Explainer: ETFs for total beginners

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ETF stands for exchange traded fund. As of December 2019, there were more than 200 ETFs listed on the ASX with a total value of $61.5 billion.

An ETF allows you to invest in a broad range of companies all at once. If shares are like single flowers, an ETF is like a bouquet.

While a share is a slice of a particular business, an ETF tracks an asset class, such as Australian shares (S&P/ASX 200), global shares (S&P 500), bonds, or even property companies.

An ETF usually provides investment exposure to a wide range of investments within a particular asset class, so as opposed to owning a slice of one business, you get smaller slices of many different businesses within the asset you own (your ETF). With a property ETF you get a slice of many different real estate investment trusts (REITs) or with a fixed income ETF, you get a piece of many different bonds.

ETFs have experienced a surge in popularity in recent years and it’s not hard to see why. Instead of paying high fees to a fund manager who picks shares or tries to time the market, ETFs aim to provide the return of a whole entire asset class or index. Additionally, buying an ETF is more cost effective than buying multiple shares within the same category or theme.

The other benefit is that Australian ETFs can be traded on the ASX in the same way as shares in a company.

What is an ETF? Watch this simple explanation.

Retirees and ETFs
More Australians are investing in low-fee ETFs in their own personal portfolios and self-managed super funds (SMSFs). That’s because ETFs can provide investors with low-cost asset exposure, greater transparency, liquidity and tax advantages over traditional funds.

Investing in ETFs suits people who may not want to actively manage a portfolio, or want exposure to international markets, but don’t want to manage international trading accounts. Conversely, they also suit the more hands-on investor who might be happy managing their portfolio but who wants to diversify their investments, for which ETFs are perfect.

The other benefit for retiree investors interested in ETFs is that you benefit from share capital gains, dividends and franking credits paid by the shares contained within an ETF.

Popular ETFs in 2020
The popularity of an ETF can be judged in two ways:

1) an increase in the price of the ETF and its underlying holdings

2) new investors moving their money into the ETF (i.e. flows).

If we look at popularity of ETFs only from a ‘flow’ perspective (i.e. the number of new investors investing in a particular ETF), then the most recent popular ETFs are ones that simply track a market index such as the S&P/ASX 200.

For example, the Vanguard Australian Shares Index ETF (VAS) continued to attract investors and retained its crown as Australia’s largest ETF with $1.6b in net flows. VAS now manages $4.2b of Australian’s ETF money.

Benefits of ETFs

1. Lower fees
ETFs are passively managed, meaning they attract a lower cost than actively managed funds. Passive investing broadly refers to a buy-and-hold portfolio strategy for long-term investment horizons, with minimal trading in the market.

2. Cost efficient
ETFs are usually more cost efficient than purchasing a large number of individual shares, as there are fewer trading costs involved.

3. Diversification and accessibility
ETFs give investors exposure to a range of investment strategies, asset classes, geographic regions, sectors or industries through one simple transaction. ETFs can contain hundreds of holdings providing diversification and alleviating the risk of concentrating all your investments in one area.

4. Transparency
ETFs provide daily information about the holdings inside an ETF. They clearly state their investment objective, which is usually to achieve results in line with a market benchmark.

5. Ability to buy and sell quickly
ETFs provide the ability to buy or sell your investment quickly and easily as they trade just like a company on the share market. Unlike managed funds, investors are able to trade ETFs during ASX trading hours.

6. No minimum investment
ETFs provide a low hurdle initial investment making it easier for investors to get started. Unlike active funds, which can have minimum investment requirements of thousands of dollars, ETFs can be purchased with a few hundred dollars.

7. Tax efficiency
Tax can take a large slice out of investment returns, so it pays to invest in ways that are tax efficient. The low turnover (i.e. less buying and selling of companies) of an index ETF minimises the amount of capital gains being distributed to investors each year. This can improve after-tax performance and tax efficiency over the longer term.

Risks of ETFs

1. You’re still exposed to market risk
ETFs protect you against the specific risk of an individual security or stock performing poorly. Still, all investors are exposed to market risk. For example, if the broad Australian stock market falls, an ETF that tracks the S&P/ASX 200 index will equally fall in value.

2. Discrepancies in performance
An ETF’s performance may differ from the performance of the underlying assets it tracks. This could be caused by fees relating to the structure of the ETF and the management costs.

3. You may not be able to sell your ETF for a fair price
Liquidity can vary between different ETFs. Some ETFs are actively traded, so it’s easy to buy and sell. Others have relatively low turnover, which can make buying and selling at a fair price more difficult since there may not be many buyers when you want to sell.

There is also a risk of getting stuck in an ETF that shuts down, such as the one that AMP recently shut down. For this reason we avoid ETFs with low liquidity and low assets under management.

Chris Brycki is a passionate consumer champion and founder and CEO of Stockspot, Australia’s biggest online investment adviser. With more than 21 years of investment experience, he sits on two advisory committees for industry regulator ASIC, and was previously a fund manager at UBS. He has holds a commerce degree from UNSW.

Have you had experience with ETFs? Given this detailed explainer, are you now tempted to? 

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