A beginner’s guide to exchange traded funds (ETFs)
How to invest in exchange traded funds – the benefits, the risks and how to get started.
If you’re looking for an easy and affordable way to create a diversified portfolio of shares, you might want to consider investing in exchange traded funds (ETFs). ETFs are investment funds made up of multiple shares and other assets that can be traded on a stock exchange.
ETFs have become increasingly mainstream in the last few years thanks to the rise of index fund investing and the simplicity of accessing many local or global shares in one trade. But how do they work, are they safe and how do you invest in them? Our guide covers everything you need to know about ETF investing.
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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 are comprised of a basket of securities such as shares and bonds.
Each ETF is allocated an ASX code and can be bought and sold by investors 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 shares, global shares, fixed income, debt, foreign currencies, commodities and metals.
There are two main types of ETFs in Australia:
- Passive ETFs. Also known as indexed ETFs or index funds, 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.
- Active ETFs. Active ETFs aim to outperform the market or a particular index to generate higher returns. These generally come with a higher level of risk and usually have higher management fees.
Having trouble choosing an ETF? Read our guide to the best performing ETFs of 2019.
What is an index fund?Index funds track a selection of stocks that make up an index. For example, the ASX200, S&P500 and Nasdaq are indices comprised of some of the world's biggest companies. An index fund will try to match the returns of its underlying index.
There are several reasons you may want to consider investing in ETFs:
- Diversify your portfolio. Buying units in just one ETF allows you to invest in many shares and asset classes at once. By spreading your money across asset classes, you can minimise 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.
- Easy to access. Rather than researching and then selecting a broad range of investments, the ETF issuer does all the hard work of choosing investments for you; all you have to do is choose the ETFs and purchase the units via a broker or online share trading platform.
- Relatively inexpensive. Creating a diversified portfolio through shares and other traditional investment options usually requires a significant amount of capital. But if you invest in ETFs, you can get started with as little as a few hundred dollars at a time or less if you use a micro-investing platform such as CommSec Pocket or Raiz.
- Lower fees. ETFs tend to have lower fees than traditional managed funds or LICs. 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 investments 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 or an emergency or opportunity, you can quickly liquidate your ETF holding.
- 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.
Top tips when buying and selling ETFs
Like share prices, the price of ETF units can fluctuate day-to-day. However, many ETFs move up and down in line with the index they are tracking, so 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 many standard ETFs are designed to mimic the performance of a specific market 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, 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. Because spreads are wider to account for potential market volatility when an underlying market is not trading, it can be better to place buy and sell orders when the market for the underlying asset 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. ETFs come in all shapes and sizes and carry different levels of risks depending on the type of assets it tracks. 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.
When you invest in an ETF, the first cost you'll be aware of is the ETF unit price; however, there are other less obvious costs you need to be aware of, such as the management fees. While ETFs typically charge lower fees than unlisted managed funds, this isn't always the case.
You should always read the PDS provided by the ETF issuer for full details of any fees that apply and how they will affect your investments. Here are the main costs to take note of:
- Management fees. Just like any other managed fund, ETFs have management fees, which are sometimes referred to as the management expense ratio (MER). This fee is charged by the ETF issuer and is usually included in the unit price.
- Brokerage fees. 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 $10 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.
ETFs are often advertised as being a safer investment than directly buying shares on the stock market, but this is not always the case. Although many ETFs are relatively safe index funds that track major indices, it's also possible for an index fund to track a volatile global market, such as rare earth metals or the oil market.
You should also remember that technically any kind of asset can be bundled into a fund as well as risky derivative-type products. This means that not all ETFs are passive index funds as you may believe. Always do your research before you invest. Here are some of the main risks to consider:
- 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'll 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 listed 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.
Physical ETFs vs synthetic ETFsPhysical 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). 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.
Synthetic ETFs have all the same risks as physical ETFs, but they also expose you to a few additional 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 of 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.
If you’ve researched the benefits and risks of investing in ETFs 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'll need to do the following:
- 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
Trade ETFs via CFDs
It's 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.
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