Exchange-traded funds (ETFs) give investors a cost-effective avenue for capturing the returns of an asset class, an index, or a commodity. While the name is fairly new, ETFs are simply managed funds which can be bought and sold through a stockbroker, mirroring the process of trading shares.
How ETFs Operate
An ETF is just a managed fund that can be bought and sold on the Australian Securities Exchange (ASX).
When an investor buys units in the ETF, the product provider then goes and purchases the underlying shares on behalf of the investor.
Types of ETFs
- Passive: ETFs that aim to track the performance of an index or a specific commodity like gold. The largest ETFs in Australia track indices such as the ASX200 or S&P500.
- Active: are actively managed investments, employing potentially higher-risk trading strategies to try and outperform an index or deliver a target return e.g. the RBA cash rate + 2%
- Synthetic: often do not own physical assets, but instead employ derivatives to mimic index or asset movements. These tend to be higher risk than physical ETFs as the derivative counterparty could fail or not deliver the intended return.
Investment Options in ETFs
ETFs cover diverse asset classes and individual assets, encompassing Australian and international shares, sectors within share markets, fixed-income investments, precious metals, commodities, foreign currencies, crypto assets, and diversified portfolios spanning multiple asset classes.
Pros and Cons of ETF Investments
Pros:
- Diversification: ETFs enable the purchase of a basket of shares or assets in a single trade, fostering diversification within an asset class.
- Transparency: Daily publication of the net asset value (NAV) aids in tracking asset performance and assessing ETF pricing.
- Low Cost: Many ETFs feature a low management expense ratio (MER), often more cost-effective than equivalent managed funds.
- Easy Trading: ETFs are conveniently traded during exchange hours through a broker, and units can be bought in smaller quantities than unlisted managed funds.
Cons:
- Market or Sector Risk: The value of an ETF may decline if the market or sector it tracks experiences a downturn.
- Currency Risk: Investment in international assets exposes investors to currency movements, though some ETFs offer ‘currency hedging’ to mitigate this risk.
- Liquidity Risk: Some ETFs invest in illiquid assets, potentially complicating the creation or redemption of securities.
- Tracking Errors: Variations between an ETF’s return and the target index or asset may arise due to asset differences, fees, taxes, and other factors, impacting trading decisions based on indicative net asset value (iNAV).
As with any investment, it’s important to understand the underlying strategy of any ETF you’re considering so as to ensure it aligns with your goals.
If you would like to know more about how to incorporate ETFs into your portfolio, please call us at Align Financial on (02) 9913 9995