An exchange-traded fund (ETF) is an investment fund that is traded on the stock exchange. The funds are traded much like companies’ stocks are traded.
Like any fund, an ETF holds assets, commodities or bonds. There are two types of ETFs.
Conventional ETFs
These were first made available for trading in Australia on the ASX in 2001. These funds have investments in a broad array of Australian assets. Most ETFs are measured against a stock or bond index.
Conventional ETFs cover a series of stock market indices such as the S&P/ASX 200. Conventional ETFs aim to deliver a return based on investing directly in some or all of the securities included in an index or benchmark. The ETF aims to have a portfolio that provides a representation of the index.
The range of conventional ETFs was expanded in 2010 to include a range of Australian sector funds. These are funds that specialise in a specific industry sector.
Investing in a sector ETF allows investors to build a portfolio that allows for an increased exposure to specific industries. This is done while still achieving a diversification across many companies within the sector.
Say you wish to invest manufacturing, for example. Rather than investing your cash in just one company, you could invest in an ETF that specialises in manufacturing. This way, for the same cash investment, you will be investing in manufacturing, but your risk will be spread across all the companies that are a part of the fund.
Synthetic ETFs
Synthetic ETFs in Australia may invest in other assets, such as cash. Or it may have shares in companies that do not match the composition of the index being tracked.
Usually these funds also enter into swap agreements with other financial instruments, with the aim of ensuring that the fund tracks as closely as possible to the relevant index.
What are the pros of investing in ETFs?
The factors that make ETFs attractive investment options include their:
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low cost
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tax efficiency
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stock market-like features for trading
What are the cons of investing in ETFs?
Conventional ETFs come with the same risks as the underlying assets in the fund. A synthetic ETF may come with greater risk, as the assets are more fluid or intangible.
Synthetic ETFs tend to have at least 10 per cent of the fund represented as money owing under the derivatives. This means investors in synthetic ETFs are exposed to counterparty risk. This is not the case for investors in conventional ETFs.
Investors must carry the risk that the counterparty to the derivative will not fulfil their obligations. If the counterparty does fail, then the fund may not be able to deliver on the investment objective. In this case, the investor will lose however much of the value of the fund is exposed under the derivatives.
To counteract this risk, the ETF should have in place measures to mitigate and limit the exposure. If the exposure rises above the 10 per cent preferred by the ASX, then immediate steps needs to be taken to lower the risk. However, this is not always the case, and the investor has to wear the loss.
What to consider before investing in an ETF?
As with all investments, you should thoroughly read the product disclosure statement (PDS) for the specific ETF you are considering investing in.
The PDS will outline the details of the investment strategy of that particular ETF. It will also include the objective of the fund, the risks and the cost of the investment.
If in doubt, talk to your accountant or financial planner before making an ETF investment.
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