WTF is an ETF?
So, you’ve been thinking about investing in shares; you’ve saved some money, set up a trading account, had a sneak peak at the Australian Securities Exchange — you’re ready to get started, but now the big question is: what can you invest in?
With over two thousand stocks listed on the Australian Securities Exchange (ASX), it can be a daunting prospect to think about picking the most competitive performers — and that’s without considering options available through international markets. It’s one of the reasons why so many people get stuck and often end up delaying making any type of investment decision at all, and why the Australian Government’s Money Smart website specifically recommends that you focus on building a diverse portfolio of investments — so that all your eggs aren’t in one basket.
The good news is that making a sensible investment decision as a novice, or even as an experienced investor, doesn’t have to involve picking individual companies on the share market. Another way into investing is to buy shares in funds which will allow you to invest in hundreds of companies at once.
This leads me to ‘Exchange Traded Funds (ETFs)’. You may have heard of the term as they’ve been exploding in popularity in recent years. Recommended by internationally revered investor Warren Buffet as well as the Australian Government, ETFs are a relatively easy and low cost way of getting started with investing through the share market, that allows anyone to invest in hundreds of companies at once, and reduces risk through diversification.
So WTF is an ETF?
ETFs are a type of ‘managed fund’. A managed fund is a group of individual investments (stocks, alternatives, bonds) that have been combined by an Investment Manager, to create one entity. When you buy into this fund, you are owning a share of all of these investments.
If that sounds confusing, imagine that an ETF is like a buffet where someone else decides what gets dished onto your plate. Your plate is filled with lots of different types of food instead of paying for a single meal off the menu.
Let’s take an ETF of ASX Top 200 companies as an example. If you make one purchase of $1000 worth of shares in this ETF, you’ll become a shareholder in these 200 companies – all in one trade! You get the buffet of 200 different companies for one price, rather than having to buy into each company individually. And your investment grows along with the value of these top 200 companies.
While some managed funds are “actively managed” (meaning the people who operate the fund are regularly buying and selling the underlying investments), ETFs tend to be passively managed (which means the investment selection tends to reflect a benchmark, or a certain categorisation of different types of stocks or listed companies) — this typically reduces the operational cost, which in turn reduces the cost of investing into the EFT, and is one reason why ETFs are so popular.
What are some of the benefits of investing in ETFs?
This is a big tick when it comes to making your first trade on the stock market and it’s often still a requirement for more experienced investors. Instead of wading through annual reports and investor commentary about hundreds of companies or investments, you can instead select an industry, geographic region or asset class to invest in through the one ETF. This limits the burden on your personal understanding of each underlying investment.
Diversification is seen as an important aspect of investing as it helps to limit the risk of having ‘all of your eggs in one basket’. Diversification can be difficult to achieve if you don’t have a lot of money to invest, but ETFs make this possible irrespective of the size of the investment. You can get exposure to a range of different types of investments, different asset classes, investments from different geographic regions — all through purchasing one single share in an ETF.
Another big tick. Given ETFs are generally not ‘actively managed’, fees are generally kept to a minimum because there is less human capital required to manage the fund. However, it is important to check fees across a few different ETF options to choose one that is competitively priced.
Information on the underlying investments and fees can be accessed at any time via the fund manager’s website, something that is not always available with other investment options. You can take a look right now at what’s on offer at Vanguard and BetaShares — two of Australia’s top ETF providers. Or check out some other ETF providers here.
There are also great options for investing ethically through ETFs. Investing your money ethically doesn’t mean that you’re automatically opting for low returns. Alex Dunnin, a Director of Rainmaker, the leading Australian wealth management research firm, commented that “anyone who claims that ethical, social or corporate governance will cost you returns is a dinosaur.”
Both BetaShares and Vanguard have ethical ETF options as do many other ETF providers. For instance, the ETHI ETF, developed by BetaShares, invests in companies that are considered sustainability leaders in their industry.
If you’re interested in investing in an ethical ETF, then a starting point of your research could be this list of ten high-performing ethical investment managed funds and exchange traded funds by Canstar.
Of course, no investment is perfect, and ETFs have their downsides too. Here’s what to watch out for.
Outperformance is not guaranteed
Because of their passive management, ETFs don’t offer as much potential for above market performance as actively managed funds. Tracking a market index also means that ETFs don’t have as much potential to minimise the effects of market downturns.
Too narrow a focus increases vulnerability to sector underperformance
A narrowly focused ETF that tracks a single-sector segment such as healthcare or technology stocks may increase the risks to your portfolio, particularly if that sector underperforms. These types of ETFs also tend to be more expensive than your garden variety low-cost, broad market ETFs. All this means that if you’re going to invest in a country-specific or sector-specific ETF, you should consider combining this with another ETF which gives you exposure to a wider variety of regions, industries, and individual companies.
How to buy an ETF?
Just like shares, ETFs can be purchased or sold through a broker or an online trading platform. Most of Australia’s large banks have trading platforms that you can link to your savings account.
Once you have researched a few different ETFs and have decided which one you want to invest in, then all you will need is the ASX code or ticker (a three or four letter identifier) specific to the ETF you’d like to purchase. When you make the trade through your trading platform or broker you will need to use this code to ensure you buy the correct shares.
There is no minimum amount required to make a trade through the ASX, however, broker fees on trading platforms tend to be approximately $20 per trade, so making trades of $500-$1000 or more on a quarterly, six-monthly or annually basis might make more sense rather than topping up your investment by trading regularly in small parcels.
ETFs are likely to be a cheap and efficient way to gain exposure to the investment market. Nevertheless, look carefully before you leap. Do your homework about what you’re investing in and how much it’s going to cost you, and make sure you’re making a decision that’s suited to your own personal needs. If you need some help, consider engaging the services of a professional financial adviser.
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