The A to Z of ASX ETFs

If you looked through the average investor’s portfolio 20 years ago, you’d probably find a few banks, a couple of major resources companies, the obligatory supermarket, and a few big-name brands like Wesfarmers, Telstra, and Qantas.

Today, I’d wager at least one holding in the average Aussie investor’s portfolio is an exchange-traded product (ETP). An ETP is a security that trades on the ASX just like any of the shares mentioned above, but the main difference is an ETP can represent an investment in more than one company. Certain ETPs may represent an investment in a portfolio of shares, or a range of bonds, commodities, or other assets.

Most investors are familiar with ETPs by their more common name of exchange-traded funds (ETFs). On the ASX, ETPs refer to a class of exchange-traded products including ETFs, exchange-traded managed funds (ETMFs), single asset exchange-traded products (SAETPs), and structured products (SPs). We’ll touch upon some of these in this article, but given that ETFs are the best-known and most popular type of ETP, they’ll be our focus.

If you’re new to investing on the ASX, or even if you’ve been investing for a while but haven’t yet explored the world of ETFs, this article is for you! Let’s investigate the A-Z of investing in ASX ETFs.

A is for Asset Class

ETFs give investors exposure to an asset or a group of assets. A group of assets with similar characteristics, for example, fixed interest, is called an “asset class”.

There are many ASX ETFs that aim to track the performance of particular asset classes, for example, a share index like the S&P/ASX 200 Index, a commodity like gold, cash, fixed income, and currencies.

B is for Bonds

Bonds fall under the fixed interest asset class and are one of the most important and widely traded securities in the world. They’re a little bit like a fancy term deposit, but rather than being transacted between consumers and their banks, bonds are securitised and traded on regulated exchanges.

Bonds may be issued by corporations or governments. Bond issuers receive the initial purchase price of the bond (the “principle”) on the basis it will be repaid at an agreed date along with periodic interest payments based upon an agreed interest rate.

You might have heard of the “60/40 Portfolio”. This is where one invests 60% of their capital in shares and 40% in bonds. It’s a long-held portfolio allocation tenet designed to offset the volatility inherent in shares with the relative stability of returns in bonds.

ASX bond ETFs provide everyday Aussie investors with access to the global bond market straight from their regular share broking accounts.

C is for Clearing and Settlement

ETFs trade, clear, and settle in a similar way to shares on the ASX. This means you won’t notice any difference in the way you buy and sell ETFs compared to shares. It also means it’s just as easy to buy Pilbara Minerals (ASX: PLS) shares as it is to buy an ETF on battery tech & lithium companies.

D is for Diversification

Diversification is the process of spreading one’s investing risk across a range of securities. Many Aussie investors consider diversification to be investing in a range of ASX shares, but this is only a small part of the diversification puzzle.

It’s generally considered prudent to also diversify across other share markets, as well as other asset classes like cash, fixed interest, property, and infrastructure. When done correctly diversification can increase a portfolio’s returns whilst also reducing its risk.

E is for Exchange-Traded

Exchange-traded, and more specifically ASX traded, means you don’t have to engage the services of a bond broker to trade bonds, or a futures broker to trade indices, commodities, and forex.

It also means you can invest in several other emerging thematic strategies otherwise inaccessible to small investors like ESG and infrastructure. Even better, you can buy and sell your investment in a click of a button via your regular share broking account.

F is for Fees

I’ve pointed out many similarities between regular share investing and ETF investing, but fees are a big difference. In addition to regular brokerage fees, ETFs generally have embedded into them an additional fee that is paid to their issuer.

Issuers charge a fee for managing and maintaining the investments within an ETF. This fee is known as the management expense ratio (MER). ETF investors don’t pay the MER directly to the issuer, rather, it is reflected in the ETF’s price. MERs are usually accrued daily, and then deducted from the ETF’s assets, and therefore its market price, on a periodic basis (usually monthly).

While MERs on ASX ETFs tend to be lower than the fees charged on regular, non-exchange traded managed funds, they can vary widely across issuers and funds. Generally, the more complex the investments within an ETF and the more active the ETF issuer is in buying and selling the fund’s assets, the higher the MER will be.

Over the long term, fees can have a major impact on an investor’s returns, so it’s important to compare ETFs based on their assets, investment style, and MERs.

G is for Growth

ETFs have experienced massive growth in the roughly 20 years since they were introduced on the ASX. Recent data suggests the Australian ETF industry grew by roughly $44 billion in 2023, reaching a record high of $178 billion in January this year.

ETFs are now the go-to investment for over 20% of Aussie investors, and this means they’re big business for issuers. This is a good thing because it drives both innovation and choice, while at the same time keeping the costs of investing in ASX ETFs low.

H is for Hedging, Hold Time

Hedging is the act of investing in two or more assets which tend to deliver positive returns under different circumstances generally offsetting each other’s returns. The goal of hedging is to smooth out the volatility in one’s returns, thus reducing risk.

For example, when shares deliver positive returns bonds often deliver negative returns, and vice versa. This means holding a portfolio of shares and bonds increases the probability that at least one asset class is delivering positive returns.

A more efficient way to hedge is to use a concept called “short selling”. Short selling involves selling a borrowed asset and buying it back after its price falls. In this way, short sellers profit when the price of the asset they’ve shorted goes down.

If an investor shorts an asset which has similar return characteristics to other assets in their portfolio, there is a good chance when the asset class experiences a broad decline, the profit on the short trade will help offset losses in the rest of the investor’s portfolio.

There are several short selling-focused ETFs listed on the ASX that can assist investors in short selling, and therefore in hedging their portfolios. Check out this page for a list of short selling ETFs for Australia and the USA.

Hold time refers to how long an investor can hold their investment. Securities over many asset classes such as share indices, commodities, and currencies have expiry dates. At expiry, investors must close their positions and renter a longer-dated security if they wish to maintain their exposure. Investors in ASX ETFs may hold their investments as long as they like without having to worry about expiry.

I is for Issuers

Issuers, or “providers” as they’re also known, are responsible for issuing an ETF on the ASX, as well as maintaining its listing requirements, and managing its assets. Well known issuers of ASX ETFs include: Betashares ETFs, ETF Securities, Fidelity International, iShares by BlackRock, SPDR by State Street Global Advisers, VanEck ETFs, and Vanguard Australia.

J is for Junk Bonds

A “junk” bond is a common term for a high yielding bond, often issued by corporations and governments with an investment grade of Ba1/BB+ and lower.

Junk bonds can be more volatile than investment grade bonds, but also offer higher yields and capital return. They are a segment of the fixed interest asset class that investors can access via the ASX using ETFs. An example is the iShares Global High Yield Bond (AUD Hedged) ETF.

K is for Key Metrics

When evaluating ETFs, investors should consider key metrics such as MER, management style, net asset value, tracking error, liquidity, distribution schedule, historical returns, historical volatility etc. These metrics can help investors assess the efficiency, risk, and potential returns of an ETF before making an investing decision.

L is for Liquidity

Liquidity refers to how easily an investor can enter and exit a security without moving its price. A lack of liquidity can increase the cost of investing because investors may have to pay a higher price to enter an investment than originally thought or receive less when they’re exiting.

The “spread” is a key liquidity factor. It is the difference between the bid and offer prices for an asset. Smaller spreads are preferred as this represents a smaller cost to transact in the asset.

Securities which have a higher turnover (volume) are generally more liquid, but it’s also important to check the volume attached to buy and sell orders in the market for an asset. This is often referred to as the asset’s “market depth”. A more liquid asset will have a “deep market”, that is, a large quantity of orders packed closely together around the spread.

ETFs have similar liquidity considerations as any other asset, and investors should aim to invest in the most liquid ETFs. Issuers can contribute to an ETF’s liquidity by acting as or organising a market maker for the ETF. Market makers actively participate in the bid and offer side of an asset's market depth to increase its liquidity.

M is for Management Style

Each ETF typically has one of two management styles associated with it. “Passive” ETFs aim to replicate or “track” the performance of a specific index, typically holding each of the securities within the index in the same weights represented in the index.

“Active” ETFs usually don’t match the index, instead, active managers buy and sell securities based on achieving the highest risk-adjusted return possible in those securities. Active managers are therefore trying to beat an index’s performance, and they do this by applying better research and timing techniques.

On the ASX, passively managed funds are generally categorised as ETFs, whilst actively managed funds are generally categorised as ETMFs. To be fair though, the colloquial term for all ETPs traded on the ASX is simply ETFs.

One important distinction between passively and actively managed funds is fees. Given there’s a great deal of expertise involved in active management compared to passive management, actively managed ETFs typically have substantially higher MERs than passively managed ETFs.

N is for Net Asset Value

The net asset value (NAV) of an ETF is the per-security value of its underlying assets minus its liabilities. NAV can provide investors with a valuable insight into the underlying value of an ETF, which can then be compared back to its market price to help determine mispricing opportunities.

Note, however, an ETF may not trade exactly at its NAV all the time. Timing irregularities in the revaluation of assets within the ETF which are bought and sold infrequently, such as property, can result in large discrepancies between an ETF’s NAV and its market price.

O is for Open-ended, Objective

Open-ended means the number of units on issue for an ETF can increase or decrease in response to demand and supply. All ASX ETFs are open-ended.

Objective is the term used to describe an ETF’s investing goals. Generally, the issuer will state the objective of each ETF it offers on the respective ETF’s webpage. For example, the objective of the Vanguard Global Infrastructure Index ETF (VBLD) is “to track the return of the FTSE Developed Core Infrastructure Index (with net dividends reinvested) in Australian dollars, before taking into account fees, expenses and tax”.

P is for Portfolio Allocation

You might have heard of a guy called Warren Buffet. He’s kind of a big deal in the investing world. Well, one of Warren’s most famous investing tips is the 90/10 portfolio. This involves investing 90% of one’s assets in a S&P 500 Index fund (a passive investment) and 10% in short-term US Treasury Bonds.

This is just one example of a portfolio allocation strategy, but using by ASX ETFs, the possibilities for everyday investors to diversify and grow their portfolios are endless.

No longer do investors have to build their portfolios one security at a time. With a click of a button, you can add five hundred of America’s biggest blue-chip stocks to your portfolio, and with the click of another, you can add a range of US T-Bonds (if you want to do the “Buffett 90/10” that is!).

Q is for Quality

Apart from the strength and reputation of the issuer, investors should consider the quality of the underlying assets within the ETF. High-quality holdings with strong fundamentals can contribute to the long-term performance and stability of an ETF, while lower-quality holdings may introduce additional risk.

R is for Risk & Return

ETF investing isn’t without risks, so it’s important to know the quality parameters and the key metrics of each ETF you’re considering. Careful consideration of the issuer and risk profiles of the assets held within an ETF will help you understand its risks.

Issuers can help by providing qualitative data on an ETF’s style and objectives, and quantitative data on its asset allocation, historical return and volatility. You’ll also likely see information on an ETF’s distribution schedule, i.e., how often it pays a distribution (i.e., like how a share pays a dividend). This might be important for those looking for regular income.

Generally, you can find all this information on the issuer’s website for each ETF they offer.

Remember, historical returns are not an indication of future returns, but they can provide valuable insight into the reliability of an ETF’s returns through various market cycles, as well as give investors a rough idea of what to expect.

S is for Sectors & Strategy

Check out some of the sectors and strategies offered via ASX-listed ETFs:

Sectors

• S&P/ASX 200 Australia Banks Index

• S&P/ASX 200 Financials
  

• S&P/ASX 200 Resources Index

• S&P/ASX All Technology Index

Strategies

• Agriculture

• Commodities: Copper, Gold and other Precious Metals, Crude oil, Global Uranium & Nuclear Components

• Countries: China, India, Japan, South Korea, Europe, USA

• Dividend Yield Focus

• ESG: Battery Value-Chain, Carbon, Clean Energy, Hydrogen

• Healthcare & Biotechnology

• Property (Australia and Global)

• Small-Caps

• Technology: Crypto Innovators, Cybersecurity, Digital Payments, Global Cloud Computing, Robotics & Artificial Intelligence, Semiconductors, Video Gaming and eSports

T is for Tracking

For passive ETFs, the objective is generally to track the performance of a particular benchmark as closely as possible. Investors in a passive ETF want to know how closely it’s meeting its objective.

“Tracking error” is measured as the standard deviation of excess returns compared to a benchmark over time. It's an indicator of how consistently an ETF's performance reflects its benchmark. Investors in passive ETFs prefer those with minimal tracking error as this reduces uncertainty in returns.

U is for Underlying Assets

An ETFs underlying assets are the securities it holds. It’s important to understand the underlying assets of any ETF you intend to invest in because this will determine the ETF’s returns and volatility.

In most cases, issuers will provide a web page or a fact sheet for each ETF they provide which clearly states the nature of the ETFs underlying assets. Often, they’ll even provide asset allocations within the ETF to help you drill down to what you’re really getting as an investor.

V is for Volatility

Volatility is the variance in an asset’s return over time. In the investing world, the terms “volatility” and “risk” have become interchangeable.

It is fair to say the greater an asset’s volatility, the greater the possibility it delivers a negative return, and therefore the greater its inherent risk. But it’s equally true that an asset with greater volatility has a greater possibility of delivering a positive return.

This highlights the risk versus reward relationship. Risk-averse investors typically forego the opportunity for greater returns to achieve safer and more reliable returns. On the other hand, risk-seeking investors understand they must ride some of the inevitable investing bumps to achieve their long-term return goals.

Before investing in an ETF, investors should consider the typical volatility in the returns of the assets held in the ETF. As a broad rule of thumb, cash is the least volatile asset class as it has zero downside apart from the usual opportunity cost associated with all investments. It also has the lowest return of any asset class.

The next least volatile asset class is fixed interest, then shares, and then commodities. Again, as you up the volatility spectrum in asset classes, you also go up the return spectrum.

W is for Weighting

You’ll see many ASX ETFs that have the words “Equal Weight” in their title. Many benchmark share indices, like the S&P/ASX 200 in Australia, or the S&P 500 in the USA, are based upon market capitalisation. This means their performance is weighted proportionally towards the largest capitalisation companies within the index.

The main issue with market capitalisation-based indices is that their performance can be dominated by a few large companies, for example, Apple, Alphabet, and Microsoft in the S&P 500. This is fine if these companies are doing well, but it can increase an index’s volatility when they’re not – even if the rest of the companies are still performing strongly.

Equal-weight indices and ETFs seek to avoid the issue of a few assets dominating performance by apportioning the same weighting to each asset. An example of an equal-weight ASX ETF is the VanEck Australian Equal Weight ETF (MVW).

Y is for Yield

Yield represents the income generated by an investment, typically expressed as a percentage of its market price. Cash and bonds generate a yield by paying interest, while stocks pay dividends.

If these assets are held by an ETF, the regular income they generate for the ETF is usually passed onto its investors in the form of “distributions”. ASX ETFs may also pass on any franking credits they’ve received from the assets they hold.

It’s also important to consider the frequency of an ETF’s distributions, as there may be a preference for more regular receipts.

It’s worth noting for ETF investors who are chasing income, there are several options targeting high yields, like the Vanguard Australian Shares High Yield ETF (VHY). Some ASX ETFs, like the BetaShares Australian Dividend Harvester Fund (Managed Fund) (HVST) even pay distributions on a monthly basis.

Z is for…

Ok, I couldn’t think of an ETF trait that starts with Z! But hopefully, you agree this A-Z for ASX ETFs is a comprehensive overview of the opportunities, risks, and rewards that these amazing products afford Aussie investors.