Exchange traded funds (ETFs) allow you to reap low cost investment returns similar to those of a share index or other underlying assets. However, you should note that some ETFs are more complex and risky than others. We shall take a look at ETFs more closely in this article.
What Are ETFs?
ETFs are a type of investment that you can trade through your stockbroker or online trading account just like shares. ETFs are often promoted as an easy way to diversify investments and a cheaper alternative to traditional managed funds as they usually attract lower fees.
In Australia, all ETFs are ‘passive’ investments that track assets or market indices; for example an index that tracks the top 200 Australian shares, up and down. ETFs generally do not try to perform those markets or assets.
ETFs are also available for assets such as international shares, fixed income products, foreign currencies, precious metals and commodities.
Types of ETFs
There are two types of ETFs: physical and synthetic ETFs.
Physical ETFs
Most ETFs buy the underlying investments such as shares or other assets, on the reference index that the ETF is seeking to track. These ETFs are known as standard or physical ETFs.
If you invest in an ETF, you won’t directly own the underlying investments that the ETF buys. Instead, you will usually own units or shares in the ETF. Your main investment risk however is not the ETF’s performance but the performance of the ETF’s underlying shares and other assets. You are also exposed to other risks which are discussed in this article.
Synthetic ETFs
Synthetic ETFs have a material exposure to derivatives as well as to underlying assets the ETF is seeking to track. Synthetic ETFs are exposed to more risks and rewards in addition to those of physical ETFS (such as price errors and fees and costs) which are discussed later in the article.
When The Product Is Not An ETF
Some products that track indices and other investments may ‘look and feel’ like ETFs but are not ETFs. These are structured products but their issuers sometimes use product labels such as ‘exchange traded commodities’, ‘exchange traded notes’, ‘exchange traded certificates’ and ‘exchange traded securities’.
There are also exchange traded managed funds and exchange traded hedge funds that unlike ETFs, do not simply track an index; they also may try to outperform an index or seek enhanced returns. The risks of these products can be different and sometimes much higher than those of ETFs.
See other exchange traded products for more information.
What You Need To Know Before You Invest In ETFs
The value of a physical ETF investment can rise and fall daily, usually in line with the index that the ETF is attempting to track.
Here are some of the features that you’ll need to know before you invest.
Tracking Error
ETF prices will not exactly follow the price of the index or investments they are designed to track. This is what is referred to as a tracking error. This tracking error may be caused by a number of factors such as fees and taxes.
Under the ASX Quoted Assets (AQUA) market operating rules, some ETF issuers need to engage market makers, who aim to ensure that the ETF’s price stays relatively close to its ‘net asset value’ or NAV. This also helps create a more liquid market for ETFs.
Price Errors (Gapping)
The market price of an ETF unit should be close to the NAV per unit of the assets held by the ETF. The disparity between the market price of an ETF and the NAV per unit of the assets held by the ETF is referred to as a price error or gapping. If the offer price of an ETF quoted to you by a broker is significantly above the NAV, there is a risk you might pay far more for an ETF than it’s worth. If the bid price is significantly below NAV, there is a risk you could sell for less than the underlying investments held by the ETF are worth.
Check The Price
You can check if the ETF is fairly priced before you trade by comparing the offer price (if you’re buying) or the bid price (if you’re selling) quoted by a broker with the latest NAV information available for the ETF.
Many ETF issuers provide NAV updates in ‘real-time’. These real time price updates are referred to as the indicative or intraday NAV or the iNAV. You can access the latest iNAV from your broker by prefixing the ETF ticker code with a ‘Y’ (for example, ‘YABC’ for ticker code ‘ABC’). Some ETF issuers’ websites regularly update their estimated NAVs.
Fees and Costs
While ETFs may have lower fees compared with other management investments, management fees can vary. Here are some of the factors to consider:
- Some management fees may be higher than the fees for an equivalent (unlisted or unquoted) index fund.
- You will have to pay fees to your broker or online trading account (usually at least $20-$30 per trade) to buy or sell ETF units.
- If you want to make a small regular investment in a product that tracks an index, you might be better off using an unlisted managed investment such as an index fund as stockbroker fees won’t apply to each contribution, although other fees may apply.
- The ETFs’ buy-sell spread (the prices that you can buy and sell ETF units at) can also be a cost for you when you buy or sell ETF units, though market makers should ensure that the spread remains relatively small.
- If you’re selling you can work out the buy-sell spread by subtracting the bid price from the NAV for the dollar spread and then dividing the dollar spread by the bid price for the percentage spread.
- If you’re buying you can calculate the dollar spread by subtracting the NAV from the offer price, and then calculate percentage spread by dividing the dollar spread by the offer price.
Exposure To Less Liquid Investments
Some ETFs offer exposure to investments such as small companies, emerging markets or commodities that may be harder for the ETF to sell in certain circumstances, or more complex and volatile than ordinary company shares. This may mean extra risks for investors.
Timing of Trades for ETFs That Track The Share Market
To receive an ETF price that is closer to the value of the underlying assets held by the ETF, only place orders to buy or sell ETF units at least 30 minutes after the share market opens; at 10.00 am EST. This may help you receive an ETF price that is closer to the value of the ETF’s assets.
You should only buy or sell ETFs when the market for the ETF’s underlying asset is open. For example, if you’re buying or selling an ETF that tracks Asian shares, try to place your orders when the Asian market it open. This may help reduce the price discrepancies between the ETF and the price of the shares that it holds.
International Taxes
When you buy units in an ETF located in another country (but also traded on an Australian market such as the ASX), foreign taxes may apply. If you buy units in a US ETF for example, US estate taxes may be payable when you die.
Read the PDS to understand how your investment will be taxed, and if you’re not sure contact the ETF provider or a tax adviser.
Currency Risks
If the ETF tracks overseas assets, changes in the value of the Australian dollar may also affect the value of your investment. Fortunately, some ETFs are ‘currency hedged’ to reduce this risk.
Specific Risks With Fixed Income ETFs
Fixed income ETFs aim to replicate the performance of assets such as bonds and debentures. The Australian Securities Exchange (ASX) has restrictions on what indices or non-exchange traded bonds or debentures can underlie an ETF. Nonetheless, these products may still have risks, such as volatility in the value of underlying assets and the level of activity of bond investments compared to that of equity investments.
Volatility In The Value of Underlying Assets
The value of the underlying assets (bonds) of fixed income ETFs may rise and fall. This volatility means that the price of the ETF will also rise and fall to reflect the change in value of its underlying assets.
Level of Activity Of Investments
The secondary market for corporate bonds (such as the ASX) may be less active than the market for ordinary shares, making it harder for the ETF issuer to sell its bond investments.
See ASIC’s investing in corporate bonds for more information about fixed income investments.
Things To Check
Read the PDS carefully, ask questions of the ETF provider and consider getting professional advice from a licensed financial adviser. You should also check recent ASX announcements about the relevant product.
Here are some things to check in the PDS and with the ETF provider:
- Are the ETF’s investments liquid (easily bought and sold, such as blue-chip shares), or are they less liquid? It may be easier to sell your ETF units for a fair price if the ETF invests in liquid assets and is regularly traded (liquid).
- Does the ETF use derivatives? If the answer is yes, the risks may be higher.
- What are the fees (including hidden fees when you buy and sell ETF units)? Higher fees may reduce your returns.
- How will the ETF returns be taxed?
- Does the price you’re about to buy or sell the ETF at match the NAV quoted by the ETF issuer? See our tips on how to check the NAV.
- Are you buying an ETF or a different type of exchange traded product that looks like an ETF? Some of these products may have much higher risks than ETFs.
- Is the ETF available through the ASX? If you buy an ETF traded on a market in another country, the same rules and protections may not apply.
- Consider the index being tracked. Is it provided by a reputable index provider? If you’re not sure consider getting advice from your financial adviser or stockbroker.
Do your homework before you invest in ETFs. Check the details in the PDS and consider getting advice from a licensed financial adviser. Also remember that diversifying your investments between different asset classes and product issuers can help control your risks
Consistently ranked one of Sydney’s top financial planners (Adviser Ratings), Brenton helps his clients life a great life by making the most of their money. Read his full bio here.
