What is an ETF?
An exchange-traded fund or ETF is a fund that is bought and sold on the share market in the same way you might buy or sell shares in individual companies like CBA, Woolworths or BHP.
However, rather than investing in just one security, ETFs typically invest in a basket of assets. These assets might be shares, bonds, property, currencies or commodities, usually with a focus on a specific region, industry or market.
When you buy an ETF, you buy an interest in that ETF’s basket of assets. Thus with a single share, you have passive exposure to an underlying index or asset class and can instantly create a diversified portfolio.
EFTS are one of the fastest-growing investment products in Australia and the world and they are an increasingly popular investment tool for many investors.
How does an ETF work?
As with shares, investors can buy and sell units in an ETF during the trading day on the Australian Stock Exchange (ASX).
Except for voting arrangements, investors generally have the same ownership rights as investors in the underlying shares; distributions or interest payments, franking credits, bonus issues and rights issues generally flow through to ETF investors.
ETFs operate as ‘open-ended’ funds, which means that the number of units on issue is not fixed. Instead, it increases or decreases in response to investor demand and supply. This process helps ensure that ETFs trade at or near the net asset value (NAV) of their underlying holdings.
This process is facilitated by market makers, who provide liquidity to the ETF market through buying and selling ETF securities during trading hours and can create and redeem ETF securities off-market. This way you know you can buy an ETF at any time – you don’t need to wait for an investor to be selling. Importantly, the presence of market makers ensures there’s always a buyer when you want to sell.
As with shares, an investment in an ETF is settled through CHESS and recorded under each investor’s Holder Identification Number (HIN). When you invest with Six Park, your portfolio is held in your own name, so you can rest assured your assets are readily accessible.
How is ETF exposure achieved?
Some ETFs track a niche market, such as gold or a currency, while others track a broad index with hundreds of holdings such as the S&P/ASX200 Index or S&P500 index.
ETF exposure is achieved by buying every (or almost every) asset in the target index, usually in the same proportion that those assets are represented in that index.
By way of example, if an Australian equity ETF is tracking the S&P/ASX200 Index, it will own each of the stocks in that index, in the same proportion, or weighting, as in the index. As those index weights change with stock or market movement, so too does the proportion of each owned by the ETF.
In mimicking the holdings of an index, so too ETFs mimic the performance of their targeted index, and with low costs and high tax efficiency. Using the SPDR S&P/ASX200 Fund as an example – the fund Six Park uses to provide investors with Australian equity exposure – a 2% rise or fall in that index would result in approximately a 2% rise or fall in the value of the ETF.
Why invest in ETFs?
At Six Park, we believe that exchange-traded funds (ETFs) are an ideal investment vehicle for our clients. With just a few trades on the ASX, you can instantly and inexpensively create a truly diversified portfolio.
For example, we provide our clients with exposure to international shares through the Vanguard MSCI Index International Shares ETF. It invests in household names, such as Apple, Google, Microsoft, Facebook, and Nestlé, along with 1,500 other high-performing global companies, located across 22 countries – all in one single fund.
When investing with Six Park, your portfolio will be thoughtfully invested in ETFs across a globally diversified, low-cost mix of asset classes, tailored for your risk profile and investment horizon.
The benefits of investing in ETFs
We use ETFs across all our Six Park portfolios because they offer investors a range of benefits:
Immediate diversification: With just a single trade, an ETF can provide you with instant exposure to hundreds (if not thousands) of positions within a specific asset class. For example, we use the SPDR S&P/ASX200 Fund for Australian equities – just one unit provides exposure to 200 stocks, rather than needing to buy all those underlying exposures individually.
Cost efficiency: ETFs can be very cost-effective. The management fees charged by ETFs are generally much lower than those charged by an equivalent actively managed fund or the brokerage costs you would incur to trade those securities individually.
Asset allocation simplicity: ETFs offer investors ready access to practically any asset class, geographic region and investment strategy. Using Six Park, you’ll get exposure to Australian and international assets spanning shares, property, infrastructure, bonds and cash.
Flexibility: ETFs can be bought and sold during market hours just like any other listed security. Investors can place limit and stop orders just like they would with any other listed instrument. This makes ETFs a flexible, liquid and readily tradeable investment proposition.
Transparency: ETFs generally publish their underlying holdings each day; this way, investors always know what they are buying and where their funds are invested. This provides much greater transparency than traditional managed funds, which typically report their holdings monthly or quarterly.
Tax efficiency: ETFs generally have much lower levels of portfolio turnover compared with actively managed funds, which tend to buy and sell assets more frequently. Lower portfolio turnover can help reduce/defer capital gains tax levels and improve overall post-tax returns. The unique structure of ETFs (in which units are bought and sold from market makers) also means investors are better insulated from paying capital gains tax triggered by the redemption actions of other investors (read more here).
Lower risk: Passive ETFs will experience a reduced level of tracking error, as they will generally match the returns of the benchmark the fund replicates.
Distributions: Investors receive income distributions from dividends and interest paid by the underlying assets. Any franking credits received from domestic ETFs are passed on with distributions to the investor; generally, franking credits may be offset against Australian income tax payable for the relevant year.
The risks associated with ETFs
No investment is risk-free – even cash with its current low return runs the very real risk of not keeping up with inflation. There are potential risks with all investments, and those pertinent to investing in ETFs include:
Market risk: The value of an ETF will rise and fall in line with the value of its underlying assets. If these assets decline in value, ETF holders may experience a loss of capital and/or income. This risk is inherent in all investments, particularly with shares and other growth assets whose prices are influenced by investor sentiment and other market factors.
Market risk is one of the largest risks faced by investors and is best mitigated by a well-diversified portfolio across different asset classes – this is exactly how Six Park allocates your investment. Learn more about the importance of diversification.
Pricing risk: There may be times or circumstances where the market price of an ETF may not properly reflect its net asset value (for example, where the ETF’s underlying assets are illiquid). This may result in investors paying too much to buy an ETF or selling at a discount.
Generally, ETF issuers engage market makers to ensure the pricing of ETFs remains close to net asset value; as a result, it’s rare that ETFs trade a significant premium or discount to their NAV.
Six Park ensures it places orders to buy and sell at those times of day considered optimal to receive a price that is close to the NAV of the underlying assets. For Australian assets, that’s generally 30 minutes after the market opens. For international assets, when the market for the underlying asset is open.
Tracking error: Fees, taxes and other factors can all influence how closely an ETF is able to track its target index. This tracking error differs across ETFs and can influence investor returns.
Six Park has carefully selected low-cost ETFs to mitigate the impact of tracking error as far as possible.
International exposure risks: If an ETF with overseas assets is not hedged against currency risk, fluctuations in exchange rates may affect the value of its portfolio; this can work for and against international assets. Other factors, such as geopolitical events or country-specific economic conditions may also affect the value of the portfolio. Investment in well-diversified ETFs with international exposure mitigates this risk as far as possible.
Fixed income (bond) index risk: Some fixed income indices exclude large parts of the universe that could potentially have performance and diversification benefits to a portfolio. In addition, the construction of fixed income indices tends to reflect the market capitalisation of fixed-rate investment grade sectors – in other words, the issuers with the greatest debt have the highest index weights.
Six Park’s portfolios invest in the iShares Core Composite Bond ETF, which focuses on investment-grade fixed income securities. It’s most heavily weighted to AAA-rated government-issued bonds, a debtor that is unlikely to default.
How does Six Park invest in ETFs?
At Six Park, our Investment Advisory Committee and management team spend a lot of time reviewing and assessing the ETF marketplace, taking into consideration many factors including fund size, liquidity, tracking error and relative costs.
While there are risks associated with ETFs, as a Six Park client you will be invested in a portfolio of high-quality ETFs, carefully selected by our expert investment team, to match your recommended asset allocation. Our ETF selections are regularly reviewed to ensure they represent the best available investment option for our clients.
It’s tough to ‘pick winners’ or ‘time the market’ in a way that consistently and meaningfully beats the market. Instead, we believe the best approach is to focus on passive, broad-based index funds such as ETFs – we believe it’s better to buy the market, rather than try to beat it!
Glossary
As with many aspects of finance, there’s jargon you’ll encounter in relation to ETFs. Here are the main terms you’re likely to come across:
Liquidity: The degree to which transactions in an ETF can be undertaken without the action affecting that fund’s unit price.
Passive Management: Passive funds aim to track the returns from a specific market index.
Active Management: Active funds aim to generate outperformance through active asset allocation or stock selection decisions.
Net Asset Value (NAV): The NAV is calculated by subtracting the total value of a company’s balance sheet liabilities from its assets. The NAV per share, is calculated by dividing the NAV by the total number of shares on issue.
Premium/Discount: When the buy/sell price of an ETF is higher/lower than its NAV. If it is higher, it’s said to be trading at a premium, when lower, at a discount.
Market Maker: Market makers have two roles: (1) to provide liquidity to the market through buying and selling ETFs during trading hours (2) to create and redeem ETF securities off-market to ensure that supply and demand for individual ETFs is met.
Tracking error: A statistical measure of risk that measures the deviation of an ETF’s returns from the returns of the relevant index.
Issuer: The company that issues the ETF securities to the market.
Units: Shares in ETFs are referred to as units.
Get started now with Six Park
Investing in ETFs through Six Park is an efficient, low-cost way to access a diversified portfolio designed for your risk profile.
To start your investment journey with Six Park, click the “Get started now” button. Take our personalised risk assessment and get your free investment recommendation now.
This article may contain general financial product information but should not be relied upon or construed as a recommendation of any financial product. This information has been prepared without taking into account your objectives, financial situation or needs.
For further details on our service please see our Financial Services Guide at http://www.sixpark.com.au. Past performance is not a reliable indicator of future performance.