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What is an Exchange-Traded Fund (ETF)?

Are you looking for a quick and not-so-expensive way to diversify your portfolio? Then, exchange-traded funds (ETFs) can help you. An exchange-traded fund, or ETF, is a low-cost way that can help you earn a return similar to a commodity or an index.

So, to help you know everything about it, here is a blog that will simplify everything for you.

What is an ETF?

An ETF (exchange-traded fund) is similar to managed funds, but the main difference is that you can buy and sell ETFs on a stock exchange, like the ASX (Australian Securities Exchange). This means you can trade ETFs during the day, just like regular stocks.

Exchange traded fund

Let’s simplify this. An ETF is an investment product that allows an individual to purchase a diversified portfolio of assets, such as bonds, stocks or commodities, in a single transaction. These are pretty similar to mutual funds but rather trade on the stock exchange, just like individual stocks.

The ETF provider possesses the assets or shares, while you, as an investor, only own units in the ETF. This means that when you invest in an ETF, you don’t directly own the actual underlying investments.

ETF units can be created or redeemed to match investor demand and to help the units’ prices stay close to the NAV (net asset value) of the ETF. Shares in a company, on the other hand, differ from price fluctuations based on investor demand.

Although some exchange-traded funds are actively managed ETFs, the majority are passive investments.

Key features of ETFs

Here are the key features of exchange-traded funds:

  • An exchange-traded fund (ETF) is a collection of securities that may include shares, commodities, bonds and currencies.
  • ETFs may include Australian and international assets.
  • You generally buy units in an ETF and not its underlying investments.
  • Buying and selling units in an ETF is similar to buying shares via an online share trading platform or through a stockbroker.
  • ETFs usually have low MERs (management expense ratios) or fees.
  • The unit price of an exchange-traded fund fluctuates during the data because it is purchased and sold on an exchange.
  • Just like most of the other securities, when you purchase an ETF, you are required to pay a broker commission or online trading fee. However, the commission on a single purchase of exchange-traded funds shares is considerably cheaper than what you would have to pay to purchase each individual asset held within the ETF.

What can you invest in through ETFs?

There are numerous ETFs available on the ASX, thanks to which investors are presented with a plethora of choices that can help them build a diversified portfolio suitable to their needs. ETFs are available for multiple asset classes and individual assets.

etfs trade

Here are listed the emerging and already established categories of ETFs:

  • Australian shares and sectors
  • International shares and sectors
  • Fixed-income ETFs (bonds)
  • Property securities
  • Foreign currencies
  • Precious metals and commodities
  • Digital assets
  • Diversified ETFs

Different types of exchange-traded funds (ETFs)

The following are the kinds of ETFs:

Passively managed ETFs or Passive ETFs

The majority of EFTs in Australia are passive investments, and they do not try to outperform the market. A fund manager of a passive investment has the role to track the value of:

  • a specific commodity
  • an index

The value of the exchange-traded fund (ETF) will go up or down with the asset or index they are tracking. These are designed solely to match a particular index’s performance before fees.

Active ETFs

Active ETFs, also known as Exchange-Traded Managed Funds and exchange-traded hedge funds, are both types of actively managed investments. In these cases, the investment manager might employ more aggressive trading strategies in an attempt to achieve better returns than a benchmark index.

These aim to beat the index or achieve a particular return objective by using a considerably higher level of human resources as well as trading activity.

active and passive etfs

Physically-backed and synthetic ETFs

ETFs can be synthetic or physically backed.

Synthetic ETFs – hold some of the underlying assets and use derivates to copy the movements of an asset or index. Such a kind of ETF may use the ‘synthetic’ in its name. Synthetic ETFs also have an additional risk, which is the failure of the counterparty to the derivative.

Phyically-backed ETF – invests in every securities in the index or a sample of of the securities in the index.

Advantages and Disadvantages of ETFs

ETFs have a lot of advantages to offer. However, you must remember that with advantages come disadvantages as well. Let us pay attention to those:

Pros

Diversification – With ETFs, you are allowed to purchase a plethora of assets or shares in a single trade. It becomes really helpful to diversify within asset classes. An ETF can let you invest in markets or even assets that can be expensive or difficult to access.

You also get to diversify across ETFs to reduce the chance of loss in case an ETF provider collapses.

Transparency – ETFs publish the NAV (net asset value) every day. So in this way, you can easily track how the underlying asset is performing. Along with this, you can also track if the price of an ETF is close to the NAV.

Most ETFs publish the list of assets owned by the fund. As a result, you get to know exactly what the ETF is invested in.

Low cost – A lot of ETFs have a low MER or management expense ratio. Usually, these are cheaper than equivalent managed funds.

Easy to trade – You can purchase and sell an ETF during the trading hours of the exchange via a broker. You can generally purchase smaller quantities of ETF units than unlisted managed funds.

Cons

Market or sector risk – The market or sector the ETF is tracking could fall down in value. This risk will always be there when it comes to an ETF.

Currency risk – Suppose the ETF invests in international assets. In this case, there is always going to be the risk of currency movements impacting your returns. However, some ETFs are currency hedged, which removes this risk.

Liquidity risk – Some ETFs invest in assets that aren’t liquid. As a result, it can be difficult at times to redeem or create securities for the ETF provider.

Tracking errors – An ETF’s return may be different from the index or asset it is designed to track. This can be because of the differences in the assets owned by the ETF and the index it’s designed to track, taxes, fees and other factors. It means that you could purchase and sell when it is not trading at iNAV (indicative net asset value).

Do ETFs pay dividends?

ETFs provide distributions, much like the dividends you might receive from other stocks. However, the key distinction lies in the timing of these payments. Companies typically issue regular dividends twice a year, whereas funds, in general, make quarterly distributions.

etfs pay dividends

If your ETF holds shares, you could potentially receive a share of the dividends paid by the listed companies.

Since dividends come from profits, companies make their own decisions regarding the proportion of earnings to be paid to shareholders.

A lot of Australian companies pay franked dividends, which results in you receiving franking credits. These will provide you with a tax credit for the tax that has already been paid by the company to its profits.

ETF investment taxes

Are ETF investments subject to taxes? Yes, there is a tax obligation when you sell your ETF investment and when you receive dividends.

In Australia, selling an ETF for a profit typically incurs a Capital Gains Tax (CGT). Some ETFs pass on the capital gains or losses from their asset sales to investors. So, every time the ETF sells an asset, it can trigger a capital gain or loss for you.

When it comes to other ETFs, CGT liability is triggered when the ETF is sold. Additionally, you could potentially receive franking credits on the dividends paid by Australian companies in which the ETF has invested.

There is another scenario when you might also have to pay tax. If your ETF includes international assets, it’s important to note that you might be required to pay withholding tax on the income earned from these assets. Such an amount is going to be withheld at the time of making the payment.

ETF creation and redemption

You do not hold all the assets of the exchange-traded fund directly when you invest. When you invest in an ETF, you purchase units, with each unit representing a portion of the underlying securities. These units are generated by an Authorized Participant (AP), and their quantity can be adjusted based on demand. This process is referred to as “creation and redemption.”

To gauge the performance of an ETF, you can compare its Net Asset Value (NAV) to its unit price. The NAV represents the value of the ETF’s underlying assets.

Ideally, you would expect the unit price of the ETF to move in sync with its NAV. However, depending on market dynamics, these two numbers may deviate from one another.

ETF investment – How to buy and sell

Both purchasing and selling an ETF is quite straightforward, and these can be purchased as well as sold at any time of the ASX trading day through a stockbroker.

You do not need a separate trading account besides your existing share brokerage account. The ASX ticker of the fund is used to buy or sell ETFs once your brokerage account is established, that too without any additional paperwork.

Along with this, it also means that there is no minimum investment requirement except the one stipulated by the broker. There are three main ways of purchasing and selling ETFs.

Via an online broker

Purchasing and selling an exchange ETF can be done through an online broker. If you do not have an online brokerage account, you just have to follow the sign-up procedures. Once the account is activated and funded, you can start trading.

Via a traditional broker

A traditional broker (or full-service broker) usually charges more than an online broker would. However, a traditional broker provides other services besides purchasing and selling ETFs and other securities.

They can help you with research, estate, financial planning, superannuation services and access to initial public offerings.

Via a financial adviser

A lot of financial planning firms are actively adopting ETFs as a part of their service offering. Although using a professional financial adviser costs a lot more, they will help you build a portfolio as per your goals and also your risk tolerance. Along with this, they can also manage your portfolio on your behalf.

What do you need to consider before purchasing an ETF?

Every ETF is different from the other. So, what should you consider before purchasing an ETF? The following key factors can help you choose the right ETF provider and fund:

What do you need to consider before purchasing an ETF?

Reputation of the provider

It is important to consider how long the ETF provider has been around, the track record and assets under management.

Quality of exposure

You need to pay attention to the methodology of the index used by the ETF. You should look for an ETF issuer that works with reputable index providers.

Total cost of ownership

You will need to compare the complete cost of purchasing and holding the ETFs against similar products. This includes the management fees and the transaction fees it typically incurs.

Tracking error

You also need to take note of how well the ETF provider replicates the performance of the index it is meant to track.

Limit order

When you place a buy or sell order, it is suggested to always use “limit orders” instead of a “market order”. It will help you make sure that you are filled at the price you chose after considering the iNAV.

Since underlying markets are moving throughout the day, the iNAV can also change quite fast, especially when it comes to volatile markets.

With the changes in iNAV, the bid or offer prices change as well. By using market order, you are putting yourself at the risk of being filled at the prices the bid or offer has changed to.

Where will your assets be held?

ETFs are regulated unit trusts, and their units trade on the ASX (like shares). ETFs have the same legal structure as traditional managed funds. They are subject to the highest form of protection regulation available in Australia.

Key Takeaways

ETFs in Australia are a cost-effective and convenient way to invest in a diversified portfolio of assets. ETFs provide investors with transparency, flexibility and the potential for long-term growth.

They have gained popularity among both individual and institutional investors as a way to build a balanced and diversified investment portfolio.

When it comes to liquidity, ETFs can be bought and sold at any time during the trading day. Along with this, they also provide transparency to let you know what you are investing in.

With a range of investment options available, you can invest in numerous asset classes and markets through ETFs. Examples include many ETFs, such as equity ETFs, commodity ETFs, currency ETFs, inverse ETFs, industry ETFs, international ETFs, and many more.

In case you have some questions about an ETF, you should contact the fund manager, or you can seek financial advice. Checking recent market announcements will also help you get new information on an ETF.

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