparity between supply and demand (i.e., a narrower spread indicates better liquidity).

Expert Tip.

The fund provider can create or redeem (buy back) ETF units to ensure supply matches demand, enabling investors to buy and sell easily. They also do this to keep the market price of ETF units close to the NAV per unit. For instance, if the ETF was trading at a lower price than its NAV/unit value, they’d reduce the number of units to lift the market value of each unit.

What Are The Benefits Of ETFs?

ETFs are attractive to investors because of:

Low Entry BarrierYou don’t need to be wealthy to invest in ETFs. While most mutual funds insist that you deposit a minimum of $5,000 to join, you can buy into an ETF for as little as $50 to $500.
DiversificationRising cross-asset volatility during 2023 sent investors piling into ETFs. Because units in an ETF can reflect hundreds of securities, they can offer traders refuge from market volatility.
High LiquidityETFs are easy to buy, sell and own. You can usually quickly buy and sell units of an ETF on an exchange as needed during the market’s trading hours.
TransparencyWhen researching ETF products, you can view their historical performance and a complete list of the specific assets they hold.

What Are The Disadvantages Of ETFs?

Like all investments, ETFs have potential downsides:

Reduced choiceYou don’t get to make portfolio construction and asset allocation decisions. The ETF provider decides what’s included based on the index funds the fund is tracking and the underlying investment strategy.
Reduced PerformanceSimilar to stocks, ETFs with lower trading volumes may be harder to sell. Where an ETFs underlying assets are not highly liquid, that can also impact how an ETF is managed and your ability to sell units.
Market RiskYou can lose capital because of a declining market or industry, currency fluctuations, changes in broader economic conditions or shifts in consumer spending.
Liquidity RiskSimilar to stocks, ETFs with lower trading volumes may be harder to sell. Where an ETF’s underlying assets are not highly liquid, that can also impact how an ETF is managed and your ability to sell units.

Important!

While many popular ETFs track a market index, returns may not perfectly correlate to the benchmark’s performance (this is called tracking error).

Main Types Of ETFs (With Examples).

An ETF can own hundreds or thousands of assets across industries or focus on a specific asset class, geographical area, company type, industry or sector.

Here are the most common ETF categories:

1. Index ETFs.

Indexes are benchmarking tools that help investors measure the stock market’s performance, developed and updated regularly by independent market intelligence firms like S&P Dow Jones.

Important!

You’ve probably heard of Australia’s leading index, the S&P/ASX 200, which offers a snapshot of how our market is travelling based on the top 200 ASX-listed companies by market capitalisation and liquidity.

You can’t invest in an index, but you can invest in funds that mirror the composition of an index and aim to match its level of returns — which is often described as passive investing.

Passive investing is gaining popularity, and this trend is largely driven by index-based exchange-traded funds (ETFs).

Two of the largest index ETFs in Australia include:

  • Vanguard Australian Shares Index ETF (ASX: VAS), which tracks the S&P/ASX 300 index (top 300 ASX-listed companies) and manages more than $12.7b in funds.
  • SPDR S&P/ASX 200 ETF (ASX: STW), which was the first ETF listed in Australia, has more than $4.4b in assets under management, and tracks the S&P/ASX 200 index.

2. Actively Managed ETFs.

Behind the scenes of an actively managed ETF is a team of people responsible for finding trading opportunities and timing trades to exceed an index’s performance.

Accessing this knowledge comes at a cost, with active ETFs usually charging a higher annual fee (with no guarantee of superior results to an index ETF).

Actively managed EFT examples available to Australian investors include:

  • Betashares Western Asset Australian Bond Fund (ASX:BNDS).
  • Fidelity Global Demographics Fund (ASX: FDEM).

(Related: What Is An Index Fund?)

3. Stock ETFs.

Many ETFs listed on the ASX have holdings of Australian or international stocks. For example, the index-based funds I listed above comprise Australian stocks.

Some examples of international stock ETFs available on the ASX:

  • VanEck MSCI International Quality ETF (ASX: QUAL).
  • iShares Global 100 ETF (ASX: IOO).

4. Bond ETFs.

A potentially attractive choice for investors seeking reliable income, bond ETFs distribute the interest earned on the underlying bonds as cash payments.

These ETFs can offer low-risk returns if the underlying assets are investment-grade, low-risk bonds.

Two prominent bond ETFs you can buy on the ASX:

  • iShares Core Composite Bond ETF (ASX: IAF).
  • Vanguard Australian Fixed Interest Index ETF (VAF).

5. Commodity ETFs.

Commodities are physical goods like oil, gold or agricultural products that are traded directly via exchanges, but also through derivatives.

The assets behind a commodity ETF could be physical (e.g., real gold bars) or futures contracts (synthetic ETFs).

Commodity ETF examples available to Australian investors:

  • Global X Physical Gold ETF (ASX: GOLD).
  • Crude Oil Index ETF – Currency Hedged (Synthetic) (ASX: OOO).

(Related: How To Start Trading Futures In Australia).

6. Sector/Theme Based ETFs.

You can get exposure to securities related to a specific industry or interest area (e.g., Electric vehicles) through more targeted ETFs.

Some highly niched ETFs are seen as riskier investments and also run the risk of being less liquid. Examples of sector-based ETFs are:

  • Global X Battery Tech & Lithium ETF (ASX: ACDC).
  • iShares Global Healthcare ETF (ASX: IXJ). 

7. Ethical ETFs.

A desire to support ethical and sustainable industries, and socially responsible business practices, means ethical investing is a priority for some investors.

Ethical and sustainable ETFs commit to holding underlying assets that meet a certain ethical standard.

The yardstick for judging this varies across providers.

Two examples of ethical ETFs in Australia:

  • Betashares Global Sustainability Leaders ETF (ASX: ETHI).
  • Russell Australian Responsible Investment ETF (ASX: RARI).

What Are Niche And Thematic ETFs?

ETF issuers can offer ETFs in response to heightened investor interest in hot trends such as self-driving cars and space exploration, cloud computing and cybersecurity

You can buy niche as well as “thematic” exchange traded funds that give you exposure to companies launching products into these markets.

More broadly, ETFs can focus on specific currencies, geographies or risk profiles:

  • Currency ETFs. Give you exposure to the forex market without forcing you to buy the underlying asset. Some track a single currency while others track a basket of currencies.
  • Geographic ETFs. Give you exposure to a specific region. For example, a North American ETF will track blue-chip companies across the USA and Canada while an APAC ETF will track large and mid-cap stocks from developed countries in the Asia-Pacific region.
  • Leveraged ETFs. Amplify your exposure by tracking an underlying asset and ramping up leverage. For example, a leveraged 2X ETF will maintain $2 of exposure for every $1 of your capital.

Flows into thematics have either flatlined or declined in recent years.

Above: ETF investors have yanked roughly $2.6 billion out of thematic funds during the last 2 years, which include clean energy and fintech-centered ETFs.

How Do ETFs Compare To Other Asset Classes?

ETFs are popular but you must weigh them up against other investment options.

ETFs vs Stocks.

ETFs are similar to stocks due to being listed products with high liquidity.

Direct purchases of individual shares in either Australian or overseas companies remain a popular option for many Australians who want the freedom to pick the stocks and own the underlying shares.

Equity ETFs that contain a basket of shares offer a more hands-off way of investing in the stock market, while still benefitting from capital growth and dividend returns.

ETFs vs Mutual Funds.

Managed funds are similar to ETFs in that they pool investor funds to purchase a collection of assets, supporting the diversification of your portfolio.

Mutual funds have traditionally been popular with buy-and-hold investors making long-term decisions for retirement portfolios.

Here’s what you need to know about the differences between ETFs and mutual funds. They:

  • Aren’t traded on the stock market. Instead, you invest by providing your money directly to the investment firm that creates and manages the fund day-to-day.
  • Typically cost more, especially when it’s an actively managed fund — due to the fund provider using its expertise to choose, monitor and adjust the assets it holds to pursue a higher rate of return (compared to an index). However, you may not be required to pay a fee each time you buy or sell units in the fund (this depends on the fund).
  • Are less transparent. ETFs disclose their holdings daily, while mutual funds typically reveal their portfolios once a quarter.

Above: Mutual funds have been losing popularity while ETFs have gained ground. Investors pulled roughly $950 billion in cash from mutual funds in 2023, the biggest outflow on record.

Do ETFs Charge Fees?

Yes. You will pay an annual when you buy units of an ETF.

They vary wildly, but most are in the ballpark of 0.40%, with some charging less than 0.10%

You will also pay brokerage fees and bid-ask spreads each time you place a trade.

Do ETFs Pay Didivends?

Yes, if the underlying equities that the ETF holds pay dividends.

These are collected by the ETF issuer and are distributed to investors (typically every quarter).

How Do ETFs Affect Your Tax?

Returns from your exchange traded fund investments count as income by the ATO. You must declare them during tax time.

ETFs may offer more tax-effective income mutual funds.

Mutual funds frequently rebalanced by a fund manager create more capital gains ‘events’, each taxable. Contact your accountant for professional tax advice.

How To Buy And Sell ETFs.

Buying and selling exchange traded funds is very straightforward. Follow this three-step process if you’re ready to invest in ETFs.

  • Know why and how you’ll invest: Clarify your financial goals and consult a professional financial advisor for advice (this is not it).
  • Research ETF products: Look at their past performance and other key metrics, consider the upside potential of underlying assets and ensure you understand the costs and risks involved.
  • Buy ETF units: Using a stockbroker, financial adviser or online brokerage app, place your buy orders and then monitor your investments to determine whether they still align with your goals. Read our guide to the best trading apps.

Important!

Check the ETF’s product disclosure statement (PDS) before you invest. It contains information that the ETF’s marketing may gloss over, including the fees and historical performance.

Buy ETFs With Our Featured Partner.

Trade Australian and international ETFs on an easy-to-use trading platform with 0% commissions on ETFs.

eToro Service ARSN 637 489 466 promoted by eToro AUS Capital Limited ACN 612 791 803 AFSL 491139. Capital at risk. See PDS and TMD. Zero commission does not apply to short or leveraged positions. Zero commission means that no broker fee has been charged when opening or closing the position. Other fees apply.

Final Word On Exchange Traded Funds

ETFs were invented for small investors and are increasingly gaining popularity across APAC, US and Europe, with growth at 16% per annum over the period 2016-2022.

This meteoric rise beats mutual funds by a long shot, which have grown at 5% per annum over the same period.

Now that you know what an ETF is and how it works, you’re (hopefully) more prepared to determine if investing in ETFs is a step towards your financial goals.

Jody

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