ETF Investing – What Different ETFs Are There, How Do They Work?

Maqro Academy Apr 9, 2021 / Reading Time: 4 mins
By Andre Thomas Reading Time: 4 mins

An exchange traded fund (ETF) is a security that tracks an index, sector, commodity, or another asset(s). ETFs can be traded on a stock exchange just like regular stocks. ETFs are a growing space in the ASX market, with new products coming live to offer exposure to new types of assets as their popularity increases. ETFs provide the flexibility to invest in a particular thematic, product or region. This provides a platform for different investing approaches, one of which could be more tailored to your specific process or risk profile.

Types of ETFs

There are several types of ETFs:

  1. Equity ETFs: Tracks a broader index or a basket of indices.
  2. Industry ETFs: Track a specific industry such as technology or oil and gas.
  3. Commodity ETFs: Track commodities such as gold.
  4. Property ETFs: Tracks the performance of various REITs.
  5. Fixed Income ETFs: Usually tracks corporate and/or government bonds.
  6. Currency ETFs: Track FX movement such as the Euro or AUD
  7. Inverse ETFs: Makes gains on declines by shorting an asset.
  8. Mixed Asset ETFs: Holds a basket of various assets such as property, equities, and bonds.

There are ASX listed ETFs, these are a few examples that Maqro has covered in the past:

  • GEAR: An ETF which aims to give investors a leveraged exposure to the ASX 200 – when the index rises 1%, the ETF aims to rise 2%.
  • ACDC: Tracks the lithium battery value chain, from providers of electrochemical storage technology to mining companies that produce metals used in Lithium-ion batteries.
  • BBOZ: An ETF product that shorts the ASX 200 – when the index falls by 1% this ETF aims to rise by 2-2.75%.

ETFs Popularity has been on the rise globally over the past decade, not just globally but also in Australia – the funds under management (FUM) of ETF providers has risen by 47.0% since the start of 2020.

How Do ETFs Work? 

The company providing an ETF normally physically owns the underlying assets and designs a product that tracks their performance. They do this by buying the underlying asset and creating a fund, of which shares can then be bought by investors on the market. These shares are what can be bought and sold on the exchange.

However, some ETFs are known as synthetic, which means that they do not necessarily own the underlying asset but use derivatives to track the underlying index. These derivatives tend to involve using swap contracts, which could expose investors to counterparty risk. Counterparty risk is the chance that a party in a contractual agreement may default on their obligation.

Nonetheless, in both tracking methods the market price of a share in an ETF will usually closely align to the net asset value, that is, the value of the underlying asset/s the ETF is tracking. Any divergence between these values is short lived under the principle of market efficiency. If this divergence persists the tracking error can be a useful metric to consider.

Positives:

There are a number of advantages in ETF investing:

  1. ETFs allow investors to buy and sell a group of assets within one transaction. This tends to provide the benefit of lower brokerage and lower transaction costs relative to buying each asset individually.
  2. Diversification.ETFs provide an opportunity to have access to a wide variety of assets and in turn decrease the effect of asset specific risk and potential declines.
  3. Provide access to markets normally out of reach. Examples of assets ETFs can provide that are normally difficult for retail investors to access are fixed income markets, international emerging markets, commodities such as gold (such as ASX: PMGOLD).
  4. Dividends can still be paid. For ETFs that track a group of stocks, managers of the product receive dividends on the underlying security and then pay these out on a pro rata rate based on ownership in the shares of the fund.

Caveats:

Although ETFs provide a number of benefits on various fronts, there are still some things to take note of.

  1. Each ETF will inherently have differing risks which might not be palatable to individual investors, in line with the exposure it offers, meaning that all ETF products are not equivalent. Each ETF should be treated on its own characteristics and its consequent congruence with your risk profile. This could involve researching the current or previous holdings of the ETF and assessing the underlying index’s criteria that is implemented to filter holdings – after all, their criteria may be fundamentally incongruent with your own investing philosophy.
  2. Management fees are charged on ETF products, meaning that there is an additional cost that could impede your returns. Higher management fees generally indicate a more active style of ETF management.
  3. Tracking Errors. ETFs are not always able to track the value of the underlying asset perfectly. The larger the tracking error, the more it deviates from the index it tracks – both positively and negatively.

At Maqro Capital, our ETF division specialises in analysing and recommending ETF products. The ETF universe is growing, and we believe that there is an ETF for almost all investing strategies. ETFs also allow investors to explore new markets that were once beyond reach and in turn broaden horizons regarding new strategies.