Five common myths about ETFs

• The investment structure of an ETF is no riskier than an investment directly into the underlying stocks, or via a managed fund or LIC
• ETFs can be used as building blocks in an investment portfolio
• ETFs from different providers can track the same index – but this doesn’t mean they’re the same in every way
• The vast majority of ETFs in Australia are backed by physical assets
• ETFs are traded on an exchange like stocks or shares, but unlike listed shares, ‘on-screen’ volume is not a true indicator of liquidity

The investment structure of an ETF is no riskier than investing directly in an equity, or via a managed fund or a LIC. ETFs cover all types of asset classes and exposures, from currencies and commodities to fixed income and equities, and will be subject to different types of investment risks.

As such, it’s helpful for investors to consider their risk profile when determining how to use ETFs within their investment portfolios and to consider what the actual underlying exposure of an ETF is. For example, an ETF holding 200 of the largest stocks on the ASX (such as the BetaShares Australia 200 ETF), will have a very different risk level and volatility than an ETF which tracks the price of small companies on the ASX.

Most ETFs are passive investments, because they typically aim to track an index that has been constructed by an index provider such as S&P, MSCI or FTSE.

While these types of ETFs do not aim to outperform the indices they are based on, adding ETFs to your portfolio can give you access to asset classes that you otherwise may not have access to, or allow you to ‘overweight’ or tilt a portfolio to a sector such as financials or resources.

When used in conjunction with a broad market ETF, this could increase the outperformance potential for your portfolio over a broad market exposure alone. In other words, a single index-tracking ETF will typically replicate the performance of the underlying index, but combined with other ETFs (or direct equities or unlisted managed funds), there may be an opportunity to add alpha, and construct more complete portfolios.

Active ETFs exist too. The performance of an active ETF may deviate from its benchmark index, with the investment manager typically seeking to outperform the benchmark index or the broader sharemarket.

As the ETF market evolves, you can expect there to be multiple ETFs tracking similar indices. However, there can be quite a few important differences that you may want to take a closer look at besides management costs, buy/sell spreads and volume.

For example, you should look at the particular index the ETF seeks to track, whether the ETF is using a market cap, equal weight, or fundamentally weighted approach, and whether there may be any tax advantages in using one ETF over another.

Paying attention to these differences may result in better performance or returns, and potentially more money in your pocket.

ETFs are traded on an exchange like stocks or shares, but unlike listed shares, ‘on-screen’ volume is not a true indicator of liquidity. When trading a share, liquidity is a primary concern since you will generally want to buy or sell the share  without pushing the price up or down.

However when purchasing or selling an ETF, the volume traded of the ETF is not a true indicator of its liquidity. ETFs are required to have market makers that are available to purchase or sell your units when you need to buy or sell, and ETF issuers are able to issue additional units or redeem units as demand rises or falls.

These features facilitate ETF liquidity, and aren’t present for ‘ordinary’ shares. This is why we say that the actual liquidity of an ETF is based on the liquidity of the underlying asset, as opposed to the volume traded the ETF.

The vast majority of ETFs in Australia hold the actual underlying investments you are exposed to. There are some ETFs, such as commodity ETFs, which seek to track the performance of underlying assets that are simply not feasible to hold directly (e.g. physical oil), but even these are generally backed by cash.

In either case, your ETF is most definitely holding some type of asset.