Exchange traded funds (ETFs) are booming and have become one of the biggest forces driving share markets. In Australia, inflows into the major ETFs such as IOZ, VAS or STW are a key reason driving up the prices of the top 20 stocks, notwithstanding that some of these stocks are horribly over-priced.

If you are not familiar with ETFs, here is an example that demonstrates their utility. In one trade through your online broking account, you can buy the top 200 companies listed on the ASX. If the market goes up 2%, your ETF will go up 2%. If the market falls by 2%, your ETF will fall by 2%. You will get distributions, with franking credits, paid quarterly that match the market. And you will pay $20 or less in brokerage to do the trade, and can invest as little as $500.

And there are ETFs that give access to overseas markets – so you can do exactly the same and buy the top 500 US companies or the 100 companies that make up the NASDAQ. Or you can invest in Asia, or Europe or specific countries. ETFs are multi-asset class, covering not just shares, but fixed interest, property and commodities such as gold. Here is the full list of categories:

  • Shares, fixed interest, property and commodities
  • Local and international
  • Broad market and component (for example, small caps or mid-caps)
  • Industry sectors (for example, healthcare or information technology)
  • Thematic (high yield, robotics etc)

When you invest in an ETF, you are investing in a managed fund traded on the ASX. It is an ‘open-ended’ fund, meaning that it can grow in size as more investors purchase units, or contract in size as investors exit their holdings. Most ETFs are designed to closely track the performance of an underlying index. The ETF then invests exactly in proportion to the stocks that make up that index – so that in the case of an ETF tracking the benchmark S&P/ASX 200 index, it buys the 200 stocks in the same weighting as their weighting in the index. The ETF is effectively on “auto-pilot”.

This “auto-pilot” approach, also known as “passive management”, allows for very low management fees because there is no expensive fund manager to feed. In some cases, the management fee is less than 0.10% pa. Other advantages include improved transparency (ETFs are required to publish their portfolios), and in most cases, strong liquidity, meaning the ability to exit an investment when you want to at a fair value. ETF issuers promote liquidity arrangements by engaging professional market makers to deliver an active market in their stock.

Importantly, if you invest in an ETF passively tracking an index, you should expect to get the index’s return minus the management fee. Nothing more, nothing less.

Some ETFs employ active management – that is, where the investment manager chooses the stocks to invest in. This is a newer form of investment, and while employing an identical structure to an ETF, is sometimes referred to as a “quoted managed fund”.

What are the risks of investing in ETFs?

Of course, the major risk is to the performance of the underlying assets. If you invest in an ETF that tracks gold and the price of gold goes down, so will the value of the ETF. But there are other risks which are particular to ETFs, and specific to just some ETFs.

Firstly, not such a big issue with Australian domiciled ETFs , but there are ETFs that invest in “synthetic” assets such as derivatives. For example, a gold ETF that rather than investing in the physical gold bullion, invests by buying gold futures. Because this is a horizon removed, it will typically be a more volatile and hence a little riskier.

Not all indices are “widely adopted benchmarks”. Some are constructed (because they don’t exist, so the ETF manager develops a criteria and creates an index), while others are barely used. This doesn’t automatically imply that you are taking on more risk, but an extra degree of caution is recommended.

And then like any investment in a managed fund, there are risks relating to the manager and the liquidity of the ETF. While managers are regulated by ASIC and must meet a minimum capital requirement, you still would prefer to have a manager that is credible, experienced and with the capital reserves to support and develop the ETF. Liquidity is a function of this, because typically the bigger, better supported ETFs from the strongest and most respected managers will be the most liquid.

What to consider when choosing an ETF?

Start with the type of exposure you want and the relevant index. If you want broad based exposure to the Australian sharemarket, then you need an index that tracks the top 200 or top 300 stocks  – you probably don’t want an index that just tracks the top 20 stocks. This means VAS, IOS, STW or A200. I prefer VAS because it tracks the top 300 stocks. The same if investing in the USA – IVV or VTS. If you want a strong technology bias, then consider at an ETF that tracks the NASDAQ.

Avoid synthetic ETFs. Be careful with ETFs using constructed indices – the index methodology should be considered.

Who is the manager? Blackrock (iShares), Vanguard and State Street are global giants in the ETF world. Betashares and ETF Securities are largely Australian focussed and have been responsible for many of the innovations on the local scene.

What is the management fee? If it is an index that is capable of being closely tracked, you should get the index return less the management fee, so all other things being equal, the fee becomes relevant.

Finally, size and track record count, typically leading to stronger liquidity. That doesn’t mean you shouldn’t consider investing in lesser known, smaller ETFs, but there is also not much upside in sticking your neck out.