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What’s an exchange traded fund?

Exchange traded funds (or ETFs) are among the fastest growing financial products in the world, and with good reason. This is because ETFs are one of the easiest and cheapest ways you can diversify your portfolio.

They’re easy because you buy the ETF just as you would buy a share on the stock market. Having said that, there is a big difference between a share and an ETF. Where as one share in a company gets you just that – one share – one ETF gets you what’s basically equivalent to lots of little shares in many different companies.

They’re cheap because in just one transaction you can buy yourself a slice of the profits or losses of all the companies included in that ETF. And while there’s a small management fee involved, it will cost you relatively less than buying the same companies separately or paying fees to a managed fund for similar exposure.

ETF basics

Exchange traded funds were first introduced to the United States in 1993 and to the Australian market in 2001. Despite being a relatively new product in Australia, strong investor interest has lead to the rapid growth of the number of ETFs listed on the ASX, with new ones popping up regularly.

Unlike other hot products, ETFs are relatively simple in concept: their price follows the movements of whatever shares or bonds are included in the fund. They can also track the prices of commodities like gold and silver, and we call these products exchange traded commodities (or ETCs).

Some ETFs give you exposure to a broad stock index, like the SPDR S&P/ASX200. When you buy this ETF, the price of your investment will follow the daily movement of the S&P/ASX200 index. Other ETFs, like the iShares S&P 500, allow you to buy exposure to an overseas stock market, which in this case is the US market. There are also ETFs that focus on specific sectors, like metals and mining or financial stocks. These types of ETFs are particularly useful if you like to hedge your investments.

Many investors like to include ETFs in their self managed super funds because the diversification they offer can help reduce risk in their portfolios. But while ETFs provide many benefits, there is still an element of risk involved. And just as with any other investment, there are things you should know about them before you splash out your hard earned cash.

ETFs stick close to index returns

Unlike listed investment companies, ETFs are structured in a way that means they should rarely trade far from their underlying net-asset value. If the portfolio of stocks comprising the S&P/ASX200 index increases by 5% over a given week or month, then the market price of the ETF should rise by a very similar amount.

It is very important that the value of an ETF sticks closely with the value of the index it tracks because any significant deviation would open up opportunities for professional traders to take advantage of the market.

Say for instance the price of an ETF was higher than it should be. An authorised trader could buy a cheap bundle of equivalent shares and exchange them for a new ETF certificate from the ETF provider, then make a profit by selling that ETF on the market.

Different types of ETFs

There are three types of ETFs: full-replication, partial-replication and synthetic replication.

Broad-based or full-replication ETFs fully replicate the index that they track. For example, an ETF that tracks the S&P/ASX200 will hold all 200 stocks in that index in proportion to their market value.

Sector-based or partial-replication ETFs, as the name suggests, partially replicate an index. These ETFs generally select a sample of key stocks from across the market or sector on the view that this can still match index performance reasonably well without the added cost of owning every stock – some of which may be very illiquid.

Synthetic-replication ETFs provide similar market exposure to full and partial-replication ETFs, however, their structure is quite different. In a synthetic-replication, a third party agrees to provide index-like returns to ETF providers through derivative contracts, without the ETF provider needing to own any or all securities within the index. This can result in lower management fees and sometimes more accurate returns than may otherwise be the case, but can give rise to other risks – such as the failure of these third parties to meet their side of the contract. You can tell a synthetic ETF by the inclusion of “(synthetic)” in its name.

What ETFs can I buy in Australia?

There are more than 50 ETFs listed on the ASX of which the oldest and largest is the SPDR S&P/ASX 200 run by State Street Global Advisors. Launched in 2001, the SPDR S&P/ASX 200 trades with the ticker code STW, and offers exposure to the entire Australian S&P/ASX 200 index with an annual management fee of only 0.286%. Vanguard and iShares also offer ETFs that broadly cover the Australian stock market for annual management fees of 0.15% and 0.19%, respectively.

Along with ETFs that track the Australian stock market, there is also a range of sector-based ETFs available that cover the resources, metals and mining sector, financials, listed property, industrials, and the energy sector.

There are also ETFs that provide exposure to the United States, Europe, Japan, Asia and the emerging markets. Some of these provide access to certain sectors that are not highly represented on the Australian market, such as health care, consumer staples and telecommunications. These sectors are often called ‘defensive’ sectors and can be very useful in an economic downturn.

You can buy ETFs based on their market capitalisation, with small cap ETFs available with exposure to either the Australian market or US market. Several providers have begun to introduce ETFs over more specialist indices, such as those designed to produce relatively high dividend returns. There is also presently one ETF from Russell Investment that invests in an index of large cap “value” stocks. This ETF is made up of stocks in companies that meet certain price-to-earnings ratios and expected earnings growth metrics.

Click here [1] for a full list of available ETFs.

Continue reading, How ETFs can benefit your SMSF portfolio [2].

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.