What are you actually buying in your ETFs?

For a market that was a slow burn for a while, exchange-traded funds (ETFs) have hit their stride in recent years. 

In fact, the latest report from the ASX shows the industry grew to a market capitalisation of $119.04 billion across 252 listed products (as of 30 June 2022). 

So there’s a fair chance even if you haven’t personally traded ETFs, you are familiar with them or professionals have invested in them on your behalf. But do you actually know what they are and how they work?

What are ETFs?

ETFs are effectively baskets of investments that are listed on the share market and you can buy or sell them using your share trading account or broker. 

Any asset you can think of, there’s probably an ETF covering it. We’re talking anything from commodities, currencies, fixed income, shares, derivatives and even newer assets like Bitcoin. Basically, ETFs can be broad or niche in their underlying investments and cover a range of investment styles.

The original ETFs were passive, which means they follow an index, like the S&P/ASX200 or the S&P500, but today’s iterations can even be active.

Wait a minute… isn’t an ETF just effectively a LIC?

Not quite, but they are definitely similar!

For the unfamiliar, LIC stands for Listed Investment Company. They are actively managed, whereas ETFs can range in styles from passive to active.

Like an ETF, it is a pool of managed investments that you can trade on the stock exchange and you own ‘units’ in.

The differences largely come down to structure.

ETFs are open-ended meaning the investment pool expands or shrinks depending on how many investors want to invest (i.e. limitless units on offer). LICs are close-ended meaning the investment pool is a set size, therefore there are a set number of units on offer regardless of how many people want in.

This structure means differences in prices to NAV (net asset value). ETF prices tend to track closely to NAV whereas LICs can fluctuate based on demand for a restricted number of units – in fact, most LICs end up trading at a discount to their NAV.

LICs can also be less liquid (aka harder to trade) than ETFs due to this structure too. After all, if you want to sell your units in an ETF, the investment pool can shrink to accommodate this rather than requiring someone else to purchase your units.

Traditionally ETFs were viewed as cheaper than LICs. If you’re talking about the pure-passive plays then this is correct. There’s less administration and expertise involved and therefore they typically charge lower management costs. However with the growth of actively-run ETFs, there is more variation when it comes to investment fees, depending on the intensity of the management strategy.

The different investment styles of ETFs

ETFs can be passive or active. Passive ETFs aim to replicate the performance of an index and can do this in a few ways:

• Physical replication: This is where the ETF purchases assets to match those that are held in the index. It can be done as a full replication, where the complete holdings match the index, such as buying all 200 companies in the S&P/ASX200 and weighting them by their market capitalisation. Alternatively it can be done as partial replication or sampling where a selection of assets are chosen to represent the index, for example, only purchasing 30 companies from the S&P/ASX200 that are deemed to generate the closest performance.
• Synthetic replication: This is where the ETF uses derivatives to replicate performance, such as futures or swaps.

Some examples of passive ETFs include SPDR S&P/ASX 200 ETF (ASX: STW) which tracks the S&P/ASX200 or the BetaShares NASDAQ 100 ETF (ASX: NDQ) which tracks the NASDAQ 100 index.

Active ETFs aim to outperform an index or investment using the expertise and research of an investment manager. An example is the Magellan High Conviction Trust (ASX:MHH) or the BetaShares Martin Currie Equity Income Fund (Managed Fund) (ASX: EINC). These can follow any investment style the manager choses.

More recent forms of active ETFs use leveraging as a strategy and are designed as short-term trading tools, rather than buy and hold strategies. An example would be an ETF that seeks to offer inverse performance to the ASX200 by shorting it. 

Generally speaking, these are sophisticated products and require close monitoring and knowledge of markets, they also typically come with a higher risk of losses.

Finally, there’s also a middle ground – smart beta ETFs. These still classify as passive but might aim to outperform the index in certain circumstances by use of specific eligibility and selection criteria. 

An example of this would be following the S&P/ASX200 index, but rather than using weighting by market capitalisation as per the index, all the investments might be equal weighted. An ETF example is the VanEck Morningstar Australian Moat Income ETF (ASX:DVDY) which uses filters including dividends and Morningstar’s MOAT methodology to identify stock inclusions.

What am I buying?

When you buy an ETF, you don’t directly own the holdings in the ETF, you own ‘units’ equivalent to the value of your investment. For example: 

You and your 20 closest friends want to buy all the companies listed on the S&P/ASX200 so you pool together your money to buy a share in each of the companies. You effectively then own 1/20^th of each share you purchased together.

If you want to sell your ETF, you are selling your units and typically you can’t ‘claim’ a portion of the holdings instead. There are some exceptions to that of course, with large institutional partners able to request liquidated units be supplied as shareholdings instead, for example. 

From a retail investor perspective, one of the few options to redeem for holdings instead of cash tends to lie in those ETFs with physical assets. For example, both Perth Mint Gold (ASX: PMGOLD) and ETFS Physical Gold (ASX: GOLD) have the option for investors to redeem units for the physical gold bullion.

What’s in the basket?

Depending on what type of ETF you buy, you should typically be able to access a complete list of holdings. In fact, this was one of the original appeals of ETFs - complete transparency on underlying investments.

However, for actively run ETFs, this might not be the case. It really depends on the individual manager.

To buy or not to buy ETFs

ETFs are like any other investments – there are pros and cons.

There are typically three key reasons investors like them:

• Instant diversification depending on the ETF, for example, spread your money across 100 shares instead of just one.
• Transparency and liquidity.
• Easy to use (aka buy and sell in one click)

There are also a few reasons to be wary… some of these apply to investing in general. This is by no means a conclusive list.

• Economic and market risks, that is, the performance of the general market or external macro events can affect performance.
• Operational risks such as a systems failure, impacting the ability of an ETF to operate at a point in time.
• Tracking difference, which is where the ETF fails to track its intended index objective at a particular point for a range of reasons, such as structure and costs.

Where to next?

You’ve got the basics and you’re ready to buy an ETF – the question is which ETF? 

You can start your research on Livewire’s Find Funds page here (don’t forget to select “ETFs” under “Type”) or check out the cheapest and most expensive ETFs here.

This article is part of our new Investment Guide series. If there is a topic you would like to learn about next, please leave a comment below.