Your guide to investing in Exchange Traded Funds – the benefits, risks and how to get started with ETFs.
If you’re looking for an easy and affordable way to create a diversified portfolio, you might want to consider investing in Exchange Traded Funds (ETFs). These flexible investments combine the benefits of managed funds with the simplicity of online share trading, allowing you to generate returns in line with a share index.
Compare Online Brokers Who Trade ETFs
But what exactly are ETFs, how do they work and what are their benefits and risks? Let’s take a closer look.
What is an ETF?An ETF is a low-cost investment fund that can be traded on a stock exchange such as the Australian Securities Exchange (ASX). These funds are created by ETF issuers and fund managers and comprise a basket of securities.
Each ETF is allocated an ASX code and can be bought and sold by investors on the ASX in the same way that you would buy and sell shares. By investing in ETFs, you can easily create a diversified portfolio and spread your investment across a wide range of asset classes, including Australian and global shares, fixed income, debt, foreign currencies, commodities and metals.
There are two types of ETFs in Australia:
- Passive ETFs. Also known as indexed ETFs, these funds aim to replicate the returns of a specific index or benchmark. For example, you may want to invest in a fund that tracks the performance of the S&P/ASX 200 or the S&P 500. This is the most common type of ETF and what we will largely concentrate on in this article.
- Active ETFs. Active ETFs are those that aim to outperform the market or a particular index to generate higher returns. These are traded on the ASX AQUA market and generally come with a higher level of risk.
What are the benefits of investing in ETFs?
There are several reasons why you may want to consider investing in ETFs, such as:
- Diversify your portfolio. Buying shares in just one ETF allows you to invest across an extensive range of asset classes. This means you can spread your money across and within asset classes, thereby minimising your level of risk.
- Capital gains. If the underlying assets held by an ETF increase in value, the value of the ETF units you hold will also increase.
- Dividend income. If the underlying assets held by an ETF pay dividends, those dividends and franking credits (if applicable) will be passed on to you.
- All the benefits of a managed fund. Rather than researching and then selecting a broad range of investments, ETFs make it much simpler to create a suitable portfolio. The ETF issuer or fund manager does all the hard work of choosing investments for you; all you have to do is choose the ETFs you want to buy.
- Enjoy full transparency. The complete list of all underlying holdings of an ETF is provided to the market each day, while the net asset value of the ETF is also provided regularly. This means you can constantly monitor your risk exposure and invest with confidence.
- Minimal investment required. Creating a diversified portfolio through shares and other traditional investment options usually requires a significant outlay of capital. But if you invest in ETFs, you can get started with as little as $500.
- Lower fees. ETFs tend to have lower fees than traditional managed funds, providing a low-cost way for you to invest in a diversified portfolio. You can find more details on the cost of investing in ETFs further down the page.
- Tax-effective investment. Because most ETFs attempt to track the performance of a specific index, there is usually a low turnover of investments when compared to actively managed funds. This results in fewer capital gains tax (CGT) liabilities for investors.
- Easy exit. Unlike some other types of investment that lock you into a contract for a fixed term, ETFs are open-ended. This means that as long as there is sufficient liquidity available, you can buy and sell ETFs whenever you choose. For example, if you need fast access to your funds to pay an unexpected bill or take advantage of an opportunity in the market, you can quickly liquidate your ETF holding.
Top tips when buying and selling ETFs
Just like the value of a particular share, the value of an ETF can fluctuate each day. However, ETFs will usually move up and down in line with the index they are tracking. With this in mind, there are a few simple tips to keep in mind to help you get more out of your ETF investments:
- Compare the price. ETF issuers regularly provide net asset value (NAV) information, often in real time. This is commonly referred to as the indicative NAV (or iNAV), and by comparing it with the buy and sell prices quoted by your ETF broker, you can determine whether you will get value for money when buying or selling units in an ETF.
- Keep an eye out for tracking errors. While standard ETFs are designed to mimic the performance of a specific index, they won’t exactly replicate what the index does. This is known as a tracking error and it occurs because fees, taxes and a range of other factors can influence the value of an ETF. Under ASX rules, some ETF issuers must use “market makers” to ensure that the ETF’s stock market price stays within a specific range of its NAV.
- Time your trades. In the first and last 30 minutes of the day’s trading, when stock markets are opening and closing, there tends to be much more volatility in share prices. This means the spread between the ETF offer (for buyers) and bid prices (for sellers) can be wider.
- Know the opening hours of the underlying market. Due to the fact that spreads are wider to account for potential market volatility when an underlying market is not trading, it’s best to place buy and sell orders when the market for the underlying asset is open. For example, if you wanted to buy a fund that tracks shares on the Tokyo Stock Exchange, time your trade for when that exchange is open.
- Consider limit orders. The iNAV can change quite quickly throughout the day, as volatility in underlying markets drives it up or down. As a result, it’s safer to place limit orders rather than market orders when buying or selling, which will ensure that you get the price you want.
- Choose carefully. There are several risks associated with ETFs and you need to consider the index an ETF tracks when deciding whether it’s right for you. For example, while an ETF focused on resource stocks might offer the potential for higher returns, it also comes with a higher risk attached than an index that tracks the top 200 stocks.
What are the costs of investing in ETFs?
ETFs typically charge fewer management fees than managed funds, but there are still a few fees you need to consider:
- Management fees. Just like any other managed fund, ETFs attract management fees. This fee is charged by the ETF issuer and is usually included in the unit price.
- Brokerage fees. Next, you’ll need to pay brokerage fees whenever you buy or sell ETF units. These fees vary depending on the online broker you choose, but usually start at around $15 or $20.
- The buy/sell spread. This is the difference between the highest price you’re willing to pay for an ETF unit and the lowest price at which a seller is happy to sell.
Read the PDS provided by the ETF issuer for full details of any fees that apply and how they will affect your investments.
Are there any risks?
Just like any other investment, ETFs come with a range of risks. These include:
- Losing money. If the underlying assets owned by an ETF don’t perform as hoped, the value of an ETF will fall – and the value of ETF units you own will fall along with it.
- Tracking errors. As we mentioned above, ETFs don’t always exactly mimic the performance of the index they’re designed to track, with fees, taxes and other factors potentially resulting in lower-than-expected returns.
- Risks associated with individual ETFs. The underlying assets held by your ETF also come with their own risks. For example, if your ETF exposes you to investments that may be difficult to sell in certain market circumstances, such as commodities or emerging global markets, you will need to accept an increased level of risk.
- Currency risks. If you invest in an ETF that tracks the performance of overseas assets, fluctuations in the value of the Aussie dollar will have an impact on the value of your investment.
- International taxes. If you buy units in an ETF that is run in a country other than Australia, you may need to pay foreign taxes. Make sure you’re aware of all tax implications of an ETF before you commit any funds.
Synthetic ETFs have all the same risks as physical ETFs, but they also expose you to a few other potential problems:
- Counterparty risks. Synthetic ETFs take out contracts with third parties, which are usually investment banks. If these third parties are financially unable to fulfil any commitments they make to the ETF, such as paying the return on the underlying index to the ETF, the performance of your investment will suffer.
- Commodities risks. Most ETFs that track the performance of commodities are synthetic ETFs that track the futures price of a commodity or index. However, in some circumstances the price of futures differs from the price of the actual commodity, so it’s essential to be aware whether a fund tracks current or futures commodity prices before you buy.
Before deciding whether ETFs are the best investment solution for you, make sure you’re fully aware of how they work and have an in-depth understanding of all the risks involved. Read the PDS closely, ask questions of the ETF issuer if you’re unsure about anything, and consider seeking help from a qualified financial adviser.
How do I get started with ETFs?
If you’ve researched the benefits and risks of Exchange Traded Funds and you’re ready to get started, you’ll need to sign up for an online trading account. Most online share trading platforms allow you to trade ETFs and a range of other investment classes, so to start trading you will need to:
- Compare online trading accounts and choose one that’s right for you
- Sign up for a trading account. You’ll need to provide personal details and proof of ID
- Transfer money into your trading account
- Log in to your account
- Search for the ETF you want and place a buy order
Physical ETFs vs synthetic ETFs: what’s the difference?
ETFs allow you to invest in a diverse range of asset classes, but the way you access those asset classes varies depending on whether you select a physical ETF or a synthetic ETF:
- Physical ETFs. Standard ETFs are commonly referred to as physical ETFs, and they work by purchasing the underlying assets (such as shares) on the benchmark index that the ETF aims to replicate. This means that when you invest in an ETF, you don’t actually own the underlying assets; these are owned by the ETF and you own shares in the ETF.
- Synthetic ETFs. These types of ETFs are a little more complex. Not only do they directly own the underlying assets the fund invests in, but they also use derivatives to achieve their desired returns. Derivatives are instruments that derive their value from underlying assets (such as shares or commodities), and two well-known types of derivatives are options and futures contracts. The main advantage of synthetic ETFs is that they allow you to access investments that may otherwise be too expensive or simply impossible to buy.
Trade ETFs via CFDs
It is also possible to trade CFDs with ETFs as the underlying asset. CFDs are contracts for difference, which allow traders to speculate on the value of financial products without owning the underlying asset. For example, traders can purchase a CFD with an ETF as the underlying asset, and speculate if you think the ETF will rise (go long) or fall (go short) in value. CFDs are leveraged products, meaning that the potential returns on your investment are magnified, however so are your potential losses, and you can lose more than your initial deposit.