INVESTOR EDUCATION – Exchange Traded Funds
The prevalence of Exchange Traded Funds (ETFs) has grown rapidly over the last few years, and explains the basic mechanisms of ETFs, their key features, and how they can be an important tool for investors. ETFs are listed publicly traded investment vehicles, which usually aim to track the performance of a market or sector index. There are different ETF structures, with the most widely used being a ‘physically backed’ ETF, where the fund buys and holds the underlying assets in the index it aims to follow. ETFs allow investors to diversify their portfolio easily in a cost effective manner, and provide the ability to implement broader strategies such as focussing investment in a particular region or sector.
What is an ETF?
An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes
throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.
In the simplest terms, Exchange Traded Funds (ETFs) are funds that track indexes like
the ASX 200 (Australia’s top 200 stocks weighted by size). When you buy shares of an
ETF, you are buying shares of a portfolio that tracks the yield and return of its target index. The main difference between ETFs and other types of index funds is that ETFs
don’t try to outperform their corresponding index, but simply replicate its performance
As ETFs are passive and not actively managed (see our note published Investor
Education – Active vs Passive Investment), the returns from an ETF should not differ in
any significant way from the index it aims to follow, except in that returns may be
slightly lower due to fees. This is because there is usually a management fee charged
on ETFs but the ETF provider in order to manage ETFs traded on the stock market.
ETFs offer daily liquidity, and trade just like shares do, while at the same time providing the diversification benefits of investing into a fund.
What are the different types of ETFs?
There are two broad classes of ETFs, physically backed and non-physically backed.
Physically backed ETFs hold the underlying shares in the index which the fund tracks,
while non-physical ETFs hold contracts (options between two parties, where the ETF
provider is promised the return on a market index, usually from a bank) to replicate
the return of an index.
We prefer physically backed ETFs, and will only invest in non-physically backed ETFs
when there is no reasonable alternative. This is because while most of the
organisations who run ETFs are large financial institutions, there is still a higher level of credit risk with non-physical ETFs.
This is because with physical ETFs the underlying assets (e.g. the shares of the largest
companies in the Australian market) are held by the ETF provider in a trust/custodial
arrangement. Hence if the ETF provider was to go bankrupt the ETFs assets would be
safe as the ETF holders have claim to the shares. However, in a non-physical ETF there
are contracts between different institutions (usually banks) and ‘counterparty risk’, i.e.
the risk that one of the banks involved in the contract defaults on their obligation.
In saying that, many ETFs are mitigating such risks by holding ‘collateral’ – assets such
as cash which are held by the ETF provider to protect against the possibility that the
counterparty defaults on an obligation to pay whatever return was promised under the contract.
Why use ETFs?
Most investors will be familiar with buying shares and focussing on individual
companies, in order to create a portfolio or trade. In essence, ETFs combine the range
of a diversified portfolio with the simplicity of trading a single stock.
Investors also see this as a way to diversify away individual company risk. ETFs allow
investors to diversify their portfolio easily and in a cost effective manner
ETFs also provide the ability to implement broader strategies such as focussing on a
particular region or sector (For example buying US Technology Companies can be done through an IShare ETF with its top holdings shown below).
will at times use ETFs in order to implement an economic view. For example we
may believe oil companies have been oversold, and there is an opportunity to buy oil
stocks globally at cheap levels, hence we may recommend investment in a global oil