Investing basics: Get acquainted with ETFs


Emma Rapaport  |  08 November 2018  |  8 min read

Key Points
  • ETFs are exchange-traded funds that replicate a specific market index.
  • Traditional ETFs are great if you want to start investing or passively invest a chunk of money. 
  • ETFs are low-cost, diversified and highly liquid. 

Let’s say you want to diversify your investments, but you don’t have the time. Or you want to start investing, but you don’t think you have the means. An exchange-traded fund, or ETF, might be the answer. An ETF is traded on an exchange, like stocks, and mimics the performance of a specific market index.

Instead of say, buying a few shares in every company that makes up the ASX 100 Index, you could buy an ETF that replicates its progress. There are also ETFs that shadow other benchmark indices, such as the ASX 300, the S&P 500, the NASDAQ 100 and plenty of other smaller indices.

Take the Vanguard Australian Shares Index ETF (ASX: VAS), for example. It’s one of the better-known Australian ETFs, and tracks the returns of the country’s largest 300 listed companies by market cap, the ASX 300. Of these, the top 10 make up about 44% of the ETF’s net assets. The largest stock holding in the VAS is the Commonwealth Bank of Australia (ASX: CBA), which sits at 7.53% of the portfolio. The smallest is Beadell Resources Ltd, clocking in at just 0.0002% of the total holding.

The VAS is also one of the cheapest broad market ETFs available in Australia, with a 0.14% fee. But when you’re choosing an ETF, fees aren’t the only consideration: you should also look at buy/sell spreads and brokerage, which are par for the course with ETFs, and often fall through the cracks in initial calculations.

What’s the good stuff?

ETFs are popular for a reason. Well, five main reasons.

Low cost

Annual expenses are low, more so than traditional tracker funds. ETFs aren’t actively managed, so you’re not paying an investment manager to pick stocks. And thanks to automation, fees generally float under the 0.5% mark each year.

Diversification

Diversification is in the bones of ETFs. You’re not singling out individual stocks—instead, you’re investing in an overall market. The automation helps with this, too.

Easy access to other markets

They also open a wealth of foreign markets to Aussie investors, who were previously locked out of certain industries or overseas markets. This could be soybeans, forestry, a corporate bond fund or an FTSE 100 tracker.

Accessibility

Unlike most other forms of investing, there’s no minimum to get started buying ETFs. You can buy them in bulk or test them out with just one.

Liquidity

Because they’re traded like stocks, ETFs are also liquid—meaning there are no trading restrictions like you’d find with a managed fund. This means they can be bought and sold without limitations throughout the trading day. However, as you’ll see in the next section, this is also a quality to keep an eye on.

What should you look out for?

Performance

ETFs aren’t designed to beat the market average. If this is your goal, you’re probably better off with a managed fund. Though it isn’t impossible for an ETF to outperform the market, it isn’t intended to, and there’s also a chance it could underperform.

Wide product variations

Investors are told to diversify, and as we’ve covered, ETFs are great for this. But ETFs cover such a wide range, and use several methods to mimic their chosen index, that they can create risk that might be too much for individual—rather than institutional—investors to bear. Even if you’re satisfied that your chosen ETF looks like the whole package, it’s worthwhile doing a scan of its chosen index and methods so you know where you’re putting your money.

Liquidity

And here we are on the other side of the liquidity coin. Just because you can buy and sell whenever you want, it doesn’t mean you should. A lack of restrictions on trading doesn’t mean a lack of trading costs. Buying and selling will incur transaction fees, so it quite literally pays to be disciplined.

You’re ready to buy ETFs. Where should you sign up?

To buy an ETF, you’d need to engage a broker and start a broking account. When you have that, you have a choice of more than 150 ETFs on the ASX. It’s a lot and sifting through them can feel difficult when you’re not sure where to start.

If you’re choosing your own, you can look at how Morningstar’s fund analysts have rated more than 60 Aussie ETFs. The ratings range from Negative to Gold, and are based on five pillars:  People, Process, Performance, Parent, and Price. Each of the below passively-managed ETFs have received Gold or Silver ratings:

And at Morningstar Next, we’ve carefully considered factors like liquidity, accessibility, and performance to deliver a simpler way to invest. That’s because we recognise ETFs as one of the key building blocks of our diversified portfolios, and because we believe you’re better off investing smarter, not harder. 

author

Emma Rapaport is a reporter with Morningstar Australia covering all things business, markets and personal finance.


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