What is an exchange-traded fund (ETF)?

Why invest in ETFs?

Exchange-traded funds, or ETFs, can provide a quick and inexpensive way to diversify your portfolio. ETFs are pooled investment vehicles where a fund manager raises money from many investors and then uses that cash to invest in a portfolio of assets. These might include shares, bonds, commodities, or even cryptocurrencies.

An ETF is very similar to a managed fund, with the critical difference being that ETFs are listed on a stock exchange, like the Australian Securities Exchange (ASX). This means they can be traded during the day, just like other listed shares.

While some ETFs are actively managed, most are passive investments that attempt to replicate the returns of a particular benchmark index, such as the S&P/ASX 200 Index (ASX: XJO).

Key features of exchange-traded funds

• An ETF is a collection of securities that can include shares, bonds, commodities, and currencies
• ETFs might include Australian or international assets
• You can buy and sell units in an ETF the same way you purchase shares through a stockbroker or via an online share trading platform.
• You usually purchase units in an ETF, not its underlying investments
• The unit price of an ETF 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 purchasing most other securities. However, the commission on a single purchase of ETF shares is vastly cheaper than what you would otherwise pay to buy each individual asset held within the ETF. 

What are the different types of ETFs?

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

• Industry ETFs focus on a specific industry, like financial services, resources, or healthcare.
• Commodity ETFs invest in commodities, such as gold or iron ore.
• Fixed-income ETFs concentrate 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 defined values, like sustainability.

Benefits and disadvantages of ETFs

ETFs allow you to invest in diverse securities at a low cost but have other advantages and disadvantages. Some of the pros include:

• Diversification: Invest in a wide range of assets in a single trade.
• 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 daily, so you can monitor this.

There are a few disadvantages to keep in mind too, including:

• Passive: Most ETFs aren't actively managed (although this keeps fees low).
• Market risk: If you invest in an industry ETF, you will be more susceptible to events that affect that sector.
• Liquidity risk: If you invest in an ETF that holds underlying assets that are difficult to sell quickly, such as real estate, 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.

Does investing in ETFs impact the market?

ETFs are a popular way to invest in many assets simultaneously through a single trade, but some argue that ETFs can negatively impact the market. 

This is because ETFs mimic an index but can be bought and sold quickly, so they can provoke a decline or increase in the index's market value. 

Examples of ETFs on the ASX

There are many exchange-traded funds available in Australia. Here are just a few examples:

• SPDR S&P/ASX 200 (ASX: STW) is an index fund for the ASX 200. This means it purchases all shares in the ASX 200 – the top 200 companies listed on the exchange by market capitalisation
• Vanguard MSCI Australian Large Companies Index ETF (ASX: VLC) tracks Australian companies with a market capitalisation of more than $10 billion
• VanEck MSCI Australian Sustainable Equity ETF (ASX: GRNV) has a diverse portfolio of Australian companies with high environmental, social, and corporate governance (ESG) performance
• iShares S&P/ASX Small Ordinaries ETF (ASX: ISO) invests in 200 Australian companies with small market capitalisations and high growth potential
• SPDR S&P/ASX Australian Government Bond (ASX: GOVT) is a bond ETF that invests in federal and state government bonds 
• BetaShares Australian Equities Strong Bear Hedge Fund (ASX: BBOZ) is an inverse ETF, which means it is designed to increase in value when the rest of the market falls.

Are these funds actively managed?

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 weight by market capitalisation. 

A passive ETF aims to replicate its index's returns, not outperform it. The benefit of this passive investment is that it allows you to diversify your portfolio quickly and at a very low cost. 

Some ETFs are actively managed, meaning a professional manager decides which assets to buy and in what proportion. An active ETF's goal is to beat its benchmark index's returns.

However, active ETFs usually require a dedicated team of analysts, researchers and stock pickers, which means they charge higher fees than passive ETFs. This can eat into the fund's returns, reducing the amount paid to shareholders through regular distributions.

Do ETFs pay dividends?

EFTs pay distributions that are similar to the dividends you might receive on other shares — the difference being the frequency of the payments. Companies that pay regular dividends generally do so twice yearly, whereas funds usually pay quarterly distributions.   

If your ETF is invested in shares, you might be entitled to a proportion of the dividends those listed companies pay. Dividends come from profits. Each company makes its own decision as to the proportion of earnings it will pay to shareholders. 

Some Australian companies pay franked dividends, which means you will receive franking credits. Franking credits give you a tax credit for the tax already paid by each company on its profits. 

What about 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 benefit from franking credits on the dividends paid by Australian companies in which the ETF has invested. 

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. 

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, with each unit representing a proportional share of the underlying 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. 

Looking at its NAV compared to its unit price, you can see how an ETF performs. The NAV is the value of its underlying assets.

As an investor in an ETF, ideally you would like the unit price to move in tandem with the NAV. However, market forces can sometimes cause the two numbers to deviate from one another.

Understanding the lingo

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, it's trading at a premium. The AP can purchase assets and sell them to the ETF in exchange for more units to bring the ETF price in line with its NAV. This increases the number of units available for sale, bringing the ETF's price down in line with the fund's NAV. 

Redemption: The redemption process 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 then trade. 

Redemption when units trade at a discount: An AP might use redemption to increase the value of the units in an ETF if they're trading at a discount (in other words, when units in the ETF are trading for a lower price than its NAV). By purchasing units in the ETF, the AP is reducing the number of units on the market. This reduction in supply should cause the price per unit to increase. 

The bottom line

ETFs allow you to invest in a broad range of assets at a minimal cost. They come in many shapes and sizes to suit your preferences and values. 

Like all investments, ETFs come with potential drawbacks, so reviewing your options is essential to help you make the best decision to suit your objectives and attitude to risk.