ETFs

ETFs generally track an index and aim to replicate

the returns and yields of the underlying product.

Investing in ETFs

The rise in passive investing in recent years has been due in part to the growing range and availability of Exchange Traded Funds or ETFs.

Investing using ETFs, allows investors to effectively manage their own portfolios and in doing so reduce costs with the added benefits of flexibility, diversification and leverage.

An ETF is a security that tracks an underlying product, like a stock index, a commodity or a sector.

They operate in a similar fashion to managed funds, however they differ in that they trade directly on a stock exchange, like shares in a company.

For example the STW trades on the ASX and aims to replicate the returns and yield of the ASX 200 index.

ASX 200 Index (XJO) vs SPDR 200 ETF (STW)

etfs

The differences between ETFs and managed funds

While a managed fund is similar, they differ in that an ETF trades directly on a stock exchange like the ASX, and investors are able to buy and sell them directly during market hours.

They also differ in that they are priced based on market movements, unlike a managed fund which is generally priced based on its net asset value (NAV) at the end of the trading day.

As a result ETFs offer a range of advantages to investors of all levels.

 ETFManaged Fund
DiversificationYesYes
Management CostsAs low as 0.14%Around 1.4%
Intraday MarketYesNo
MarginYesNo
Short SellingYesNo

Some things to watch out for when trading ETFs

Liquidity

Given the fact that ETFs trade directly on a stock exchange like the ASX, investors are able to buy and sell them directly through their broker. This allows investors and traders added flexibility to manage their own portfolios and easily execute their orders. The market liquidity also helps to lower the bid/ask spread which is significantly lower than buying and selling managed funds through a broker or financial advisor.

Dividends

If you own an ETF, as an investor you get access to regular dividends, in the same way you would if you held the individual stocks. ETFs offer a great way to gain access to yield and at the same time reduce the risk of holding individual shares

Leverage

Many ETFs offer two or three times leverage to potentially improve your returns. However the expense ratio on a leveraged ETF will often be higher as there are costs associated with obtaining margin.

Wide bid/ask spreads

Not all ETFs are liquid and one of the signs of an illiquid ETF is a wide bid/ask spread and low volume. If you’re forced to buy and sell an ETF at an unfavourable price due to a lack of liquidity, it can potentially hurt your returns.

Costs

All ETFs and managed funds have management costs associated with running and administering the funds. ETFs generally offer low costs, also known as expense ratios, especially on ETFs that track individual indexes. For example the STW that tracks the ASX 200 has an expense ratio of just 0.19%, compared to a managed fund which can average around 1.4%.

Commissions

When you buy and sell an ETF you execute your trade through a broker and as a result are often only paying discount brokerage rates. In comparison when you buy and sell with a full service broker or an adviser you can often be forced to pay higher fees.

Inverse ETFs

In many cases you have the ability to short an ETF directly through your broker, however there are certain ETFs that are structured in such a way that they trade inversely to the underlying asset, meaning they are set up to be short the product. That allows long only investors to get short exposure to an asset without the direct costs associated with shorting a regular ETF. Again investors need to be aware of the expense ratio on inverse ETFs.

Tracking Error

While an ETF aims to replicate the returns of an underlying product, it’s not necessarily feasible to perfectly achieve that for a number of reasons. There are management and trading costs associated with managing an ETF. There are also costs when using margin that are associated with inverse or leveraged ETFs. While often times only small – tracking error can lead to reduced returns for investors.

Investing in ETFs

Australian investors have access to a wide range of liquid ETFs, representing a broad range of both Australian and international stocks, bonds and commodities.

Some of the most popular and liquid ETFs listed on the ASX include

SymbolNameCategory
STWSPDR® S&P/ASX 200 ETFStock Index
VASVanguard Australian Shares ETFStock Index
BOND SPDR® S&P/ASX Australian Bond ETFBond Index
GOVTSPDR® S&P/ASX Australian Govt Bd ETF Bond Index
VGBVanguard Australian Government Bond ETFBond Index
VAPVanguard Australian Property Secs ETFAustralian Property

Constructing a portfolio

In the same way investors are able to build a diversified portfolio through investing in managed funds – it’s possible to do the same with ETFs.

For example an investor seeking to construct a 60/40 stock/bond portfolio can easily do so purchasing ETFs directly through their broker.

For example:

SymbolNameCategoryWeighting
VASVanguard Australian Shares ETF60%
VGBVanguard Australian Government Bond ETBonds40%

Here we see that investors are able to gain exposure to both stocks and government bonds and can rebalance according to their own requirements.

In Australia the ETF marketplace continues to grow and evolve, however it’s heavily dominated by a few large firms that hold the bulk of the assets under management (AUM), including Vanguard, Blackrock’s iShares and State Street’s SPDR.

Investing with ETFs is a great way for Australian investors to construct their own low cost portfolios that fit their needs in terms of diversification, risk and yield.

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