ETF Research, ETFs 101

What are ETFs?

An introduction into Exchange Traded Funds (ETFs), how they work and trade, their key benefits, and risks.

Content

  1. What is an ETF
  2. Benefits of ETFs
  3. How ETFs Work
  4. Types of ETFs
  5. The Key Difference Between ETFs and ETFMs
  6. Risks of ETFs

What is an ETF?

An exchange traded fund (ETF) is a simple cost effective way to invest in a broad range of investments like shares, bonds or commodities. Australian ETFs can be traded on the ASX in the same way as shares in a company.

Rather than owning shares in a business, an ETF tracks an asset class, such as Australian shares (S&P ASX/200) or global shares (S&P 500), and provides direct exposure to a wide range of investments within that asset class.

Instead of giving investor money to a fund manager who picks shares or tries to time the market, ETFs aim to provide the return of a whole entire asset class or index.


Benefits of ETFs

Lower fees
ETFs are passively managed, meaning they attract a lower cost than actively managed funds. ETFs are usually more cost efficient than purchasing a large number of individual shares, as there are less trading costs involved.

Diversification and Accessibility
ETFs give investors exposure to a range of investment strategies, asset classes, geographic regions, sectors or industries through one simple transaction. ETFs can contain hundreds of holdings providing diversification to reduce concentration risk in portfolios.  

Transparency
ETFs provide daily information about the holdings inside an ETF and it’s Net Asset Value (NAV). They clearly state their investment objective, usually to achieve results in line with a market benchmark.

Liquidity
ETFs provide the ability to buy or sell your investment quickly and easily as they trade just like a company on the sharemarket. Unlike managed funds, investors are able to trade ETFs during ASX trading hours.

ETFs provide an extra layer of liquidity compared to regular shares because of their open ended structure. The number of units in the ETF can increase or decrease based on investor demand, supported by the creation and redemption process by authorised participants, ensuring an underlying depth of buying and selling liquidity.

No minimum investment
ETFs provide a low hurdle initial investment making it easier for investors to get started. Unlike active funds which can have minimum investment requirements of thousands of dollars, ETFs can be purchased with a few hundred dollars.

Tax Efficiency
Tax can potentially take a large slice out of investment returns so it pays to invest in funds that are tax efficient. The low turnover (i.e. less buying and selling of companies) of an index ETF approach minimises the amount of capital gains being distributed to investors each year. This improves after-tax performance and tax efficiency over the longer term.

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How ETFs work

Investors can buy and sell ETFs on the sharemarket (often referred to as a secondary market). However, there is a primary market where large financial institutions called Authorised Participants (APs) are able to create and redeem ETF units directly with the issuer.

For the creation (buy) process, the APs role is to acquire the underlying securities that the ETF wants to hold. For example, if an ETF wants to track the ASX 200 index, the AP will buy shares in all the companies in the ASX 200 and deliver this basket of securities to the ETF provider.

The ETF provider then gives the AP a block of ETF shares called a ‘creation unit’. The required basket of securities is published every day by the issuer and reflects the investments and value of the underlying ETF.

The redemption process can work in reverse order if the AP needs to redeem (sell) units. An AP buys ETF shares and then gives these back to the issuer who redeems them for the equivalent value of the underlying securities.

The ability to create and redeem shares keeps the ETF price in line with the Net Asset Value (NAV), a distinct advantage ETFs have over other funds like LICs. Given an ETF trades like any other share, the price may fluctuate due to demand and supply. This is when the AP can jump in to drive the ETF share price back towards it’s NAV.

There’s another player in the ETF process which helps with the liquidity. Market Makers are brokers/dealers who seek to provide liquidity to the market by providing ongoing buy and sell prices (often called buy/sell or bid/ask spreads) throughout the trading day.

The process begins with the ETF issuer distributing the current fund composition to the market every morning, allowing market makers to price the basket of securities underlying the ETF.

Market makers place a buy/sell spread around the true value of the ETF and send these prices to the stock exchange as orders, which allows investors to execute trade orders of the ETF.

Market maker orders are updated continuously throughout the day to reflect price changes in the underlying securities. Firms that are market makers can also be APs but their roles are clearly distinct.

Types of ETFs

Exchange Traded Funds (ETFs) are a subset of Exchange Traded Products (ETPs) but these acronyms are used interchangeably. The ASX has more specific naming conventions to capture the subtle differences, splitting ETPs into 3 categories:

1) Exchange traded fund (ETF)
Under ASX naming conventions, ETF technically refers only to funds that passively track an index. These are usually structured as a managed investment scheme, where investors hold units in a trust.

The majority of ETPs are indeed ETFs and the remaining ETPs are types of actively managed funds with additional identifying characteristics.

The indexes can come in 2 forms – traditional index funds (based on market capitalisation weighting) or rules based indexes (also referred to as Smart Beta focusing on a certain factors other than market capitalisation).

2) Exchange traded managed fund (ETMF)
These are also admitted to trading status on the ASX like ETFs, but are actively managed funds. Similarly to ETFs they are typically structured as managed investment schemes.

These are a specific type of exchange traded managed fund that fits within the regulations set out by ASIC criteria and class orders.

Some ETMFs are called Exchange Traded Hedge Funds (ETHF) which are complex instruments such as borrowing, options and short selling and are required to have the words ‘hedge fund’ in their title for identification.

The ‘hedge fund’ title is a little confusing since these funds are not actually hedge funds as most people know them to be, but rather funds that offer leverage or inverse exposures.

3) Exchange traded structured products (SP)
These ETPs do not typically invest in the underlying asset, but instead aim to mimic the performance of an index synthetically via a structured agreement or derivative over futures contracts.

This structure is most commonly used by issuers creating commodity indices as it is not feasible to hold most physical commodities. Where investors are exposed to counterparty risk of more than 10% of the fund’s net asset value structured products must have the word ‘synthetic’ as part of their name for easy identification.

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The key difference between ETFs and ETMFs

Active Managers will sometimes list their funds as an ETF (called an ETMF), but this does not mean that they are the exact same as ETFs. Both trade on the sharemarket, but ETMFs have several disadvantages of using an ETF as a wrapper:

Transparency
Some ETMFs do not provide daily disclosure about what makes up their portfolio in order to protect their intellectual property. On the other hand, ETFs are required to provide daily disclosure of all their holdings.

Cost
ETFMFs are more expensive than ETFs due to their active nature. Higher costs means less money in investors’ pockets. ETMFs have higher trading costs which also means greater potential of CGT events.

Conflict
Some ETMFs use internal market making arrangements to provide liquidity. This creates the incentive for ETMF spreads to widen so that the market maker can profit, which can dampen returns of ETMFs.

ASIC has reported that internal market making presents a number of conflicts of interest and need to be carefully managed.1 Majority of ETFs use external market making to avoid this conflict.

Risks of ETFs

Like all investments, ETFs carry risk. The main risks are that: 1) the value of the portfolio falls; 2) fluctuations in the value of the Australian dollar affect the value of ETFs over international assets; 3) you may not be able to sell your ETFs for a fair price.

Market risk
The indices underlying an ETF usually comprise of many securities, protecting you against the specific risk of an individual security or stock performing poorly.

Nonetheless, investors are still exposed to market risk. For example, if the broad Australian stock market falls, an ETF that tracks the S&P/ASX 200 index will equally fall in value.

Tracking Difference
An ETF’s performance may differ from the performance of its underlying index. Tracking difference is mainly caused by the structure of the ETF and the management costs.

Currency risk
Investors are exposed to currency rate fluctuations if they hold an international unhedged ETF.

Liquidity risk
This is the risk you may not be able to sell your ETFs for a fair price. Liquidity can vary between different ETFs. Some are actively traded. Others have relatively low turnover, which can make buying and selling at a fair price more difficult. For many of the largest ETFs, average buy/sell spreads are typically 0.05% to 0.11%.

Generally index ETFs are lower risk than buying individual shares thanks to better diversification.

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Sources:
1 ASIC Report 584: Review of exchange traded products (August 2018)


Investment Associate

Marc has over 5 years experience in the financials services industry having previously worked for Morgan Stanley, AMP and KPMG. He holds a Bachelor of Business (Finance/Accounting) from the University of Technology Sydney (UTS), and has completed his Chartered Financial Analyst (CFA) Level 1.

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