What is an Exchange-Traded Fund (ETF)?

Here we take a closer look at ETFs, the different types of ETFs, how to buy and sell ETFs and some of the pros and cons of ETFs for investors.

ETF
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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, and commodities that are listed on the Australian Stock Exchange (ASX). They can be traded during the day, just like listed shares, and usually track an underlying index.

Key takeaways:

  • An ETF is a collection of securities that can include shares, bonds, and commodities
  • ETFs might include Australian or international assets
  • You purchase units in an ETF, not its underlying assets
  • The price of an ETF share fluctuates during the day, as it’s bought and sold on an exchange
  • ETFs often have low management expense ratios (MERs) or fees
  • You will pay a broker commission (or online trading fee) when buying into an ETF, just as you would when you purchase an individual security. However, the commission on a single purchase of ETF shares is vastly cheaper than buying each share within the ETF 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 in overseas shares, bonds, and commodities
  • Ethical ETFs invest in businesses that align with a set of defined values, like sustainability.

How to buy and sell ETFs

You can buy and sell units in an ETF the same way you purchase shares – either through a stockbroker or via an online share trading platform.

Examples of ETFs on the ASX

There are many ETFs available in Australia:

  • SPDR S&P/ASX 200 Fund (ASX: STW) purchases all shares in the ASX 200
  • Vanguard MSCI Australian Large Companies Index (ASX: VLC) tracks Australian companies with a market capitalisation of more than $10 billion
  • VanEck Vectors MSCI Australian Sustainable Equity ETF (ASX: GRNV) has a diverse portfolio of Australian companies with high environmental, social, and governance (ESG) performance
  • iShares S&P/ASX Small Ordinaries (ASX: ISO) invests in 200 Australian companies with small market capitalisations
  • SPDR S&P/ASX Australian Government Bond Fund (ASX: 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 other advantages and disadvantages, too.

Pros of ETFs:

  • Diversification: Invest in a range of assets
  • Low cost: ETFs often have low management expense ratios and lower broker commissions than other investments, like managed funds
  • Choice: You can invest in whole industries or types of ETFs that suit your values, objectives, or risk profile
  • Transparency: The NAV (net asset value) of each ETF is published by the ASX every day, so you can monitor this.

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 might not be reflected in the ETF’s price at any 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 of the shares in that index, proportional to each share’s weighting by market capitalisation, rather than selectively choosing the best ones. 

Some ETFS are actively managed, which means a professional manager is deciding which assets to buy and in what proportion. Actively managed ETFs generally have a higher expense ratio than passive ETFs, which means investors pay higher fees. This reduces the amount paid to shareholders through regular distributions.

Distributions are similar to dividends – the only difference being that companies pay dividends (usually twice per year) to investors while funds pay distributions (usually quarterly).  

Index ETFs

An index ETF tries to replicate the returns of an index, like the ASX 200. This is a passive investment that allows you to diversify your portfolio easily, and at very low cost. 

Dividends and ETFs

If your ETF is invested in shares, you might be entitled to a proportion of the dividends those listed companies pay. Dividends are the earnings that a company chooses to pay to its shareholders. Some Australian companies pay franked dividends, which means you might also be entitled to receive franking credits. Franking credits give you a tax credit for the tax paid by the company. 

ETFs and taxes

You will have to pay tax when you sell your ETF investment for a capital gain, or when you receive a dividend. 

Generally, selling an ETF for a profit 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 ETF sells an asset, this will trigger a capital gain or loss for you. With other ETFs, a capital gains tax liability is only triggered when you sell the ETF. 

You might also be able to benefit from franking credits on the dividends paid by Australian companies that the ETF has invested in. 

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

Market impact of ETFs

ETFs are a popular way to invest in many assets at the one time, through a single trade, but some argue that ETFs 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 units in the ETF. Each unit 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 unit price. The NAV is the value of its underlying assets.

Creation

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

Creation when units trade at a premium

If the ETF is trading on the ASX for a higher price than its NAV, then 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 ETF’s price down until it is equal to the NAV. 

Redemption

The process of redemption reduces the number of ETF units in the market. This happens when the AP buys units 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 units trade at a discount

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

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. 

Like all investments, ETFs do come with potential drawbacks, so it’s important to review your options to help you make the best decision to suit your objectives and attitude to risk.

Updated as of 10 November 2021. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.