An exchange traded fund (ETF) is a cross between an index fund and a stock. It combines the low fees and diversification of an index fund and the liquidity of stocks. ETFs allow you to invest in a security that tracks a specific index (ASX50, ASX100) like an index fund but unlike an index fund you do not buy into the fund directly but rather buy and sell it like a stock on an exchange, ie the Australian Securities Exchange (ASX).
For more details on index funds please visit the index fund detail page.
Exchange traded funds are one of the fastest growing investment products in the world. Although they are not as popular in Australia , Australian investors are finally seeing the benefits of it. ETF’s allow investors to access a pool of stocks in a single unit, giving instant diversification. Unlike actively managed fund (where fund managers handpicks the stocks), index funds and ETFs are designed to closely follow a particular index or sector. This means the returns generally correlate closely with the indicies performance. For example if you invest in an index fund or ETF that tracks the S&P/ASX 200, then if the S&P/ASX 200 index is up then the ETF will also be up.
The biggest difference between an index fund and an ETF is that ETFs are traded like ordinary shares on the ASX, this is the reasons why ETFs are becoming so popular, especially with professional and active traders. This mean they can be bought and sold with conditional orders like shares, can be shorted like shares and even margin purchases like shares (when available). Since ETFs are treated like shares they allow speculative investors to bet on the directions of the short term movements through the trading of a single unit.
Australian ETFs are dominated by two ETF providers: State Street Global Advisors (SSgA) and Barclays Global Investors. SSgA's launched their first product in 1991 called StreetTrack, later renamed SPDR (Standard & Poors' Despository Receipts). SSgA currently offers 3 ETFs that are listed on the ASX, the SSGA SPDR S&P/ASX 200, the SSGA SPDR S&P/ASX 50 and the SSGA SPDR S&P/ASX 200 Listed Property.
Barclays Global Investors currently has 19 ETF listed on the ASX called iShares. Unlike SSgA, iShare's products concentrate on international indices. The top iShares ETF traded on the ASX includes iShares MSCI Emerging Markets, iShares S&P Global 100, iShares S&P 500, iShares FTSE/XINHUA China 25 & iShares MSCI EAFE.
More recently Vanguard has introduced 3 new products including the Vanguard Australian Shares Index ETF, Vanguard All-World ex-US Shares Index ETF and Vanguard US Total Market Shares Index ETF, Fore more details please visit the Vanguard website.
For those wanting to invest in commodities ETF, ETF Securities has recently launched 4 ETFs on platinum, gold, palladium and Silver. For those who think commodity prices will rise in the short to medium term, these commodity ETF’s are a good option.
Without doubt, the biggest attraction with ETFs is the fee structure. This is important because fees are deducted directly from an investors return. Compared to the average fee for a managed fund, which have an average MER (management expense ratio) of about 2%, the fees of an ETFs can be as low as 0.3%. Also with ETFs there are no entry or exit fees which can be up to 4% for retail managed funds. With ETF’s investors pay a brokerage fee, just like shares.
Advantages of ETF
- Simple: Unlike traditional managed funds, ETFs are a lot easier to understand. They track a particular index by buying all the securities in that index. Simple. It is also more transparent (Net Asset Values (NAV) are listed daily)
- Low cost: One of the major attractions of an ETFs are the fees. The fees are comparable to index funds and considerably lower than the average managed fund fee (MER) 0.5% compared to about 2% respectively. There are also no entry or exit fees, which are up to 4% in retail managed funds
- Continuous pricing: Unlike with index funds or managed funds where the exit/entry price depends on the NAV the price of and ETF is continuous and transparent, like a stock. If you need to buy or sell a particular unit you pay what the market price is at the current time. You do not need to wait until the close of trade to determine the current market price of your investment
- Diversification: You can buy ETF’s that invest in the Australian share market, international share market, sector index and commodities, precious metals.
- Tax efficiency: Lower turnover rate compared to traditional managed funds means lower capitals gain tax. Also because you are in charge of when to buy or sell you are in control of your tax destiny
- No savings plan: Unlike managed funds with saving plans that allows regularly contributions, ETF must be bought through a broker and therefore incur brokerage fees. This means if you invest $1,000, $30 or 3% are brokerage fees. This makes dollar cost averaging impractical. Exchange traded funds are most practical for deploying larger sums of capital and may not suit investors who make small ongoing contributions.
- Paying more than the NAV: The fact that the prices of ETF are determined by the markets, means that there will be times when you will pay higher than the NAV price if you consider selling. However, this is offset by the fact that you may pay less than the NAV, also due to market forces.