What is an ETF?
An exchange traded fund (ETF) is a regulated investment product holding assets, such as shares or commodities, which can be bought or sold on the stock market in the same way you might buy company shares. It aims to offer investors returns in line with a specific asset class, index or strategy.
Like managed funds, your money is pooled and managed as a single fund with an agreed investment strategy. You don't own the underlying investments; you own units in the ETF. As ETFs are open-ended, there is no limit to the number you can buy or sell.
ETFs offer the benefit of broad diversification through exposure to hundreds or thousands of individual securities in a single transaction. You can also potentially access alternative investment areas, like commodities or currencies, which historically were only available to institutional investors.
Types of ETFs
Types of investment strategies
ETFs can follow passive, active or smart beta strategies.
Aims to match the returns of a benchmark index. Traditional ETFs, also called ‘vanilla’ ETFs, are typically passive. An example of a passive ETF would be one following a broad-based index like the S&P/ASX 200.
Aims to outperform the market using a fund manager’s research and philosophy to select investments.
Smart beta investing
Aims to outperform the market in specific scenarios using rules or methodology in the form of fixed selection and eligibility criteria. It still tracks a benchmark or index but in a more tailored format. An example of a smart-beta ETF is the ETFS S&P/ASX 300 High Yield Plus ETF, which invests in a selection of companies from the S&P/ASX 300 with high and sustainable yields.
There are two ways for passive ETFs to track an index or benchmark – either physical or synthetic replication.
Physical replication: invests in the securities or assets of the index or benchmark.
Full replication holds all securities in the exact same proportion, for example all 300 companies from the S&P/ASX 300
Sampling replication holds a sample of the securities, which can be more cost-effective for indices with numerous constituents or where the top holdings represent most of the portfolio.
Synthetic replication: aims to replicate the index or benchmark performance by holding derivatives rather than the underlying securities, usually in the form of swap agreements.
Why use an ETF?
You have the ability to access a broad range of markets and asset classes without buying a large number of individual assets.
Liquid and transparent
In general, ETFs are as liquid as the underlying assets they hold, and as stocks are listed on the stock market, you can always see how your investment is performing.
Easy to use
Buying and selling ETFs is the same as trading shares any time the stock market is open, using normal brokerage accounts.
Risks of ETFs
It is also important to understand the risks associated with ETFs. A list of some risks, not all exclusive to ETF investing, follows.
While ETFs aim to track a particular benchmark index, the structure and costs of the ETF may mean its performance varies from this.
The risk that day to day operations of an ETF may be disrupted by operational issues such as a systems failure.
Trading away from net asset value (NAV)
In some circumstances, the price of units in an ETF may trade at a discount or premium to its NAV.
As ETFs replicate the price movements of their underlying index or benchmark, their performance is directly affected by the volatility of these underlying markets.
Changes in a company’s products or financial position could negatively impact its stock price. This can be mitigated through diversification and holding assets that are uncorrelated.
When using synthetic replication, if a counterparty defaults on its obligations under the swap agreement, it is unlikely they will provide the agreed return, which may potentially expose investors to losses.
Some ETFs invest in assets that are not liquid, like emerging market debt. At times, this can make it difficult to trade.
The volatility of the market can be directly related to economic factors that are outside of the control of the fund. Investors should be aware that outside economic factors can directly affect the performance of their investment.