What are ETFs?

Exchange Traded funds (ETFs) have exploded in popularity in the last couple of years. They are simple, cost effective and provide immediate access to diversified markets. However, there are still risks attached for all investors to be wary of.

What are they?

An ETF is a fund that trades on the ASX.

Within each ETF are a basket of individual investments which form and thus replicate a group or basket. For example, the ETF might encompass the top 300 Australian stocks in size, or the Top 500 stocks on the US Sharemarket. They track an index or group but trade like a share.

An ETF might represent a group of companies (large or small size companies). It might form a specific sector of the sharemarket (e.g. mining sector, property sector). It might represent overseas investments (the US, Asia, Europe). It might represent bonds (government, corporate or a combination).

ETFs are wide and varied and investors need to be aware of the underlying investments within each ETF as this will be the biggest determinant of risk and return.

Where did they come from?

ETFs evolved in the US over 20 years ago. They are now one of the largest growing investment products globally.

ETFs have been in Australia for approximately 10 years but have grown enormously in use in the last couple of years with more and more types of ETFs entering the market.

In Australia alone over the last 12 months, their combined value has grown by close to 30%.

Why are they appealing?

They are obviously low cost charging a small management fee to the ETF provider (in Australia the largest ETF providers are Vanguard, iShares and State Street).

They also offer immediate diversification to the index that the ETF reflects.

They are transparent (you can look up what the underlying investments are at any time) and are liquid in that they can be bought and sold over 2 working days just like shares.

The dividends of the underlying investments flow through directly to the investor including franking credits.

Anything to be careful of?

The ETF is as risky as the underlying investments within them.

For example, an ETF that reflects the small cap Australian share sector is a lot riskier than an ETF that reflects the Australian government bond market.

For ETFs that reflect international markets, some include hedging to the Australian dollar whereas others are unhedged. This can have a substantial difference on overall returns.

What does the future hold for them?

ETFs have simplified investing significantly.

However, caution needs to be taken in the selection of an ETF specific to the investor’s needs.

There is also a risk that more and more ETF providers enter the market and create ETFs that are complicated and not well understood by investors.

Like share advice, investors should seek advice on the use of ETFs relevant to their personal circumstances.