What is an ETF? A beginner's guide to exchange traded funds
Want to invest in hundreds of companies without spending a fortune or picking individual shares?
That's one reason exchange traded funds, better known as ETFs, have become one of Australia's most popular investments.
Here's what ETFs are, how they work and what to consider before buying one.
- ETF stands for exchange traded fund.
- ETFs are bought and sold on the ASX like shares.
- One ETF can provide exposure to hundreds of investments.
- ETFs can hold shares, bonds, cash, property or commodities.
- ETFs are popular because they offer diversification at a relatively low cost.
What is an ETF?
Exchange traded funds, better known as ETFs, have become one of the most popular ways for Australians to invest.
ETFs may sound technical, but the basic idea is straightforward. An ETF is a fund you can buy and sell on the share market, much like you would buy or sell shares.
When you buy shares, you are usually buying a piece of one company, such as Commonwealth Bank. When you buy an ETF, you are buying units in a fund that holds a basket of investments.
That basket may include Australian shares, global shares, bonds, cash-like investments, gold or a specific group of companies.
One ETF can give you exposure to hundreds of investments through a single trade.
How do ETFs work?
In Australia, there are now more than 450 ETFs listed on the ASX. Many ETFs are designed to track an index. The S&P/ASX 200, for example, is an index that tracks 200 of the largest companies listed in Australia.
The job of an ETF that tracks an index is to follow that index as closely as possible, after fees and costs. These are often called passive ETFs.
Some ETFs are actively managed, which means an investment manager decides what to buy and sell. They usually aim to outperform a benchmark or achieve a particular investment outcome.
The value of your ETF units will generally rise or fall depending on what happens to the investments inside the fund.
You can buy and sell ETFs during market hours through an online broker or an investment platform that creates a portfolio of ETFs for you.
Sarah has $3000 to invest. She decides to buy a broad Australian shares ETF that holds a basket of companies listed on the ASX.
If each ETF unit costs $30, Sarah's $3000 buys her 100 units.
In her trading account, Sarah will see that she owns 100 units of the ETF, not each company inside it.
Behind the scenes, those units give her exposure to the companies held by the fund. If those companies rise in value, her ETF units should rise too. If they fall, her units will generally fall.
Why are ETFs so popular?
ETFs have become popular because they make investing easier.
Diversification is a major driver of their popularity, because one ETF can give an investor exposure to many underlying investments.
Diversification does not remove risk, but it can reduce the impact of one company performing badly.
They have also made it easier for everyday investors to access investments that were once harder or more expensive to reach, such as overseas shares and fixed income.
What are the different types of ETFs?
There are many types of ETFs. Some are broad and relatively easy to understand. Others are more specialised.
Australian shares ETFs
Australian shares ETFs invest in Australian companies. Some track the broad local market, while others focus on areas such as banks, resources or dividends.
Global shares ETFs
Global shares ETFs invest in companies outside Australia. They can help reduce reliance on the Australian sharemarket, which is heavily weighted to a few major sectors.
Bond ETFs
Bond ETFs invest in fixed income securities, such as government or corporate bonds. They are often used by investors who want a more defensive part of their portfolio, although they can still fall in value.
Income ETFs
Income ETFs focus on investments that aim to pay income, such as dividends or interest. They can appeal to investors looking for cash flow.
Thematic and sector ETFs
Thematic and sector ETFs focus on specific areas such as technology, healthcare, artificial intelligence, resources or energy. They can be interesting, but they are often more concentrated than broad market ETFs, so their returns can swing more sharply.
What are the risks of ETFs?
ETFs are simple to buy, but are not risk-free.
The main risk is that the investments inside the ETF fall in value. If you buy a share market ETF and the share market falls, your ETF will generally fall too.
There is also concentration risk. Some ETFs may hold many investments, but still be heavily exposed to one country, sector, currency or theme.
Overlap is another issue. An investor might hold a broad global shares ETF and then add a technology ETF, not realising both may hold many of the same companies, and end up paying multiple sets of fees for the same underlying investments.
Currency risk can matter with global ETFs. If the Australian dollar moves, it can affect returns. Some global ETFs are hedged, which can reduce the impact of currency volatility.
Liquidity is worth checking. Big, widely traded ETFs are usually easy to buy and sell. Smaller or niche ETFs can be harder to trade and may cost more to buy or sell.
InvestSMART uses a five-star rating system to assess every ETF on the ASX across key risk measures, including size, fees, spreads, liquidity and tracking error.
It is a free tool and a useful starting point for researching and comparing ETFs.
- ETF: Exchange traded fund.
- Unit: What you buy when you invest in an ETF.
- Index: A measure of a market, such as Australian shares or global shares.
- Distribution: Income paid by an ETF, often from dividends or interest received by the fund.
- MER: Management expense ratio. This is the fee charged by the ETF provider.
- Bid-ask spread: The gap between the price buyers are offering and the price sellers are asking.
What do ETFs cost?
The main cost is the management fee, usually called the MER. It is shown as a percentage per year. An ETF with an MER of 0.20% costs $2 a year for every $1,000 invested, before other costs.
You may also pay brokerage when you buy or sell, depending on the platform you use. The bid-ask spread is another cost, and it can be wider for smaller or more specialised ETFs.
Tax also matters. ETFs may pay distributions, and you may make a capital gain or loss when you sell. The outcome will depend on your circumstances.
- What does this ETF invest in?
- What does it cost?
- How risky are the underlying investments?
- Does it overlap with investments I already own?
- Would I still be comfortable holding it if it fell in value?
Are ETFs suitable for beginners?
ETFs can suit many types of investors, including beginners.
They may suit investors who want diversified exposure without picking individual shares.
Not every ETF suits every person. The right ETF depends on what you are trying to achieve, how long you plan to invest, and how comfortable you are with the value moving up and down.
Money needed in the next year or two probably does not belong in a share market ETF. Money being invested for longer-term goals has more time to ride out market falls.
How ETFs can form the core of a portfolio
ETFs really come into their own when they are combined to create a diversified portfolio.
A thoughtful mix of ETFs can combine growth, income and defensive assets in a way that matches an investor's goals, timeframe and comfort with risk.
The aim is not to collect as many ETFs as possible. More ETFs does not always mean better diversification, especially if several funds hold similar underlying investments.
Used well, ETFs can create excellent building blocks for the core of an investor's portfolio. Used poorly, they can become another way to chase the latest market trend.
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