What is an ETF?
An ETF or Exchange Traded Fund is an investment fund that typically aims to track an asset class or a basket of assets. In general, ETFs aim to track a published index such as the NASDAQ-100 Index in the US or the S&P/ASX 200 Index in Australia. ETFs are cost-effective, flexible, and simple to use. Being exchange traded, ETFs are bought and sold just like any share on a stock exchange.
|The first ETF was introduced in Canada in 1990, via a product which tracked the largest 35 companies available on the Toronto Stock Exchange. From then on, ETFs have grown from strength to strength, exploding in number and variety. They have become more sophisticated along the way while simultaneously maintaining their essential simplicity and broadening their appeal. The total assets in ETFs across the globe is now greater than $US5 trillion, and growing fast!|
What’s the difference between ETPs and ETFs?
ETP is an umbrella term that refers to a fund product that is traded on a stock exchange (i.e. Exchange Traded Product) and typically invests in securities (for example shares or bonds) or other assets (for example commodities or currencies). An ETF is therefore a type of ETP – one that specifically aims to track an index or asset class ie it is passively managed and therefore does not seek to outperform the relevant index.
Key characteristics of ETFs
A key characteristic of an ETF is the diversification potential that it can offer. With an ETF, an investor can have their investment diversified over an entire sector, region or a country stock market. This is because when you invest in an ETF, depending on the strategy, you are effectively getting exposure, via a single trade, in a diversified basket of securities/shares.
Secondly, as ETFs typically aim to track an Index or asset class, it is passively managed. This means that an ETF fund manager generally does not need to hire a “star” fund manager to select investments and can manage the fund for far lower cost. These cost savings can then be passed on to the investor as savings. This generally means that ETFs costs are significantly less than those funds which are ‘actively managed’.
Another benefit of ETFs is their liquidity. They provide liquidity along with flexibility as you have the ability to trade your ETF during the day, the same way you would trade your stocks using your online broker account or other stockbroker.
How are ETFs structured?
You can invest in ETFs the way you would normally buy shares, which is through your stockbroker, financial advisor, or through your online trading platform. Of course, you need to be mindful of the underlying factors that drive ETF prices before you decide to buy or sell ETFs.
An ETF’s price is dynamic in that the value of the ETF tends to rise or fall during the day. This is in response to the fluctuations in the underlying index that the ETF aims to tracks.
Unit trust structure
ETFs use a structure referred to as a unit trust, where the assets of the unit trust are held by a trustee. The unit trust structure is the most common investment structure used in Australia, and the vast majority of traditional managed funds are unit trusts.
The fact that the ETF is structured as a trust is a source of investor protection, given that the assets of the ETF are held ‘in trust’ by the ETF manager for the benefit of the ETF unitholders. This structure means that the underlying assets of the ETF are held separately from the assets of the fund manager, adding a layer of protection should anything happen to the manager.
How ETF units get created
ETFs are open-ended – the number of units on issue is not fixed, and the supply of units can vary in line with investors’ demand.
ETF units can be created through the process of “in specie” contribution, a process in which the physical shares which underlie the index being tracked by the ETF are transferred to the ETF issuer in exchange for the creation of ETF units. This process of securities being exchanged for ETF units is a “primary” market activity between the ETF provider who creates the units, and the “Authorised Participants” who are wholesale investment houses who receive these units. Note that other than this ‘in specie’ creation, ETF units can also be created via “cash creations”, which is when cash (rather than assets) are exchanged for ETF units.
ETF units created in the primary market are then made available on the secondary market ie the stock exchange by the Authorised Participants. This ‘secondary market’ is the market where you, as an investor, will be investing in ETFs.
This ability for ETF units to be created in the primary market in exchange for shares is matched by the flexibility to redeem the units in exchange for shares when the supply of ETF units exceeds demand. This flexibility on the part of Authorised Participants to create and redeem on demand in a particular ETF, along with their open-ended structure, is one of the key reasons behind the liquidity of ETFs.
How can I buy and sell ETFs?
|You can invest in ETFs the way you would normally buy shares, which is through your stockbroker, financial advisor, or through your online trading platform. Of course, you need to be mindful of the underlying factors that drive ETF prices before you decide to buy or sell ETFs.
An ETF’s price is dynamic in that the value of the ETF tends to rise or fall during the day. This is in response to the fluctuations in the underlying index that the ETF aims to tracks.
NAV and iNAV
When seeking to invest in ETFs, it is worthwhile to check what the current offer price is in comparison with the estimated net asset value (NAV) information before you buy. NAV is the market value of the ETF’s component assets after management fees, liabilities, and other expenses are deducted. If you plan to sell, you may want to check the bid price with the estimated NAV information. Estimated NAV updates are normally available in real time, often referred to as the indicative or intraday NAV (iNAV).
The iNAV is an appraisal of the value of assets of the fund at a given time, and is a useful indicator of whether the ETF’s quoted market price is over or underpriced. If you are quoted an offer price that significantly exceeds the ETF’s iNAV, you could end up paying much more than what the ETF is worth. On the other hand, if the bid price turns out to be a lot less than the ETF’s iNAV, you would be losing money on your investment as you try to sell your ETF. Note that the price you buy or sell the ETF for will likely not be identical to the iNAV – this is due to what is called “bid-offer spread”, which is essentially the compensation received by the ETF’s market maker for providing liquidity in the ETF on the exchange.
The actual performance of the index or investment that the ETF aims to track may be different to the performance of the ETF, which is called tracking error. Tracking error is a normal occurrence and is primarily on account of the associated expenses of the ETF such as its management fees.
How can I use ETFs in managing my portfolio?
One of the advantages of investing in ETFs is the instant diversification that they offer, as many ETFs effectively give you exposure to many stocks in a single trade. In other words, if you are keen on building a well-balanced investment portfolio to balance risks, you could use ETFs wholly or partly to do so.
Choose your region or country
If you were to invest in an ETF that aim to track the NASDAQ 100 Index, for instance, you are afforded exposure to the 100 companies that make up the NASDAQ 100. In effect, with a single trade in the ETF, you could accomplish this feat at a significantly lower cost, and with much less difficulty, than if you were to invest directly in 100 individual shares yourself. Other such exposures that you could have immediate access to include Australian shares, Japanese shares, European shares and many more regional or country exposures.
Choose your themes
With ETFs, you do not have to restrict yourself to a a specific country or region but can also invest in specific industry sectors that may interest you. For example, do you want exposure to Cybersecurity companies, Global Healthcare companies, Global Energy companies or Global Gold Miners? Such exposures are easy to access using global sector ETFs. ETFs such as these can be used as part of a balanced portfolio which, given the breadth of product available, can be made up entirely of ETFs.
Mix and match your investments
Some investors may wish to have the best of both worlds by combining ETFs with direct investments in shares of their choice. Experienced investors may find this useful and engaging, and the use of the ETFs also allow increased portfolio diversification.
What are the benefits of using ETFs?
ETFs are an intelligent investment solution that offer investors advantages to achieving their financial objectives, including:
One of the primary benefits of using ETFs is diversification, which can help to manage portfolio risk. With ETFs, you could invest in specific markets or in particular assets. Investing beyond one’s home market, for example, can be a great way to get geographic diversification, as using such a strategy an investor may be able to reduce exposure to the fluctuations of a particular geography or region. Also, the simple fact that an ETF aims to track a particular index of shares means that one gets an instantly diversified portfolio of shares, rather than exposure to a single stock.
Little influence from changes to supply and demand of ETF units
The price of the ETF is tied to, and tends to be in close proximity to, the ETF’s NAV. This is due to the open ended structure of ETFs which we have discussed above, and means the level of demand for a particular ETF should not directly impact the price of the ETF – but rather the underlying assets which are being tracked should be the primary determinant of the price.
Lower management costs
An ETF is a passively managed fund, as opposed to other investments that are actively managed. An actively managed fund involves a fund manager who generally actively seeks to outperform a particular benchmark. Active management typically involves higher management expenses than passive index-tracking ETFs. Hence, with ETFs, you benefit from lower management expenses.
ETFs are SMSF friendly
Like other pooled funds, ETFs are eligible investments for Self Managed Super Funds (SMSFs) and the popularity of ETFs has been strongly growing over time with this client base.
Are ETFs liquid investment products?
It is a common misconception to associate the metrics one uses to determine the liquidity of shares with the liquidity of ETFs. Investors may mistakenly see low turnover and trading volumes, and associate this low trading volume with low ETF liquidity. To the contrary, the primary liquidity of ETFs is not what you see ‘on-screen’ and so trading volumes are really only a small part of the liquidity story. To understand the liquidity of ETFs, it is important to understand the ETF structure and the role of ETF market makers.
Open-ended funds and liquidity
Shares are structured differently to ETFs as, with shares, there are finite shares outstanding available for trading. This means that share prices are dependent on the level of demand and supply for those shares. On the other hand, ETFs are open-ended funds so that the number of ETF units is not fixed, and can expand or contract depending on the level of demand for the ETF itself.
The difference is apparent – while shares available for trading are fixed in number, ETF units are not. ETF units are made available by dedicated market makers, whose responsibility is to adjust ETF supply to demand. Hence, unlike shares, ETF issuers are in constant touch with ETF market makers to buy back ETF units from them, or to sell ETF units to them, based on demand conditions. If demand exceeds supply, the market makers will want to create more ETF units, and vice versa.
Hence, an ETF’s liquidity is essentially at least as strong as that of the underlying holdings that they comprise. If ETF investments are in securities and assets that are difficult to buy or to sell, then it becomes difficult for the market maker to sell or redeem ETF units accordingly. However, ETFs available in Australia typically invest in assets that are highly liquid.
How are ETFs regulated?
|ETFs are subject to all the legislative requirements associated with other investment products under the purview of the Australian Securities and Investments Commission (ASIC). ETFs are admitted to trading under ASX requirements as stipulated in Schedule 10A of the ASX Operating Rules. These rules are broadly referred to as the AQUA Rules, which govern the conduct and activities of ETF issuers. ETFs are registered as “managed investment schemes” (MIS) with ASIC and are governed by the Corporations Act. The MIS is the structure used by most traditional managed investment funds.|
ETFs and their PDS
ETF providers have to operate in compliance with the investment mandate set out in the Product Disclosure Statement (PDS). In other words, issuers will not be able to invest arbitrarily, but can only invest on behalf of the investors in the specified assets and securities as outlined in the PDS. Hence, as long as you understand what’s in the PDS, you can have confidence about where your money is being invested.
ETFs use a trust structure
ETFs are trusts operated by a trustee for the benefit of investors. ETF assets are held on trust separate from the assets of the ETF issuer, the assets held by any other funds, or any other asset that is being held by the custodian of the ETF.
ETF issuer going out of business
What would happen to ETF assets if the ETF issuer goes out of business? Firstly, as ETF assets are held on trust, they do not form part of the issuer’s own assets and are not available to creditors of the issuer. One way that investor interests would be protected in the event of the issuer ceasing operations is through the appointment of another manager for the funds who would continue to operate the fund. If an alternative manager were not able to be found, the assets of the ETF would likely be liquidated and the net proceeds distributed to investors in proportion to their unitholdings.
What are the risks of ETFs?
Risks are primarily related to the nature of the investments made by the ETF. All investments carry risks. For example, Equity ETFs are generally linked to share indices, and so their value tends to rise and fall in line with share market fluctuations. Further, ETF risks tend to vary based on the risk profiles of the underlying assets. Some example risks are detailed below:
This is the most common risk, where fluctuations in ETF prices occur in line with the rise and fall of the value of the underlying securities and assets. If an ETF tracks a specific index, for instance, such as the S&P/ASX 200 Index, naturally, the value of the ETF would tend to behave in line with the trends of the underlying index.
This risk has to do with currency fluctuations. It applies to ETFs that track international funds or assets, and that are not currency-hedged. ETF portfolios are traded in their local currencies and not in Australian dollars. Hence, the value of international ETF portfolios would be affected, positively or negatively, by fluctuations in currency exchange rates between the relevant foreign currency and the Australian dollar. Investors dealing with international ETFs should therefore be mindful of currency risks. Investors should note that, as the ETF industry has grown, there are now a number of funds that offer international shares exposure on a currency hedged basis.
What is the role of a market maker in an ETF?
ETFs are known for their liquidity, allowing investors to normally buy and sell their units when they want to during the day. This liquidity is the primary responsibility of a key player in the ETF ecosystem – the market maker.
What is a market maker?
For ETFs, market makers are often the party you are trading with on the exchange (although you can also trade with an existing ETF unitholder). Market makers are professional traders who help you trade in ETFs by quoting bids and offers in the market. They are key players in the ETF equation, since an issuer is required to have at least one dedicated market maker whose role it is to quote bids and offers, and to buy and sell units in response to investor orders.
The role of market makers can be seen through comparison between listed investment companies, which are close-ended, and ETFs that are open-ended vehicles. Shares in listed investment companies are finite in terms of their availability. As such, when demand increases from buyers for these shares, prices tends to rise (sometimes at a premium to Net Asset Value), and when there are more shares than takers, prices can drop (sometimes at a discount to Net Asset Value).
Market makers and ETF liquidity
The difference in the case of open-ended ETFs is that market makers are able to increase or decrease their inventory of units as they require. When there are buyers looking for ETF units, the market maker sells units to investors. And when there are sellers, the market maker buys them. Apart from buying and selling units, the market maker is also responsible for creating more units to meet demand, or sell units back to the ETF fund manager to match the market demand. Thus, in normal conditions, being able to sell your ETFs when you want to could, in part, be attributed to the presence of a market maker.
Market makers and arbitrage
The process of “arbitrage” by market makers helps keep the market price of ETF units on the exchange closely in line with an ETF’s Net Asset Value (NAV). For example, if the market price of ETF units happens to be higher than the ETF’s NAV, this presents an arbitrage (or profit) opportunity for market makers, who can buy the underlying securities that make up the ETF’s NAV, exchange them for ETF units, and then sell the ETF units on the exchange for a profit. This will tend to push the market price of ETF units back down towards the ETF’s NAV.
What is the difference between an ETF’s NAV and its market price?
NAV represents the value of the underlying asset or holdings of the ETF. Since it is the “net” asset value, it refers to the net value of the underlying asset after all fees, costs and liabilities have been deducted.
Net asset value is not the same as market price. The market price of an ETF represents the price at which ETF units can be bought and sold in the course of a day’s trade on the exchange.
NAV is calculated as a sum of all assets that the fund represents after deducting all expenses and liabilities from the sum. This amount is then divided by the number of units in the ETF to arrive at NAV per unit. NAV is calculated on a daily basis and published on the respective product pages of the funds in question. An investor would typically look at the history of the NAV/Unit of a particular fund to calculate the performance of that fund (i.e. rather than a history of market prices).
Market makers and NAV
Since the traded price is simply the price at which a trade occurred on the exchange with respect to an ETF, rather than a calculation of the underlying value of the component parts of the ETF, there will necessarily be differences between the two values. However, the differences between NAV at the time of the trade and the traded price are normally not substantial, thanks to the creation/redemption mechanism in place with ETFs. This creation/redemption process is critical to keeping ETF prices in balance with NAV.
What is iNAV and how is it calculated?
During the trading day, investors are able to get more information about the ‘fair value’ of the ETF by using what is known as the iNAV (Indicative Net Asset Value). iNAVs are typically available for ETFs which invest in Australian shares.
The iNAV is updated every 15 seconds to give a sense of the value of investments to investors through the trading day. The iNAV calculation is the responsibility of a third party agent who calculates this figure by reference to the prices of the ETF’s underlying assets and securities. The methodology to calculate iNAV is essentially the same as calculation of NAV. iNAV is calculated by valuing, in real time, all assets that the fund represents and deducting all expenses and liabilities involved, such as fees and costs. This amount is then divided by the number of units in the ETF, resulting in the Indicative Net Asset Value.
Significance of iNAV
The significance of iNAV is that it is an estimate of the fund’s value in real time, since it is updated and published every 15 seconds throughout the trading day. iNAV, hence, helps investors make informed decisions on the fund’s value before they decide to trade.
What’s the difference between a market and limit order?
When investing in an ETF, an investor can place different types of orders – a market order or a limit order – that are executed in different ways.
A market order is placed to buy or sell a given number of ETF units, and is transacted at the prevailing market price at the given point in time. This is typically not the best way to transact ETFs.
For example, if an investor were to sell an ETF at market prices, there is the risk of the market price being well below NAV, depending what bid price is being offered at a particular time.
It is a similar case when buying units at market prices that are premium priced, which results in the investor paying out more than what the units may be worth, as reflected by NAV.
A limit order, on the other hand, has a limit price attached to it. The idea behind the limit order is to specify the price at which an order to buy or sell a specified number of ETF units is to be executed. This can prevent an order being executed when the market price is much higher or lower than NAV.
Do ETFs pay dividends?
As ETFs are investments in underlying assets and securities. ETFs provide distributions based on the assets or securities that the units represent. Depending on the ETF, such distributions are made on a monthly, quarterly, half-yearly or annual basis. Depending on the ETF’s investment strategy, the distribution could be made up of dividends, interest, and/or capital gains that are realised by the ETF.
ETFs and franking credits
ETFs that invest in shares are eligible to receive their portion of the dividend at the end of each distribution period. This would also include franking credits as applicable, in the case of Australian shares ETFs. When Australian resident companies distribute their after-tax profits through franked dividends, franking credits are attached to dividends.
Dividends and franking credits associated with the underlying assets are normally passed on to investors. It may be noted that dividends that arise out of shares held by the ETF will still be assessable for tax in the hands of the investor.
Eligibility to receive the distribution is similar to that associated with being eligible to receive dividends from shares. All unitholders registered with a fund on the fund’s ‘record date’ are eligible to a share of the distributable income of the ETF for the specific periods associated with the distribution.
Another aspect to note with regard to ETF distributions is that they can include realised capital gains. The fund, in the course of the year, could realise capital gains or losses when the underlying assets are sold. It may be noted that capital gains realised from the sale of underlying assets are separate from capital gains or losses arising from the sale of ETF units. Any associated net capital gain is also passed on to investors, who are responsible for any tax implications.
There are also ETFs that invest in other assets to generate interest income. Any interest accrued in the process is passed on to the investor, and is again assessable as interest income from a tax perspective.
How are management fees paid on ETFs?
There are running expenses involved with managing the ETF, which translate into the costs borne by investors in ETFs. The typical costs include the management fee payable to the ETF issuer for operating the fund, the fees payable to service providers such as the custodian, fund administrator and unit registrar, as well as transaction costs, such as brokerage, associated with buying and selling the ETF’s underlying investments.
Calculation of expenses
All such costs are calculated and deducted from the value of the fund, which ultimately reflects in the NAV of the fund.
The management fee and other costs are typically reflected in the ETF’s NAV on a daily basis, so that the fund’s published returns already take them into account.
What are the other costs of investing in ETFs?
In addition to the costs investors bear within an ETF, when investors buy or sell units they can also expect to incur brokerage fees and the buy-sell spread. These are not costs imposed by the ETF issuer, but by the investor’s stockbroker and by the market maker respectively.
Apart from the fees involved in managing the funds, brokerage fees should also be considered part of the costs incurred in investing in ETFs, since ETFs are bought and sold much like shares. These fees are levied by the broker in line with their pricing structures and are not payable to the fund managers.
The buy-sell spread is another cost of trading in ETFs. This is the difference between the prices at which you could buy and sell your ETF units vs. its NAV per unit. The buy-sell spread represents the compensation to the market maker for providing market making services.
From an investor’s point of view, it is important to look at the value of their investments from an all-in cost perspective.
How are ETFs different from managed funds?
ETFs and traditional actively managed funds tend to differ on a number of dimensions, including the level of diversification, expenses and fees involved in managing the respective investments, liquidity, and transparency.
ETFs are known for their diversification properties, particularly when they aim to track the performance of a broad sharemarket index. In the case of traditional actively managed funds on the other hand, the level of diversification is essentially the prerogative of the individual fund managers, since they decide both the number and type of stocks to invest in. On the other hand, some ETFs provide investors with exposure to entire indices. This can spread risk and often provides for broad diversification across a large number of shares and securities.
Low costs of ETFs and passive management
Cost has been a major point of attraction for ETFs since actively managed funds tend to involve higher costs. In addition, when such managed funds beat their nominated benchmarks, some also levy ‘performance fees’.
The management fees and costs of ETFs are typically much lower than the costs of actively managed funds, primarily because they are passively managed. In addition, they tend to buy and sell underlying investments less frequently than actively managed funds, which leads to lower transaction costs.
ETFs are considered to have a high level of liquidity as they are able to be bought and sold in most circumstances during the day, when the markets are open. This is facilitated by the presence of dedicated market makers who manage the buying and selling process while also seeking to keep the differences between bid and offer prices to a minimum. Traditional, unlisted funds can typically only be bought and sold at the day end value of the fund.
ETFs, by their very nature, aim to track specified indices or asset classes, with an ETF manager required to disclose to the public the full holdings of the ETF on a daily basis. This leaves the investor well-informed about what their investment goes into. Unlisted managed funds, on the other hand, tend to provide far less information about their portfolio holdings on a regular basis.
Can I use ETFs in a self-managed super fund (SMSF)?
The popularity of the ETF as an investment vehicle of choice could, in part, be attributed to the way Self-Managed Super Funds (SMSFs) have embraced ETFs over the past few years, among other factors. Yes, SMSFs can use, and are using, ETFs to achieve their financial goals.
SMSFs, ETFs and Diversification
One of the primary reasons why SMSFs use ETFs is diversification. An SMSF is typically long-term oriented, aligned with the retirement needs of its members. This makes diversification an important part of the equation, since diversification is essential for long term risk management. ETFs cater to the diversification needs of SMSFs, since they allow you to instantly add broad exposure to anything from Australian shares to global stocks, for example.
SMSFs, with their long-term orientation, tend to look for options that would further their interests and objectives. With the liquidity that ETFs have to offer, SMSFs can manage their cash efficiently and shift their investments around as needed, using ETFs as a short-term placeholder.
Flexibility and control
Another reason why SMSFs find a good investment vehicle in ETFs is the flexibility and control that ETFs provide to SMSF trustees. Since ETFs often aim to track an asset class or a basket of assets, various ETF products tend to have different strategies, risks and potential rewards. This flexibility is coupled with the control that ETFs afford to SMSF trustees, where investors can decide whether they want to hold or sell their units, and when they want to sell them.
ETFs also afford SMSF members with benefits such as simplicity of structure, low costs due to ETFs being passively managed, transparency and tax efficiency. With the number of SMSFs holding ETFs having risen from 83,000 to more than 100,000 between 2015 and 2017, it is no wonder then that ETFs continue to gain in popularity among SMSF investors.
Are ETFs more tax efficient than traditional managed funds?
Tax efficiency is one of the reasons for the popularity of ETFs. From a tax efficiency point of view, there are differences between ETFs, which are passively managed, and traditional actively managed funds.
Traditional managed funds
Traditional actively managed funds (or mutual funds as they are called in some jurisdictions) are investments made using pooled funds from investors. While ETFs are essentially taxed the same way as these traditional managed funds, the difference is in the way ETFs are structured, which often results in lower tax liabilities.
|Managed funds are often actively managed by fund managers whose objective is to outperform the market, which requires frequent buying and selling of securities. This frequent trading is not as much the case with passively managed investments of ETFs, as the indices which are aimed to be tracked by the ETF often rebalance relatively infrequently. Less trading typically means less capital gains, which in turn leads to a higher level of tax efficiency in ETFs vs. traditional actively managed funds.|
What are the differences between passive and active ETFs?
ETFs grew in popularity on account of their many advantages for investors as against traditional managed funds. As more and more investors from around the globe embrace the liquidity, flexibility, cost and tax efficiencies offered by ETFs, another stream of this investment vehicle is breaking new ground and growing into another mainstream investment vehicle – Active ETFs.
The idea of an ETF
The original construct of an ETF was to create a single security that would track an index during the course of a day’s trading. Investors could get exposure to all the securities that made up the index with a single trade, but of course, being passively managed funds, ETFs do not attempt to provide outperformance against a given benchmark or index.
Quest for performance
It is the pursuit of market-leading performance that leads investors to demand actively-managed funds, giving rise to investment vehicles such as Active ETFs. The difference in this case is that Active ETFs are often designed to outperform a given benchmark, and rely on the skill of the investment manager to do so.
An Active ETF Example – Active Hybrids Fund
An example of an Active ETF in practice is the BetaShares Active Australian Hybrids Fund (managed fund), an Active ETF which provides exposure to a portfolio of Australian hybrids that are actively and professionally managed.
Where to next for the ETF industry?
|Australia’s ETF industry is expected to continue its rapid growth trajectory in the future, as investor demand, product innovation and evolving requirements of advice models used by financial planners all drive the industry to new heights.
To find out what our predictions are for the year ahead, you can read Our 3 Predictions for 2019 article.