Written by Josh Coley and Paavo D'Castro
What Are ETF’s, and How Do They Work?
An ETF or exchange-traded fund is a pool of investor money invested by a manager that usually tracks an index, industry sector or commodity. What makes this different to a managed investment fund or superannuation is that individual shares of the fund (units) can be bought and sold on a stock exchange like the ASX, similar to regular shares. Much like regular shares, the price of an individual unit rises if the price of the fund’s underlying shares increases.
ETFs are an excellent tool for investors, allowing them to invest in a wide array of shares, bonds, or commodities by purchasing shares in these funds on the share market. This also breaks down some of the walls that traditionally have restricted investors from building diversified portfolios—allowing investors to purchase shares in low-cost ETFs that track a whole host of assets that would cost thousands if the investor were to buy them themselves.
Pros and Cons of Purchasing ETFs
As stated before, the main benefit of Exchange-Traded Funds is diversification. As the underlying shares in ETFs are spread across a selection of companies, bonds and commodities, the risk of a significant decline in price is lower than that of regular shares, making them a relatively low-risk investment. Passive Equity ETFs are also designed to mirror the performance of stock market benchmarks (S&P 500 or ASX 200), which have increased by an average of 8.7% per annum (ASX); allowing investors to confidently predict a 5-15% return on investment if drastic events do not occur. While ETFs are also cost-effective as stated before, they are also a convenient option for casual passive investors as they do not need to actively buy and sell shares to see returns. Instead, the ETF fund manager will buy and sell the fund’s underlying shares in an attempt to maximize returns.
While units of an Exchange-Traded Fund can be bought and sold on a stock exchange much like regular shares, most ETFs have a low trading volume, meaning that the difference between the price the units can be bought for (ask) and sold for (bid) will likely be fairly large, meaning that investors may not see the returns they were expecting even if the price of units has increased over time. If the underlying securities in an ETF are from an overseas market, fluctuations in the Australian dollar as well as overseas markets may also impact the potential returns, increasing the downside risk and potential to lose money even if the price of the underlying securities increases.