What you need to know before you invest in an ETF

Thinking of joining the more than two million Australians who hold ETFs in their portfolios? With more than 360 listed options on the ASX alone and more on Cboe, there’s a lot of choice. But never fear, no need to be overwhelmed. Here is your 101 guide to ETFs before you buy.

What is an ETF?

Heard the acronym and have no idea what people are talking about? ETF is short for Exchange Traded Fund. It means a basket of investments that you can trade on an exchange like the ASX or Cboe using a trading platform – there are heaps out there, from the likes of Commsec or Nabtrade to Selfwealth and Betashares Direct.

When you invest in an ETF, you receive ‘units’ in a pooled managed fund – that means your money is combined with other investors to buy a collection of assets, like shares in a company or bonds. The ‘units’ reflect your portion of the overall fund.

There are different management styles

Traditionally, ETFs were passive instruments, that is, rules-based investments that follow a particular index, like the S&P/ASX 200. These instruments invest according to the composition of that index. You might hear this style referred to as a ‘vanilla’ index.

Passive also has a more sophisticated cousin known as smart-beta – it still follows automatic rules for investment but incorporates a particular filter or tailored criteria for investors, such as filtering for income or quality, to manage specific concerns.

And then there’s active.

In active management, a fund manager will apply their own strategy to selecting investments and use their own research to identify opportunities. There are a range of actively managed investments available these days.

The key jargon ETF investors need to know

Replication

This refers to the way an ETF invests like an index or an unlisted managed fund. It might choose to use physical replication – that is where it buys the same investments. Or, synthetic – where it uses swaps and derivative investments to broadly follow the performance of the physical investments.

When it comes to physical replication, it can be full replication – where it aims to match every investment – or partial, where a representative basket is selected, for example, the top 50 stocks of the S&P 500 rather than the full 500.

Index weighting

These are used in passive and smart-beta ETFs and are methods of tracking an underlying index.

• Market-cap weighting – where the size of a holding of a company share is based on its market capitalisation compared to other companies. The largest company will have the largest allocation, and the smallest company will have the lowest. The ASX 200 and the S&P 500 are market-capitalisation-weighted indices.
• Equal-weighting – every company has the same weighting in the portfolio, regardless of any other factor. So, for example, if you were investing from the top 200 Australian companies, your investment in Commonwealth Bank would be the same size as an investment in the significantly smaller Judo Group Holdings.
• Fundamental index – where weightings are based on metrics like earnings, dividends or revenue.

Liquidity

This refers to how easy or difficult it is to sell assets. For example, equities/company shares are considered liquid because, excepting special circumstances, you can usually trade them immediately during the hours a securities exchange is open. By contrast, property is a less liquid asset because it takes longer to sell the asset to a prospective buyer.

Spread

Sometimes there is a difference between what you can buy units in an ETF for and what you can sell them for. This is known as a spread – you want the gap to be as small as possible. For ETFs that are considered very liquid, there usually won’t be much of a gap.

NAV

NAV is short for net asset value and is what the underlying assets and cash in an ETF, less any liabilities like fees or debt, are worth per unit of investment in the ETF. For example, if I have an ETF with net assets of $100 and 50 investors are holding 1 unit each, the NAV would be $2. The NAV is calculated at the end of the day.

Distribution frequency

Some ETFs will pay a regular distribution, which is a combination of any dividends and interest on the underlying investments. Your portion is based on your units in the ETF. The frequency of these distributions will be in the product disclosure document for the ETF and might be paid monthly, quarterly, twice-yearly, or annually. And for those wondering, you can receive franking credits from your ETF investments if applicable.

Tracking error

This is the difference between what an index returns that an ETF is tracking and what the ETF itself returns. There can be some performance variation because there may be delays in the ETF matching trades of the index, along with the applicable fees for the ETF. The lower the tracking error, the better.

How much should you pay for your ETF?

The price for an ETF usually tracks the NAV mentioned earlier – so you’ll find a broad range of prices out there.

It’s important to consider management fees when you choose an ETF.

Passive ETFs are typically lower-fee options, for example, you might pay as little as 4 basis points (0.04%) of the value of your investment annually and this is automatically taken from the fund returns before they are distributed.

There is a range though – smart-beta ETFs can be more expensive before there is more tailoring involved.

When it comes to actively managed funds, your management fee covers the research and expertise of an investment management team. This means the total fee will be higher than a passive fund. Some funds might also include a performance fee or hurdle which is an additional fee for a certain level of outperformance.

It’s worth analysing fees and the performance of the ETFs you are looking at – high fees can dip into your returns over time.

How to research which ETFs to buy

With a lot of options out there, you might want to give yourself some filters.

1. What your investment goals, needs and financial circumstances are and what might require to achieve
2. What is your risk tolerance – aka how comfortable are you with the potential of loss of your money? Different assets carry different levels of risk and it helps to be aware of what you can financially (and emotionally) manage in your portfolio.
3. Consider what type of asset class you want to invest in
4. Is there a particular concern you need to manage in your portfolio, such as income or quality?
5. Budget requirements - how fees affect returns
6. Whether you prefer an actively managed or passive option

You may want to speak to a financial adviser to help you through the process.

Next step, there are a few channels to identify the ETFs to take a closer look at.

Livewire has its own tool to help you kickstart the process - visit Find Funds.

You'll need to select the down arrow on the Type button and select ETF to filter.

Then select Asset Class if you want to narrow it further.

Alternatively, you can find a complete list of ETFs listed on the ASX here and a complete list for Cboe here.

Once you’ve narrowed down your search, it can be helpful to visit the product issuers’ pages to compare details and what the underlying investments are – remember that just because two ETFs follow the same theme, doesn’t mean they follow the same rules and therefore might not have the same assets. 

Many of the main ETF issuers have written extensively on Livewire, and you may also find helpful information and articles by searching the issuer names.

Why people invest in ETFs

ETFs have become extremely popular over the years for several reasons. Some of these are below:

1. Ease of access - "one-click" and you can invest, or equally, sell your investment in an ETF.
2. Diversification - using an ETF can spread your money further than trying to individually buy a company. For example, you might only have money to buy one ASX company share or you could have exposure to the performance of all 200 companies in the ASX 200. You also have the option to invest in those assets that would otherwise be difficult to access, like fixed-income bonds, commodities like gold or oil, or international shares.
3. Lower minimum investment - your ability to invest is restricted by the minimum trades on your trading platform. A typical minimum is $500 for a first investment - by contrast, many unlisted funds can require investments in the thousands.
4. Transparency - generally speaking, you should be able to see every asset an ETF holds on the issuer's site, particularly for passive options. You might not be able to see all the holdings for some actively managed options.

It is not a risk-free investment though - no investment is. Some of the risks you might be exposed to include:

• Market or sector risk: the market or sector (financials, resources, etc...) the ETF invests in may fall in value.
• Liquidity risk: if an ETF invests in assets that are lower in liquidity, it may be harder to sell the ETF should you need to.
• Tracking error: An ETF may not perfectly match the performance of an index.

The ETF space continues to grow and innovate, so keep up-to-date and don't get too attached to your investments when over time, you may find a newer form offers better exposure for your portfolio. Happy investing!