What are ETFs
What are exchange traded funds and how do they work?
ETFs (Exchange Traded Funds) provide direct exposure to a wide range of investments in their asset class such as Australian shares, international shares, bonds or metals.
ETFs track a market index rather than taking bets on individual companies. For this reason, their management fees are much lower than typical 'active' fund managers. ETF 'index management' also offers the benefits of transparency and potential tax efficiency. As an ETF investor, you directly benefit from share capital gains, dividends and franking credits paid by shares contained within an ETF.
As of December 2019 there are over 200 ETFs listed on the ASX with a total value of $61.5 billion.
ETF assets in Australia grew 52% over the last 12 months. More Australians are investing in low-fee ETFs in their own personal portfolios and Self Managed Super Funds (SMSFs). ETFs can provide investors with low-cost asset exposure, greater transparency, liquidity and tax advantages over traditional funds.
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Australian listed ETFs / asset growth
Benefits of ETFs
The management fees for index-based ETFs are usually significantly less than investing in the same exposure of individually purchased securities. ETFs are also more cost efficient than actively managed funds.
Index funds invest in all or a representative sample of securities in an index and provide a highly diversified investment. ETFs are constructed using an indexing approach, where an individual investment is pooled with other investors’ money. This offers investors access to a wider range of investments, which may not be accessible otherwise to an individual investor.
Potential tax efficiency
Tax can potentially take a large slice out of investment returns so it pays to invest in funds that are tax efficient. The low turnover of an indexing approach minimises the capital gains distribution impact. This improves after-tax performance and tax efficiency over the longer term.
The issuer of the ETF provides daily information to the market including the ETF basket and the Net Asset Value (NAV) of the ETF, making ETFs a highly transparent investment option.
Unlike unlisted managed funds, investors are able to trade ETFs during ASX trading hours and at a price quoted on the ASX. The ability to create and redeem ETF securities by Authorised Participants ensures an underlying depth of liquidity.
Risks of ETFs
Like all investments, ETFs carry risk. The main risks are that: 1) the value of the portfolio falls; 2) fluctuations in the value of the Australian dollar affect the value of ETFs over international assets; 3) you may not be able to sell your ETFs for a fair price.
The indices underlying an ETF usually comprise of many securities, protecting you against the specific risk of an individual security or stock performing poorly. Nonetheless, investors are still exposed to market risk. For example, if the broad Australian stock market falls, an ETF that tracks the S&P/ASX 200 index will equally fall in value.
Investors are exposed to currency risk if they hold an international unhedged ETF.
This is the risk you may not be able to sell your ETFs for a fair price. Liquidity can vary between different ETFs. Some are actively traded. Others have relatively low turnover, which can make buying and selling at a fair price more difficult. For many of the largest ETFs, average Buy/Sell spreads are typically 0.05% to 0.11%.
How does currency affect ETF returns?
ETFs provide Australian investors with an ability to access overseas markets and securities not usually traded in Australian dollars ($AUD). This means that ETF issuers can chose whether or not to remove or ‘hedge’ currency risk. There is no right or wrong answer to whether ETFs should be hedged or not – its merely up to investor preference. Some ASX listed ETFs are unhedged while some ETFs hedge currency exposure.
Hedging means that the ETF issuer has converted the underlying assets from their home currency to $AUD. ASX:QAU is an $AUD hedged Gold ETF. That means that Australian investors have exposure to the USD Gold price.
e.g. a 2% rise or fall in the USD Gold should result in approximately a 2% rise (before fees and tax) or fall for the ASX: QAU which tracks USD Gold.
On the other hand, ASX:GOLD is an unhedged gold ETF. For an Australian who invests in an unhedged ETF, there are two main factors that contribute to performance returns:
(1) the movement in prices of the underlying index (in this case USD Gold)
, (2) fluctuations in the $AUD rate of foreign exchange conversion with the currency of the underlying index (in this case USD).
e.g. a 2% rise in USD Gold combined with a 2% rise in $AUDUSD should result in approximately no change (before fees and tax) for the ASX: GOLD ETF since the upward move in USD Gold is effectively ‘cancelled out’ by the rise in the $AUD.
What are Authorised Participants and Market Makers?
Authorised Participants or APs have an agreement in place with the ASX and ETF issuer to create and redeem units in an ETF. An AP can effectively swap ETF units for corresponding baskets of underlying securities and vice versa. The required basket of securities is published every day by the issuer and reflects the investments and value of the underlying ETF.
A Market Maker's role is slightly different. They provide liquidity to the market by quoting buy and sell prices throughout the trading day.
Market makers seek to provide continuous liquidity to the market. The process begins with the issuer distributing the current fund composition to the market every morning, allowing market makers to price the basket of securities underlying the ETF. Market makers place a buy/sell spread around the true value of the ETF and send these prices to the stock exchange as orders. Market maker orders are updated continuously throughout the day to reflect price changes in the underlying securities.
For many of the largest ETFs, average Buy/Sell spreads are typically 0.05% to 0.11%.
Additional ETF Resources
ASX provides some good beginner reading on ETFs on their website.
- What are ETFs
- Why buy ETFs
- ETFs compared to other managed funds
- Risks of ETFs
- ETF features
- How ETFs are created
- Understanding Net Asset Value (NAV)
- ETFs – cost and tax efficient
- ETF strategies
- Buying and selling ETFs
- Price and other information
- Market makers
- Distributions and tax
- Fees and costs
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