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What is an Exchange Traded Fund (ETF)? Maqro’s Beginner’s Guide

What is an Exchange Traded Fund (ETF)? Maqro’s Beginner’s Guide

Maqro Admin

What is an Exchange Traded Fund (ETF)? Maqro’s Beginner’s Guide

At the end of June 2020, the Australian ETF space held $65.6m under assets; since then, this figure has grown 72.9% to $113.4m. What are ETFs and what has given rise to the high level of popularity of ETFs for investors? Read this article to find out more about what an ETF is and how it can help you as an investor.

Using ETFs is a great way to start investing. They are less complicated than you might think and can generate long-term returns without looking into hundreds of different stocks on the ASX, making them popular amongst both investing veterans and retail investors just starting out. Below is a guide to everything you need to know to start investing in ETFs.

What is an ETF?

An exchange-traded fund (ETF) is an investment product that holds a diversified range of assets from an index, sector, commodity, or replicates an investment strategy. In short, there’s almost an ETF for all asset classes. An ETF trades like any other stock; ETFs are bought and sold on the stock market and can be invested in through a broker account. ETFs are bought and sold as units, which makes it easy and quick to enter and exit positions. This makes ETFs particularly desirable when investing a smaller amount of money as they provide you access to benefits that usually require a larger pool of capital.

Similarly, they can rise and fall in value as well as offer dividends like any other stock which can alternatively be reinvested into the ETF through a dividend reinvestment plan. ETFs provide scale and diversification to your portfolio that you simply can’t get without a large amount of money to invest.

What are the advantages of ETFs?

Easy to trade

As mentioned earlier, ETFs trade just like any other stock listed on the ASX, meaning you can buy them through a broker account. ETFs trade at prices that fluctuate throughout the day during regular market hours.

Diversification

ETFs are managing up to hundreds of millions of dollars, making the brokerage fees they pay relatively smaller than that of a retail investor per trade. As a result, ETFs are able to manage positions in many more stocks at once, which is usually not feasible for retail investors to do themselves. Instead, by buying ETFs, retail investors gain access to exposure to entire sectors, industries, or commodities. Consequently, the realisation of company-specific risks (known as non-systematic risks) will only have a minor impact on your overall portfolio. On the other hand, if you invested in that company’s shares specifically, its fall in value would significantly impact your returns.

Wide range of markets

ETFs can provide you access to foreign markets and investments that are typically difficult to invest in and allow you to profit off your macro perspective of the market. The ability to invest in Japanese companies without making another brokerage account as well as gain a diversified position in fixed-income securities through an ETF like BetaShares Australian Government Bond ETF (AGVT).

Investment approaches of ETFs

With over 200 ASX-listed ETFs, how do you decide which ones you want to invest in? Firstly, you need to understand what your investment philosophy is, and which ETFs take an approach similar to what you do. Investment philosophies can be broken down into two key approaches – passive investing and active investing. Like retail investors take this approach to their own investing, portfolio managers managing the ETF also have their own approach.

This divides ETFs into two categories:

Passive ETFs

Passive investing focuses on minimising fees and long-term returns, thus not being swayed to buy or sell by short-term fluctuations in price. Instead, passive investors are focusing on generating returns gradually and consistently without overthinking the market. With the ETF having a wide range of investments in different assets, the ETF has a portfolio that matches an index or sector either completely or weighted based on factors like risk and exposure.

Active ETFs

On the flip side, other ETFs focus on an active investment strategy. Active investing aims to achieve a higher return than the market and outperform it through numerous trades every day that the market is open. Active ETFs are actively weighted by portfolio managers who will adjust the weighting of their investments based on macroeconomic factors, price movements, and industry trends the ETF is exposed to. Active ETFs tend to have higher management fees due to the number of trades and increased involvement of portfolio managers in adjusting the fund’s positions.

Physical vs Synthetic ETFs 

Physical and Synthetic ETFs refer to the underlying assets that the ETF holds. Physical ETFs are designed to replicate the index by holding all, or some, of the underlying assets of the index. Synthetic ETFs, on the other hand, do not invest in or own any physical assets. They seek to match the performance of an index by investing money in derivatives and swaps.

 Physical ETFsSynthetic ETFs
InvestmentsPhysical ETFs hold the underlying asset such as a stock or fixed-income security.Synthetic ETFs invest in derivatives such as swap options. They do not own the underlying asset.
Counterparty RiskMinimal.High - If the other party is unable to meet its contractual obligations this will be at the ETF’s expense.
CostsManagement fees and brokerage costs make them more expensive.Management fees and swap fees tend to be cheaper.

Main types of ETFs

Equity ETFs

Equity ETFs track sectors and indexes by holding a basket of stocks. More than just sectors, Equity ETFs can cover smaller or larger companies as well as foreign industries.

Example: BetaShares India Quality (ASX:IIND) tracks the top 30 highest quality Indian companies that enable Australian investors to gain exposure to India’s developing economy without opening an international brokerage account.

Bond/fixed income ETFs

Bond/fixed income ETFs exclusively invest in a wide range of fixed-income securities. This provides investors with the ability to gain passive exposure to bonds whilst remaining liquid.

Currency ETFs

Currency ETFs focus on either a single currency or a basket of currency’s relative value to other currencies. Investing in currency ETFs enables investors to gain exposure to foreign exchange rates relative to the Australian dollar. This is both useful for speculation and hedging against your investment portfolio against currency risk.

Example: BetaShares British Pound ETF (ASX:POU) tracks the performance of the British Pound relative to the Australian dollar. This provides currency exposure to investors without needing to directly invest in foreign exchange markets.

Commodity ETFs

A commodity is a basic good that is used as inputs in the production of goods and services, such as oil, precious metals, and natural gas. Commodity ETFs seek to track a single commodity or a basket of commodities which would usually require you to open a margin account to invest in.

Factor ETFs

Factor ETFs focus on investing in securities with particular traits such as their price, volatility, and growth trajectory.

Example: According to BlackRock, the iShares Edge MSCI Australia Multifactor ETF (ASX:AUMF) index is designed to measure the performance of Australian equities that have favourable exposure to the following target-style factors (subject to constraint):

  • Quality: Financially healthy firms
  • Value: Inexpensive stocks
  • Size: Smaller companies
  • Momentum: Trending stocks

Sustainable ETFs

With the rising phenomenon of sustainable business activities and concerns about the ethical status of companies, sustainable ETFs benefit from the reduced risks of ESG violations, which can impact the value of a company’s stock. However, most sustainable ETFs are actively managed meaning they tend to have higher management fees.

Inverse ETFs

Inverse ETFs are constructed to profit from the decline of an index or benchmark. Using derivatives, they essentially borrow securities with the hope of being able to repurchase them at a lower price.

Leveraged ETFs

Leveraged ETFs use financial derivatives and debt to amplify returns. With the potential of generating impressive returns, leveraged ETFs can also lose significant value in a downward market.

What are the types of ETFs? Person typing on their laptop.

What are the disadvantages of ETFs?

Diversification

Whilst diversification protects investors from the non-systematic risks of investing in single companies, this also means that as an investor you don’t benefit as much from strong growth in a single company. For example, if a company performs extremely well and experiences a rise in share value of 20% but only makes up 5% of an ETF, the ETFs’ value would only increase by 1%. Thus, whilst ETFs are less volatile than a single stock as non-systematic risk is eliminated, ETFs also don’t have high upside potential in yielding outstanding returns.

Management fee

ETFs carry management fees that are deducted from the ETFs’ Net Asset Value (NAV).

NAV = total value of the fund’s assets – liabilities

These fees generally range from 0.2% to 1.5% and can significantly impact your returns. For example, if an ETFs underlying stock returned 7%, with a management fee of 0.5%, your total return would be 6.5%.

Tracking errors

Most ETFs aim to perform in alignment with the target index or benchmarks they track. However, sometimes an ETFs’ portfolio does not match the performance of this target, instead of creating an unexpected deviation that results in either a greater profit or a loss. This deviation is measured as a percentage difference. An ETFs’ tracking error tends to be indicative of how actively a fund is managed and its risk propensity. Hence, actively managed ETFs tend to have more volatility providing upside but also greater risk for underperformance.

Next steps

Now that you understand more about the different types of ETFs which are available on the ASX, the next step is to find the right ETF for you. The ETFs that appeal to you might be different than the ones which appeal to other investors, and it all depends on what your investment philosophy is – your risk appetite, and if you have particularly favourable views on particular asset classes or indices around the world.

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