ETFs: What they are and how they work

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Exchange-traded funds (ETFs) trade on the stock market in much the same way as equities. Investor money is pooled together to purchase cash, shares, bonds and listed property trusts.

These underlying assets are then held by a trustee on behalf of unit holders.

Investors get a distribution every financial year of dividends (less expenses) and capital gains from the underlying investments.

how etfs work

Passive vs active

There are two main types of ETFs: passive and active.

Passive ETFs typically track an index, by buying all or a representative sample of the securities in it. This can be a broad market index, such as the S&P ASX200, a sector index, or a custom-built index.

When people mention ETFs, it's likely they're talking about passive ETFs. But there are also active ETFs.

Active ETFs represent a far smaller segment of the ETF market, and are much like traditional managed funds. Fund managers will do research to then buy the selection of stocks that they think will best achieve the fund's mandate.

"Although there are more active ETFs to choose from than ever before, ETFs that track an index still dominate, with 82% of investors using this style," says the head of SPDR ETF Asia Pacific Distribution, Meaghan Victor.

Premiums and discounts

While ETFs are generally priced based on the value of their underlying assets - the net asset value (NAV) - they can also trade at a premium or discount to this.

If investors quickly bid up the price they're willing to pay for an ETF, this will result in a premium on the NAV. Inversely, if they quickly sell off ETF units, then the ETF may trade at a discount.

However, premiums and discounts are usually fleeting, as broker-dealers typically take advantage of this by arbitraging the price difference back to fair value.

You can calculate the NAV, to compare to the listing price, by taking the assets of the fund, subtracting the liabilities and dividing this by the number of units in the fund.

Trading

ETFs can be bought or sold through a stockbroker or an automated trading platform such as CommSec.

Remember that settlement can occur up to two days after the buy or sell order is placed.

In order to avoid paying a premium to the NAV, its best to buy ETFs when the market is open. Equally, if you want to buy an ETF full of international equities, try buy when the main market it's exposed to is open.

History

The first ETFs - the SPDR S&P/ASX 50 Fund and the SPDR S&P/ASX 200 Fund - launched in Australia 20 years ago.

As of July 30, 2021, there were 223 ETFs representing a market capitalisation of $116.5 billion.

Their rising popularity has dovetailed crises, first the global financial crisis and then the COVID-19 pandemic.

"What we have seen during market crises is that ETF trading volumes have surged, highlighting that ETFs continue to function as originally intended - as buffers and sources of liquidity in stressed markets," says Victor.

"The COVID-19 pandemic has brought extreme challenges to markets across the globe, impacting liquidity across nearly all investment vehicles and asset classes," says Victor.

"Yet despite these challenges, ETFs have performed well, providing market participants with liquidity and price discovery when they need it most. Investors are particularly drawn to ETFs as a way to take advantage market downturns.

Advantages

Low cost

Passive ETFs generally have low ongoing fees since they don't demand the same amount management resources as do actively managed funds.

Up-front brokerage fees are comparable to any other stockmarket transaction. In this way, buying and selling an ETF is not dissimilar to buying and selling a single equity.

Diversification

ETFs provide extremely high levels of diversification. Indeed it's one of the free lunches in investment finance.

One ETF can provide instant exposure to an entire market or sector, for instance,

Transparency

Unlike managed funds, which typically disclose their holdings and results monthly, investors of an ETF can easily see current performance and what assets contribute to it.

Disadvantages

Won't beat the market

By definition, passive ETFs won't beat the index that they're designed to track. So while it's a safe bet that you'll capture most of the performance in the index as a whole, you won't enjoy the kind of outperformance possible with actively managed funds.

Liquidity

While the most popular ETFs are frequently traded, and thus have high liquidity, more obscure ETFs might not enjoy the same sort of turnover. If you hold an ETF with low turnover, then it may be hard to exit the position.

Currency risk

ETFs that invest in international securities may be adversely affected by currency changes. A rising Australian dollar will decrease the value of these investments. Some ETFs mitigate this risk by entering into forward foreign exchange contracts through a third party.

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David Thornton was a journalist at Money from September 2019 to November 2021. He previously worked at Your Money, covering market news as producer of Trading Day Live. Before that, he covered business and finance news at The Constant Investor. David holds a Masters of International Relations from the University of Melbourne.