What is an ETF

An ETF is an Exchange-traded fund (ETF) It is an investment fund that tracks an index, a commodity or bonds and is traded on stock exchanges. So you can buy/sell ETFs like you would a stock option.

When you buy shares of an ETF, you are tracking the return of the investment in the original asset or portfolio of assets.

What’s an example?

As an example the $SPY ETF tracks the SP500 – there are various other ETFs that do the same thing but they are managed by different institutes and different Index Managers. $IVV $VOO and $SPDN are all SP500 ETFs. The Index Manager’s goal is to deliver the same results as the Index it is trying to copy (before fees). So $SPY and SP500 should theoretically deliver the same result year on year.

One of the main things that attract investors to ETFs is the trading speed, and the flexibility of shares merged with a relatively low-cost, diversification of index funds. There are literally hundreds of ETFs out there that track various markets and sectors. It could be easier to buy $XLV, which tracks the Health Sector, rather than buying dozens of individual Health Care stocks.

What are the benefits of ETFs

Low cost

ETF fees are usually significantly less than actively managed funds. ETFs are also more cost efficient than investing in the same exposure of individually purchased shares.

Diversification

ETFs provide investors with a highly diversified investment with broad exposure to entire markets within an index. This also includes shares that investors may not be able to access directly on a given exchange, including international shares.

Tax efficiency

The traditional low turnover of investments provided by an indexing approach minimises the capital gains distribution impact. This improves performance and tax efficiency over the longer term.

Liquidity

Your Index Manager should be able to create and redeem ETF units on a daily basis ensures the primary underlying depth of liquidity. Secondary sources of liquidity exist in the volume of trading of the ETF itself and the investment environment it is trading in.

Transparency

Each Index Manager provides regular information to the market including the daily fund Net Asset Value (NAV) making ETFs highly transparent investments

What are some of the common ETF myths and misconceptions

Myth 1: All ETFs are the same

Some view ETFs (and index funds in general) as commodity-like products with no material differences. However, even ETFs supposedly tracking the same market segment can deliver very different results because of factors such as the construction methodology of their target indexes and their day-to-day portfolio management. This means that one Index Manager might allocate a higher % of a certain stock within an ETF when compared to another Index Manager.

Myth 2: ETFs are illiquid

There are two levels of liquidity to think about with ETFs. The first, like listed shares, is shown in the quotes in the market as the number of shares available for purchase or sale at a particular price during the trading day.

This liquidity is affected by the number of firms trading each ETF, the number of orders from other investors and the investment environment on that day. The second source of liquidity comes from an ETF’s capability to issue or redeem units to meet excess demand or supply for purchases or sales above the liquidity shown in the market.

Myth 3: ETFs are complex

ETFs are very simple to understand. ETFs provide exposure to broad market indices. There is no leverage or derivative structure involved with these products.

Put simply, ETFs combine the low cost, diversification benefits of index funds with the trading flexibility of shares.

Myth 4: ETFs are tax inefficient

ETFs offer investors potential tax efficiencies due to their buy and hold approach and are potentially more tax-efficient than traditional managed funds. As index portfolios, ETFs tend to realise fewer capital gains than actively managed funds. This is due to a low turnover in the underlying securities in the fund.

Myth 5: ETFs are only for market-timers

Isn’t anything? With ETFs you’re looking longer term, rather than something to flip in a day. Some believe that ETFs are only appropriate for speculators, market-timers, or other investors with short time horizons. However, ETFs may benefit long-term investors even more so as the ETFs’ low expense ratios can more than offset commissions and spread over time.

Myth 6: ETFs are derivatives

ETFs are not derivatives. Like any managed fund, the value of an ETF depends on the net asset value of the fund underlying the ETF. ETFs are invested directly in the securities in the benchmark index.

What is an ETFs risk?

Like all investments, ETFs carry risk. The main risks are that: 1) the value of the portfolio falls; 2) fluctuations in the value of the Australian dollar affect the value of ETFs over international assets; 3) you may not be able to sell your ETFs for a fair price.

Market risk

The indices underlying an ETF usually comprise of many securities, protecting you against the specific risk of an individual security or stock performing poorly. For example, if the broad Australian stock market falls, an ETF that tracks the S&P/ASX 200 index will equally fall in value.

Currency risk

International unhedged ETFs could be exposed to currency risk. Meaning if the value of the dollar drops, so could your value.

Here are some things to consider before investing in an ETF:

  • Liquidity – Is there an active market for the underlying investments? If the underlying assets are traded regularly, you’ll be more likely to get a fair price for your ETF units
  • Derivatives – If the fund uses derivatives the risks may be higher.
  • Fees – Make sure you are aware of all the fees, including buy-sell spreads, as higher fees may reduce your returns.
  • Tax – How will the ETF returns be taxed?
  • Net asset value (NAV) – Does the price you’re about to buy or sell match the NAV quoted by the ETF issuer?
  • Product – Make sure you buy an ETF. Some other exchange-traded products look like ETFs but may have much higher risks.
  • Market – Are you buying a product on an Australian market? Products traded on a market in another country may not have the same rules and protections.
  • Index – It should be provided by a reputable index provider. If you’re not sure, consider getting advice from your financial adviser or stockbroker.

Micro investing in ETFs

Micro investing apps (like Raiz) allow you to start an investment portfolio of ETFs with small amounts of money. While many types of investments require at least $500 to start, micro investing allows you to access some investments with as little as $1.

You can build your micro investment account balance by rounding up purchases you make using a contactless card to the nearest dollar (or another set amount) and investing this ‘spare change’. You can also build your micro investing account by making regular deposits or by depositing a lump sum amount.

See more about Microinvesting here. Or you can read through all my investing blogs, finance blogs or etoro blogs

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