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What are Exchange Traded Funds (ETFs) and how do they work?

Exchange Traded Funds are one of the most popular investment products in the world today. While similar to traditional managed funds or mFunds, in that they give investors access to a diverse range of securities, they are generally much more cost effective. Unlike traditional funds, they are able to be traded on the share market like any regular stock, which puts more control in the hands of the investor. Let’s look at how these funds work and examine some of the pros and cons.

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What are ETFs?

An Exchange Traded Fund, commonly known as an ETF, is an investment fund that holds a collection of assets like shares, commodities or bonds. As its name implies, ETFs are traded on exchanges like shares, so they can be bought and sold at any time during the trading day, unlike other types of investment funds.

Essentially, ETFs allow investors to trade a range of assets as one package, rather than having to individually buy all the components – you could think of it as buying a whole portfolio in one step. Because an ETF contains a range of different assets, they are popular among traders and investors looking to diversify their portfolio.

An ETF may contain hundreds or thousands of shares across various industries, or it could be solely focused on one particular industry, sector or investment type. For example, a resource-focused ETF could contain stocks of various mining and logging companies throughout the industry.

How do they work?

EFTs are created by providers – usually large financial firms – who will consider which index, sector or commodity to track, before setting up the fund to emulate it. After it has been designed, it must be approved by its relative governing body before it can be traded on the market.

ETFs that track an index, for example, buy the underlying assets of the index in accordance with their weighting, in order to mirror its rise and fall. For instance, an ETF designed to track the ASX 200 will own shares in all companies listed in that index. If the Commonwealth Bank makes up 7 percent of the index, then the ETF provider will put 7 percent of the fund into Commonwealth Bank shares. The aim is to track the overall performance of the index through the fluctuations of the individual assets.

Typically, all the assets contained in an ETF are owned by the fund provider, who then sells shares in that fund to investors. Those who purchase shares in an ETF will own part of that fund, but not the actual assets themselves. Despite this, investors in an ETF that tracks a stock index get lump dividend payments, or reinvestments, for the stocks that make up the index.

ETF vs mutual fund

Exchange-traded funds offer cost efficiency because of the way the fund is set up. Authorised participants (APs) bear the costs involved in buying the underlying assets, whereas a mutual fund will pay fees to the bank or financial institution every time they buy or sell assets. The AP then profits from the bid-offer spread of the quoted shares.

Depending on jurisdiction, ETFs may offer a more tax-efficient alternative to conventional mutual funds. The US provides some tax benefits when investing in ETFs, compared to traditional funds, but the same is not true in all jurisdictions.

Traditional funds tend to be more broad-based when it comes to the assets it contains in order to satisfy diversification of risk. This is compared to more specific ETF assets. With ETFs, one can gain exposure to a portfolio as specific as a smartphone index or real estate index. The extensive range of ETFs allows for more control in one’s diversification strategies. High minimum investments are often required to enter mutual funds, whereas ETFs do not have such limitations. This means that even a small portfolio can be diversified at an efficient cost.

Things to consider when trading ETFs

  •  Lower costs
    • One of the key benefits to ETFs is that they have much lower ongoing costs than traditional managed funds. Managed funds need an investment manager to be actively involved in analysing and selecting stocks. They will also charge clients for everything that goes on inside the fund, such as transaction fees, distribution charges, and transfer-agent costs.
      In the case of an ETF, those expenses aren’t being passed on. ETFs are also more transparent – it’s very easy to access the holdings and price of your ETF, whereas managed funds are less likely to share this information, so it’s harder to know where your money is invested.
  • Diversification and risk
    • Because ETFs allow you to buy a basket of assets in a single trade, they are seen as a fast and simple way of diversifying your portfolio and reducing risk. Owning an ETF of the S&P 500, for instance, will give you immediate exposure to the best-known companies listed on US markets, while somewhat shielding you from fluctuations in individual stocks. 
      However, some ETFs are considerably riskier than others and it is important to do your research before buying – some take on leverage, which amplifies both gains and losses. Others, particularly in the commodities space, focus on highly volatile assets.
  • Lower yields (in most cases)
    • Another thing to keep in mind with ETFs is that they tend to have lower yields than many blue-chip stocks, if they pay a dividend at all. ETFs track a broad market, so the overall yield will usually average out to be much lower than some high-yielding shares. However, some ETFs focus specifically on delivering high yields by focusing on niches like junk bonds and real estate.
  • Range of ETFs
    • There are thousands of ETFs, covering a huge range of sectors, markets, commodities and investment niches. Considering the area you would like to focus on is a great way to get started. Here are some of the key areas to look at: 
      • Market – Market ETFs usually track a major market index, like the S&P 500 or Dow Jones, but there are ETFs created to track smaller indices as well.
      • Currency – Currency ETFs track a foreign currency similar to the way a market ETF tracks its underlying index. In some cases, it may track a basket of currencies, giving investors access to multiple foreign currencies.
      • Industry – Industry ETFs will track a sector index that covers a certain industry, like the ASX 200 Materials Index, for example. This can be a great option for those looking for access to a specific sector, like finance or pharmaceuticals.
      • Commodity – Commodity ETFs are similar to industry ETFs in that they target certain areas of the market. In this case, the fund provider will not actually own any gold or crude oil, for example, but will be tracking these commodities through a swap agreement in what is known as synthetic ETF. 
      • Bonds – Bonds ETFs cover a range of areas in the bonds market. A Bonds ETF might track corporate and municipal bonds, or even bonds of different nations. They may also be based on other factors like bond length.

Bottom line

With thousands of ETFs available, covering virtually every market around the world, the range of opportunities in this area are endless. Whether you are just starting as an investor or are a seasoned day-trader, the flexibility and diversity of ETFs means it's easy to find a place for them in your investment strategy. Understanding the type of ETF you are investing in and knowing how much money you are looking to invest are key to getting the most out of your investment.
 
To find out more, visit our Exchange Traded funds page.


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