What is an Exchange Traded Fund?
Simply put, an exchange traded fund (ETF) is a basket of securities that trade on an exchange, in exactly the same manner as a stock. Like a managed fund, ETFs allow consumers to invest in an investment pool with a single trade.
An ETF can be structured to track anything from the price of an individual commodity to a large, diverse securities portfolio. ETFs can even be structured to track specific investment strategies, for example the S&P/ASX200.
An ETF’s share price will fluctuate throughout the trading day as the shares are traded on the market, making them more liquid than other investment types
Types of ETFs
An ETF can be comprised of many types of investments including bonds, stocks and commodities, and has an associated price that allows it to be easily bought and sold.
Active & Passive ETFs
An ETF will generally fall into one of two categories: active or passive. Active investments are actively managed by a fund manager whose job it is to select the portfolio’s investments, and buy and sell assets in accordance with market fluctuations. Essentially, these fund managers are working to beat the market and optimise returns. However, this also means that your active investment will come at a higher cost to you.
Passive investments track an index, and as such, cannot beat or under-perform the market.
Stock ETFs
One of the most common types of ETFs, stock ETFs replicate a stock index or a collection of stocks grouped by sector, location or other commonality. Each individual stock is weighted and the overall performance tracked; one share in a stock-based ETF will buy you a token amount of each company it is tracking. Stock ETFs can be active or passive investments.
Bond ETFs
Historically, bonds were out of reach for the average investor. However, these days bond ETFs can be traded on the ASX, giving investors exposure to the bond market with interest/coupon payments.
Sector/Industry ETFs
ETFs can be broken down into sector/industry, allowing you to track a selection of investments in that industry. For example, if you were predicting a boom in the mining sector, you could track companies limited to just the mining industry.
International ETFs
International ETFs allow you access to foreign markets without the need for an international share trading platform. However, it’s important to keep in mind that as the value of the foreign currencies fluctuate against the Aussie dollar, so will the value of your investment.
Commodity ETFs
These work much the same way as sector/industry ETFs but they focus on a certain commodity, for example, oil or gold.
Pros & Cons of ETFs
PROS
Diversification
ETFs provide you access to many stocks across various industries in a single trade, many of which can be difficult or expensive to access.
Transparency
The net asset value (NAV) of ETFs are published daily on the ASX, allowing you to track how the underlying assets are performing and if the price of the ETF reflects the NAV.
Affordability
Many ETFs are substantially cheaper than most actively managed funds.
Ease
ETFs are easily bought and sold during the ASX’s trading hours, making your investments very liquid.
CONS
Market/Sector Risk
If the market or sector your ETF is tracking experiences a decrease in value, so too will the value of your investment.
Currency Risk
International ETFs run the risk of currency fluctuations impacting returns. However, some international ETFs are ‘currency hedged’, which eliminates this risk.
Liquidity Risk
Some ETFs invest in assets such as emerging market debt, which are not liquid – this makes it difficult for the EFT to create or redeem securities.
Tracking Errors
There are a number of factors such as fees, taxes or the illiquidity of the underlying assets of an ETF that can move its price away from the index it is tracking. This can result in the ETF being traded at a disparity to the net asset value (NAV).
Risks of ETFs
In addition to the risks mentioned above, there is also the risk of ‘slippage’. Slippage occurs when the actual price you pay for an ETF is different than the price you were expecting to pay. This can happen when the price of the ETF changes after your order has been placed, and is due to the number of trades that are executed in that time.
Investing in an ETF can seem daunting, but arming yourself with the right knowledge and preparing yourself for possible risks can help you set realistic expectations. If you would like professional advice regarding investing in ETFs, the experts at Super Network can help you. Contact us now for an obligation-free consultation.
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