You may have heard of various managed investment products in the past. One of the newest, most cost effective, and convenient managed investment products is the Exchange Traded Fund (ETF). And it sure is a great way to expose your money to the share market. But what exactly is this type of asset?
An ETF is an investment product that offers investors the opportunity to invest their money in a single asset class that reflects the returns of a major index (An index is a measure of performance for a group of assets). For example, an ETF may seek to track the performance of the largest 200 companies in Australia, i.e. it will track the ASX200 index.
So, how is an ETF implemented in the real world? A company that offers an ETF will buy a portfolio that mimics the index that they are tracking. They will then split the ownership rights of this portfolio into small portions, known as units. The units are then sold to investors giving them ownership of a portion of the total portfolio.
What do Investors Gain From This?
ETFs offer investors a very convenient way to diversify their portfolio; units in a single ETF can expose the investors’ money to dozens of underlying assets that comprise the ETF. There are some other great benefits of ETFs, including:
- ETFs minimise risk – Using an ETF, investors can achieve a lot of diversification, even though they may only have a small amount of money to invest (Typically, it is recommended to invest at least $3000 per asset to overcome brokerage.)
- ETFs are easy – An ETF is a managed investment; all underlying investments are orchestrated by the professional ETF manager. Therefore, the investor does not have buy, sell and maintain the portfolio (portfolio’s usually consist of dozens of assets, managing such a portfolio can be tedious).
- ETFs are convenient – The investors do not have to track payments and the associated tax implications of each asset within the portfolio. Instead, all payments are consolidated and paid to the investor regularly.
- ETFs are cheap – The passive nature of the ETF means that all the manager has to do is maintain a portfolio that reflects an index (the composition of an index is determined by external factors). This means that the manager does not have to think, research, or create a strategy for the ETF’s portfolio. This results in cheap management fees. In saying this, arguably, passive investments such as ETFs perform just as well as actively managed assets (they virtually hold the same assets).
What are some of the risks and drawbacks?
- ETFs require brokerage accounts – ETFs are traded just like shares on the share market. This means that they need to be bought and sold using a stock broker. This requires a bit of administration on behalf of the investor and also attracts a brokerage fee every time the ETF is bought or sold. This means that investors should invest relative large amounts (at least $3000 at a time to overcome the brokerage fee).
- Tracking Error – Although the managers may try their best to make their portfolio follow the price of an index, there may be a slight difference at any one point in time. There are operating rules and regulators that ensure that the difference does not grow out of tolerance.
- Price Errors – The ETF’s assets are split into equally valued units. Therefore, each unit should be exactly the appropriate proportion of the assets. For example, if the ETF’s assets are worth $1,000,000 and there are 1,000,000 units available, then each unit is should be worth a dollar. The ETF manager will perform a complex process of creating and removing units to manipulate the supply and demand to ensure the price of the units is close to the it’s true value. This process is not perfect and the price may subtly differ from the true net value per unit of the portfolio.
ETFs are a great way for people to invest in the share market who don’t want the hassle of having to research and investigate a portfolio of multiple shares, and don’t want to pay large amounts of money for a managed investment product. Even for those who like to choose their own investments, ETFs are a great way to add diversity to your portfolio, for example ETFs are a great way to gain exposure to international shares. If you’re thinking about investing in the share market, be sure to consider the humble old ETF.