Motley Fool Australia

What is an Exchange-Traded Fund (ETF)?

ETF

Image Source: Getty Images

Exchange-Traded Funds, or ETFs, can be an inexpensive way to diversify your investments. An ETF is a collection of securities that can include shares, bonds or commodities that are listed on the Australian Stock Exchange (ASX). They can be traded during the day, just like listed stocks, and usually track an underlying index.

Key takeaways:

  • An ETF is a collection of securities that can include shares, bonds, and commodities
  • ETFs may include Australian or international assets
  • You purchase a share in the ETF, not in its underlying assets
  • The price of an ETF fluctuates during the day as it’s bought and sold on an exchange
  • ETFs often have low management expense ratios, which is how much of its assets are spent managing the fund
  • You may have to pay broker commissions when buying into an ETF but these are usually lower than purchasing each security separately. 

Types of ETFs

Depending on your objectives, values, and attitude to risk, you can invest in different types of ETFs:

  • Industry ETFs focus on a specific industry, like financial services or resources
  • Commodity ETFs invest in commodities, such as gold or iron ore
  • Fixed-income ETFs focus on investments that offer a fixed return, like government or corporate bonds
  • Currency ETFs invest in the US dollar, Euro or other international currencies
  • International ETFs invest overseas
  • Ethical ETFs invest in businesses that align with a set of defined values, like sustainable activities.

How to buy and sell ETFs

You can buy and sell a unit in an ETF the same way you purchase shares, through a stockbroker. 

Real life examples of ETFs

There are many ETFs available in Australia:

  • SPDR S&P/ASX 200 Fund (STW) purchases all stocks on the ASX 200
  • Vanguard MSCI Australian Large Companies Index (VLC) tracks Australian companies with a market capitalisation of over $10 billion
  • VanEck Vectors MSCI Australian Sustainable Equity ETF (GRNV) has a diverse portfolio of Australian companies with high Environmental, Social and Governance (ESG) performance
  • iShares S&P/ASX Small Ordinaries ETF (ISO) invests in 200 Australian companies with small capitalisation
  • SPDR® S&P®/ASX Australian Government Bond Fund (GOVT) invests in Federal and State government bonds. 

Pros and cons of ETFs

ETFs give you the opportunity to invest in diverse securities at a low cost but they have advantages and disadvantages.

Pros of ETFs:

  • Diversification: Invest in a range of assets
  • Low cost: ETFs often have low management expense ratios and fewer broker commissions than other investments like managed funds
  • Choice: You can invest in industries or types of ETFs that suit your values, objectives, or risk profile
  • Transparency: The NAV (Net Asset Value) of your ETFs are published by the ASX every day so you can monitor them

Cons of ETFs:

  • Passive: Most ETFs aren’t actively managed
  • Market risk: If you invest in an industry ETF, you will be more susceptible to movements that affect that sector
  • Liquidity risk: If you invest in an ETF that holds underlying assets that are difficult to sell quickly, the NAV may not be reflected in the ETF’s price at a point in time
  • Price risk: ETFs are traded during the day and their price can move quickly.

Actively-managed ETFs

Many ETFs are passive and just follow an index. This means they hold all the stocks in that index, rather than selectively choosing the best securities. There are some actively-managed ETFs that have a manager who decides which assets to hold and in what proportion. Actively-managed ETFs are generally more expensive than passive ETFs. 

Indexed-stock ETFs

An indexed-stock ETF tries to replicate an index like the ASX 200. This is a passive investment that allows you to diversify your portfolio easily. 

Dividends and ETFs

If your ETF is invested in shares, you may be entitled to a proportion of the dividends those companies pay. Dividends are the earnings that a company chooses to pay to its shareholders. Some Australian companies pay franked dividends, which means you may also be entitled to receive franking credits. 

ETFs and taxes

Depending on the ETF and how you’ve chosen to invest in it, you may have to pay tax when you sell your investment or receive a dividend. Generally, buying and selling an ETF will trigger a capital gains tax liability in Australia. Some ETFs give you the underlying benefit of the assets sold, which means every time the index buys and sells an asset, you may also trigger a capital gain or loss. Other ETFs only trigger capital gains tax when you sell your investment. 

You may also be able to benefit from franking credits on the dividends paid by Australian companies that the ETF has invested in. Franking credits give you a tax credit for company tax paid by the company. 

If your ETF holds international assets, you may have to pay withholding tax on the income received from those assets. This will be withheld at the time the payment is made. 

ETFs market impact

ETFs are a popular way to invest in many assets at one time but some argue that they can have a negative impact on the market. The National Bureau of Economic Research reports that because many ETFs mimic an index but can be bought and sold easily, they can provoke a decline or inflate the market value. 

ETF creation and redemption

When you invest in an ETF, you don’t hold all the assets of the ETF directly. Instead you purchase a unit in the ETF, which holds a proportion of all the securities. The units are created by an authorised participant (AP) and the number of units available can be increased or decreased depending on demand. This process is called creation and redemption. 

You can see how an ETF is performing by looking at its Net Asset Value (NAV) compared to its price. The NAV is the value of its underlying assets.

Creation

An AP buys assets and then exchanges them with the ETF for units in it. These units can then be traded on the ASX. This process is called creation. 

Creation when shares trade at a premium

If the ETF is trading on the ASX for a higher price than the NAV of its assets, it’s trading at a premium. To bring the ETF price in line with its NAV, the AP can purchase assets and sell them to the ETF in exchange for more units. This is creation and increases the number of units available for sale, bringing the price down until it’s equal to the ETF. 

Redemption

The process of redemption reduces the number of ETF shares in the market. This happens when the AP buys shares in the ETF on the ASX and sells them to the ETF. In return, they get the individual assets which they can trade. 

Redemption when shares trade at a discount

An AP may use redemption as a way to increase the value of the shares in an ETF if they’re trading at a discount. By purchasing shares in the ETF, the AP is reducing the number of shares on the market, which will increase the price per share. 

The bottom line

ETFs allow you to invest in a broad range of assets at minimal cost. They come in many shapes and sizes to suit your preferences and values. But like with all investments, ETFs do come with potential drawbacks, so it’s important to review your options to make the best decision to suit your objectives and attitude to risk.