ETF's | website

ETF's - What are they and how do they work?

Exchange traded funds (ETFs) are a simple and low-cost way to get investment returns similar to a share index or another underlying asset. However, some ETFs are more complex and risky than others. Here we explain the risks and what you need to know before you invest.

What is an ETF?

An ETF is a type of investment fund that can be freely bought and sold on a securities exchange market. In Australia, ordinary ETFs are a 'passive' long term investment used to track an asset or market index for example, an ASX200 ETF will track the movement of the Australian top 200 ASX listed companies. 'Passive' ETF's generally do not try to outperform the market and will go up or down in value in line with the index they are tracking and are used for long term more 'stable' investment.

If an investment is called an active ETF then it encompasses a fund manager who is actively trying to outperform the market or index to achieve a different investment objective.

The difference between physical and synthetic ETF's

ETFs are available for a broad range of assets including Australian shares, international shares, fixed income products, foreign currencies, precious metals and commodities. They can be used as a way to diversify your investment portfolio, and usually have lower fees than a traditional managed fund.

Physical ETFs

Standard or 'physical' ETFs buy an underlying investment (such as shares and other assets) on the relating to the index that the ETF is seeking to track.

If you invest in an ETF, you won't directly own the underlying investments, the ETF will own these, you will own units or shares in the ETF.

Your main investment risk is the performance of the underlying shares or other assets.

Synthetic ETFs

'Synthetic' ETFs have a material exposure to derivatives as well as the underlying assets that the ETF is seeking to track. Along with the benefits and risks of physical ETFs, synthetic ETFs have additional risks such as the credit risk associated with the derivative.

When the product is not an ETF

Some products that also track an index or other investments may 'look and feel' like ETFs, but they are not ETFs. Products labeled 'exchange traded commodities', 'exchange traded notes', 'exchange traded certificates', and 'exchange traded securities' are not ETFs.

There are also active ETFs, sometimes referred to as exchange traded managed funds and exchange traded hedge funds that, unlike passive ETFs, do not simply track an index. They may use strategies to try to outperform an index or seek enhanced returns. The risks of these products can be different and sometimes much higher than the risks of ETFs.

What will your ETF investment cost?

While ETFs may have lower fees compared with other managed investments, management fees can vary and may be higher than the fees of an equivalent unlisted or unquoted index fund.

You will also pay brokerage fees when you buy or sell ETF units. If you want to make a small regular investment in a product that tracks an index, you might be better off using an unlisted managed investment such as an index fund where broker fees won't apply to each contribution, although other fees may apply.

Buy-sell spread

The 'buy-sell spread' (the difference between the prices that you can buy and sell ETF units at) could be considered a cost for you when you buy or sell ETF units, although market makers usually ensure the spread remains relatively small.

If you're selling you can work out the 'buy-sell spread' by subtracting the bid price from the NAV to calculate a 'dollar spread' and then dividing the 'dollar spread' by the 'bid price' to get the 'percentage spread'.

If you're buying you can calculate the 'dollar spread' by subtracting the NAV from the offer price, and then calculate 'percentage spread' by dividing the 'dollar spread' by the offer price.

What are the Risks of ETF's?

Market liquidity

Some ETFs offer exposure to investments such as small companies, emerging markets or commodities that may be harder to sell in certain circumstances, or more complex and volatile than ordinary company shares. This could increase risks for investors.

Currency risk

If the ETF tracks overseas assets, changes in the value of the Australian dollar may also affect the value of your investment. Some funds may be 'currency hedged' to reduce this risk.

International taxes

When you buy units in an ETF located in another country (but also traded on an Australian market) foreign taxes may apply. For example, if you buy units in a US ETF, US estate taxes may be payable when you die.

Read the PDS to understand how your investment will be taxed, and if you're not sure contact the ETF provider or a tax adviser.

Fixed income ETFs

Fixed income ETFs aim to replicate the performance of assets such as bonds and debentures.

The Australian Securities Exchange (ASX) has restrictions on what indices or non-exchange traded bonds or debentures can underlie an ETF, however the value of the underlying assets may rise and fall, which means the price of the ETF can also rise and fall.

The secondary market for corporate bonds may be less active than the market for ordinary shares, making it harder for the ETF issuer to sell its bond investments. See ASIC's investing in corporate bonds for more information about fixed income investments.

Read the PDS

Read the PDS carefully, ask questions and consider getting professional advice from a licensed financial adviser. You can also check recent market announcements for new information on the product.

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

Liquidity - Is there an active market for the underlying investments? You may be more likely to get a fair price for your ETF units if the underlying assets are traded regularly.
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 buying 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 - Is the index being tracked provided by a reputable index provider? If you're not sure consider getting advice from your financial adviser.

Before you invest in ETFs do your homework. Read the PDS and consider getting advice from a licensed financial adviser. Diversifying your investments between asset classes and product issuers can help control your risks.

Disclaimer

The information in this website and the links provided are for general information only and should not be taken as constituting professional advice from the website owner.