An ETF or exchange traded fund is a type of investment fund that can be bought and sold on a securities exchange market. They are often known as ‘passive investments’ and generally track in line with the value of the market or index they are tracking.
There are a range of reasons or rationales as to why people take out ETFs, from diversification of their portfolios, through to passive management and the low cost of management. Depending on an investor’s individual and personal investment goals and strategies, their reasons may vary.
A look inside an ETF
ETFs are funds in which investors can place money, which then uses those funds to purchase securities and, in turn, issues additional shares of the fund. When investors wish to redeem their mutual fund shares, they are returned to the mutual fund company in exchange for cash. Creating an ETF, however, does not involve cash.
As outlined by CommSec, ETFs trade at a unit price close to the net asset value of the underlying portfolio and each ETF has a unique ASX code, just like ordinary shares.
Features of ETFs:
Examples of ETFs are Vanguard Australian Shares Index (VAS), which is comprised of Australia’s 300 largest companies, seeking to provide a fund that mirrors the performance of the S&P/ASX 300. Another is the BetaShares U.S dollar ETF, which tracks the USD relative to the AUD.
ETFs vary in terms of the type of market, asset class or currency that they follow, but in real terms, they are created to track the performance providing hedging opportunities for investors.
Why do people invest in ETFs?
Diversification is the key reason people invest in ETFs. ETFs allow investment in a range of companies that wouldn’t be viable for an individual investor to achieve on their own, however, through the fund and the economies of scale it brings.
The second reason people invest in ETFs is for passive investing. Passive investing costs less than active investing, because you do not require a fund manager to buy and sell your portfolio’s assets, as you are relying on the long-term strategy of market growth. Passive strategies can outperform active strategies on the savings of the transaction & brokerage fees alone.
Thirdly, ETFs are simple to buy and sell. When the ASX or exchange that your specific ETF is listed upon opens, you can trade through an investment firm or online broker at any time at the market price.
When it comes to owning ETFs, the costs are low. As the performance is tracking with the market, you are not paying a broker or manager to actively manage your portfolio, thus reducing your costs.
Finally, the transparency & accountability of the ETFs is such that they are required for the most part to publish a list of their holdings on a daily basis. As an investor to the fund – or a potential investor – you can review their weighting in the fund on particular assets so you can ensure that your investment objectives are being aligned with by investing in the particular fund. Should you see a deviation of any type to your strategy or objectives, then you can sell out at the market price.
ETFs – An Example
When looking at a particular fund, we will turn to the example of Vanguard Australian Shares Index ETF (VAS). As per their fact sheet, the fund seeks to track the return of the S&P/ASX 300 Index before taking into account fees, expenses and tax.
As at January 31st 2020, with a total fund size of $18,937.1 million in 298 holdings, the fund is heavily weighted in some of Australia’s most well known ASX listed companies including Commonwealth Bank, BHP, Westpac, CSL and ANZ Bank.
The sector allocation, as with the ASX300, is geared at 31.8% financials, 18.6% materials, 8.5% health care and 8.1% industrials as the top 5 largest segments, which stands to reason considering the state of the Australian economy.
In terms of allocation of the holding details by percentage and by company, all of the top ten companies span from 8.2% (CBA) down to 2.19% (Telstra), with anything outside the top ten (which in the case of the VAS fund lands at the Transurban Group) is invested at a rate lower that 2%.
This is representative of the Australian economy as a whole and ensures that as the nature of the fund is to track the performance of the ASX, the weighting in the fund should reflect that.
What are the risks with an ETF?
There is a lot to be gained from lower risk, solid, long term investment strategies for many investors. However, like all investments, there are risks with as many investors becoming increasingly concerned about how investments will fare when faced with an economic downturn, recession or even worse, another GFC.
But the fact is, that “investors who engage in mindless ETF strategies, believing diversification will save them, could face horrendous losses if markets tumble”.
The ETFs market is worth $60.24 billion in Australia, according to ETF Securities. There is a risk that investors become too reliant on ETFs and a market crash could send a large percentage of investors’ funds down, without alternative hedging mechanisms (such as a CFDs) in place to properly protect their portfolios.
While market risk is by far the largest concern as investors take a ‘passive mindset’ and ETFs providers start trying to out manoeuvre one another by offering no-fee options and options in ‘non-traditional markets’ such as crypto currencies, risk averse investors are being exposed to more risk than they once enjoyed, as issues scramble to cut costs.
As the number of investors looking to get into ETFs in Australia is set to expand, so are the number of funds that are set up. Although under the heavily regulated market of the ASX, there are still inherent risks of unscrupulous operators or funds that are operating in risky and underperforming sectors, not to mention the spread of performance by industry operators within the same sectors could weigh heavily on ETF investments.
Like cryptocurrency in 2017, ETFs are the ‘hot thing’ in financial markets – truth be told, many ‘traditional investors’ stayed well clear of cryptocurrency trading during that time and ETFs have an inherent risk of a similar occurrence.
As investors flock to take advantage of the ‘new ETF vehicles’ they may find they have limits on their liquidity, and if the money rushes out, the valuations could be harmed for existing investors.
Summary of ETFs
Like all financial products, ETFs have risk and should always be taken on only after you as the investor or your financial planner/broker has done the due diligence on the particular fund you are looking to become involved in.
Like any investment, should the fund begin to deviate from your investment strategy, you should review the appropriateness of the option for your portfolio, rather than staying in because “that is the way the market is going”.
As a long-term strategy, ETFs provide an opportunity for a certain percentage of your investment portfolio to effectively track with the chosen market, exchange, currency or commodity market that suits your investment needs, as provides a passive investment option.
For many investors, this provides security in the knowledge that even if their short-term strategy fails; their ETFs will be there to back them up. However, in the event of a market crash, recession or even a global financial crisis, not even ETFs are immune – and investments although passive, must always be informed and proactive when it comes to their investment portfolios.