Exchange Traded Funds (ETFs)

Exchange traded funds are becoming an ever more important part of an individual investor’s portfolio.

Indeed, the number of ETF investors in Australia almost doubled to one million in the 12 months to April 2021.

And many first-time investors will now buy an ETF before they buy a stock.

In the wake of COVID-19, investors also appreciate the need for diversification, making ETFs a prominent investment consideration.

What are ETFs?

Exchange traded funds are becoming one of the most popular investment products for institutional and individual investors alike.

For instance, by June 2021, the ETF industry’s global assets were worth more than US$9 trillion.

Investment firm BlackRock forecasts the ETF industry’s assets to hit US$15 trillion by the end of 2025.

And since ETFs, at time of writing, only account for around 3% of all assets held in equity and bond markets, analysts expect decades of growth ahead.

As the 2020 ASX Australian Investor Study reported, ETFs have become increasingly important as a ‘diversification tool, an entry level investment for new investors, and a preferred vehicle for next generation investors.’

But what exactly is an ETF?

Exchange traded funds are managed funds that you can buy and sell on an exchange like the ASX.

They can be a low-cost way to earn a return similar to an index or a commodity.

ETFs effectively collect a group of securities in a basket so that the securities are weighted proportional to their size in the ETF’s underlying index.

For instance, if the share market performs well, the value of a broad market ETF will rise in line with its underlying broad market index.

How do actively managed funds differ to ETFs?

One of the biggest reasons why ETFs are low-cost is they are passive investments — ETFs don’t try to outperform the market. The fewer trades a fund makes, the fewer fees it charges.

ETFs track the value of an index, a specific commodity like gold, or even a currency.

ETFs then try to replicate the performance of that specified index or asset. This means that an ETF manager’s job is to match the fund constituents with the underlying index or asset.

Actively managed funds, on the other hand, aim to outperform a certain benchmark — usually a broad market index.

In chasing this outperformance, the active fund manager can’t construct a portfolio that simply matches the benchmark. The active fund’s portfolio invariably varies from its benchmark index.

What is an index and how does it work?

A share market index is a measure of the performance of a group of stocks, commodities, or currencies.

Some indices measure the performance of the broad Australian stock market (like the S&P/ASX 200 Index), and some indices measure the performance of a market sector (like the S&P/ASX 200 Energy Index).

The ASX has a comprehensive list of ASX indices that benchmark the performance of particular sectors on the share market. Here are some other index examples:

  • S&P/ASX 200 Growth Index
  • S&P/ASX 200 Dividend Opportunities Index
  • S&P/ASX 200 Quality Index

Stocks don’t all move in unison or by the same amount. So what the index measures is the net effect of individual stock price movements in the index.

We can use these net movements to gauge how the market, or market sector, is performing.

Finally, most indices that ETFs track are capitalisation weighted.

Come again?

Basically, the larger the company, the greater its weighting in the index. This also means the larger the company, the greater the impact of its stock price fluctuations on the index.

For example, a 5% change in CommBank’s share price — the largest company on the ASX — will impact the S&P/ASX 200 Index more than a 5% change in the share price of Dicker Data, ranked 200th.

Now that we’ve gone through the basics, some of you may be wondering — what’s all the fuss about?

ETF investing

Perhaps there really are managers who can outperform the market consistently — logic would suggest that they exist. But they are remarkably well-hidden.

That is how Nobel Prize-winning Economist Paul Samuelson started his seminal 1974 article that led to the creation of passive indexing investment strategy.

In the article ‘Challenge to Judgment’, Samuelson mused that ‘some large foundation should set up an in-house portfolio that tracks the S & P 500 Index — if only for the purpose of setting up a naive model against which their in-house gunslingers can measure their prowess.

Well, it didn’t take long for someone to take Samuelson’s idea seriously.

Vanguard Founder John Bogle cited Samuelson’s article as the inspiration behind creating the first index fund in 1976.

And these pioneering index funds gave rise to the ETF industry we know today.

But what need do index funds and ETFs fill?

As Samuelson quipped:

What logic can demonstrate is that not everybody, nor even the average person, can do better than the comprehensive market averages.

That would contradict the tautology that the whole is the sum of its parts.’

In other words, the majority cannot expect to beat the market since the majority is the market.

Not only that, in pursuit of outperformance, active managers and retail investors incur a lot of trading fees, making it even harder to come out net positive.

Samuelson was onto something when he questioned the wisdom of active fund managers.

For instance, investors have dumped US$4.6 trillion into ETFs since the global financial crisis on the back of disappointing performance and high fees of traditional active managers.

The shift away from active managers helped the ETF industry’s two leading players — BlackRock and Vanguard — to become the world’s largest asset management companies.

ETFs and NAV

One thing to keep in mind when considering investing in ETFs is this: The price of an ETF should be at or very close to its net asset value (NAV).

What does the NAV tell you?

The NAV represents the value of all securities held by an ETF — shares or bonds, for example — minus any fees and divided by the number of shares outstanding.

An ETF’s NAV is based on the closing prices of its underlying securities.

So, when you’re looking at an ETF’s performance relative to the index it is tracking, you can compare the ETF’s NAV and the index closing price.

What is an ETF’s premium or discount?

An ETF’s NAV is also used when assessing whether an exchange traded fund is trading at a premium or a discount.

An ETF is said to trade at a premium when its price exceeds its NAV. And it trades at a discount when its price is below its NAV.

Are ETFs shares?

This is a common question asked by investors first looking into exchange traded funds.

Exchange traded funds trade on the stock exchange, just like ordinary shares. But they are not the same as the shares of, say, a stock like the Commonwealth Bank.

So, for instance, each ETF has an ASX code, just like ordinary shares.

But the difference is that ETFs trade at a unit price close to the net asset value of the fund’s underlying portfolio.

ETFs combine the investment advantages of a managed fund with the ease and cost-effectiveness of share trading.

Australian ETFs

You can think of ETFs as big picture investments that give you exposure to a broad range of assets.

For example, if someone considered investing in the resource sector, they could choose to invest in multiple resource stocks after plenty of research and study.

Or they could pick a resource ETF that would give them broad exposure to the overall resource sector.

In the Australian context, Australian ETFs are available over:

  • Australian stock market as a whole
  • Sectors within the Australian stock market
  • Particular investment strategies (eg: enhanced dividend yield)
  • Australian fixed interest market

What are some ASX-listed ETFs?

Here are some examples of ETFs listed on the ASX providing exposure to different asset classes and markets:

  • Vanguard Australian Shares Index ETF: Exposed to Australia’s 300 largest companies by tracking the S&P/ASX 300 Index.
  • Vanguard Australian Shares High Yield ETF: Exposed to ASX stocks with high forecasted dividends by tracking the FTSE ASFA Australia High Dividend Yield Index.
  • BetaShares NASDAQ 100 ETF: Exposed to the 100 largest non-financial securities listed on the NASDAQ, tracking the NASDAQ 100 Index.

For a full list of ETFs traded on the ASX, you can check out the ASX’s list here.

What are some of the top ETFs in Australia?

There are many ETFs out there, and they all cater to varying appetites of risk with different risk appetites and investing goals.

So, classifying any one ETF as best is a fraught exercise given the various investors out there.

We do, however, have a free report on ETFs for those interested in reading further on the topic.

The report discusses five ASX-listed ETFs that could benefit if low interest rates persist for years to come.

Additionally, comparison site Finder tracks the performance of many ASX-listed ETFs and has shared the relative performance of these funds in its ‘Best performing ETFs in Australia for 2021’ guide.

The guide tracks the best performing ETFs over multiple time spans —one-year, three years, and five years.

However, Finder’s lists are not exhaustive and should not replace your research.

The ETF examples listed here are for illustrative purposes only, so you should not consider them as recommendations.

Know the risks

Now, speaking of risk.

The companies discussed here are in no way recommendations. They’re merely a starting point for your research.

As the Australian Financial Review reported, there have been problems in the past with ETFs using derivatives and leverage or even providing exposure to falling markets.

Further, the rising popularity of thematic ETFs has occasionally resulted in some ETFs launching at the top of a hyped market.

Thematic ETFs may be popular, but they carry higher stock concentration risk and potentially wider buy–sell spreads.

There are also risks associated with liquidity. Some ETFs may invest in assets that are not liquid, making it difficult sometimes for the ETF provider to create or redeem securities.

ETF investing resources

ETFs are increasingly important in the finance world, and one article will not suffice to explain their intricacies and particularities.

So here are some further resources for those of you interested in exploring the topic in greater depth.

Books on ETFs:

  • A great place to start is reading John C Bogle’s The Little Book of Common Sense Investing, which focuses exclusively on the merits of index funds. Bogle was the founder of Vanguard Group, credited with creating the first index fund. Bogle was a life-long advocate of low-cost index fund investing, so his book is as good a place to start as any.
  • Another good book is Burton Malkiel’s A Random Walk Down Wall Street. Malkiel, a respected Princeton economist, followed Bogle in advocating for the passive investment style via index funds, eschewing the oft awry escapades of active investing.
  • To round off the list, the final book I’ll mention is David F Swensen’s Unconventional Success: A Fundamental Approach to Personal Investment. This book was recommended by Bogle himself and lays out an investment approach for the individual investor that favours low-cost index funds. Swensen made his name by successfully running Yale University’s endowment fund.

Online resources:

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Money Morning Australia