What is an ETF?
An ETF or Exchange Traded Fund is an investment fund that typically aims to track an asset class or a basket of assets. In general, Exchange Traded Funds aim to track a published index such as the NASDAQ-100 Index in the US or the S&P/ASX 200 Index in Australia. They are cost-effective, flexible, and simple to use. Being exchange traded, they are bought and sold just like any share on a stock exchange.
Characteristics of ETFs
Diversification – With an ETF, an investor can diversify their investment over an entire sector, region or a country stock market. When you invest in an ETF, you effectively get exposure in a diversified basket of securities/shares.
Low Cost – ETFs typically aim to track an index or asset class, but they are passively managed. This means the fund manager can manage the fund at a lower cost. These cost savings can then be passed on to the investor as savings.
Liquid – ETFs provide liquidity along with flexibility as you can trade during the day. This is how you would trade your stocks using your online broker account or other stockbroker.
How can I use ETFs in managing my portfolio?
One of the advantages of investing in ETFs is the diversification they offer. They effectively give you exposure to many stocks in a single trade.
- Choose your region or country – If you were to invest in an ETF that aims to track the NASDAQ 100 Index (For Example the BetaShares NASDAQ 100), you are afforded exposure to the 100 companies that make up the NASDAQ 100. In effect, with a single trade, you could accomplish this feat at a significantly lower cost, and with much less difficulty than if you were to invest directly in 100 individual shares yourself. Other exposures that you could have immediate access to include Australian shares, Japanese shares, European shares and many more regional or country exposures.
- Choose your themes – You can also invest in specific industry sectors that may interest you. For example, do you want exposure to Cybersecurity, Global Healthcare, or Global Gold Miners?
- Mix and match your investments – Some investors may wish to combine ETFs with direct investments in shares of their choice.
What are the benefits of ETFs?
- Diversification – This can help to manage portfolio risk.
- Little influence from changes to supply and demand of units – The ETF price is tied to and tends to be close to, the ETF’s NAV.
- Lower management costs – An ETF is a passively managed fund, as opposed to other investments that may be actively managed. Active management typically involves higher management expenses than passive management.
What are the risks of ETFs?
Risks are primarily related to the nature of the investments made by the ETF. For example, Equity ETFs are generally linked to share indices, and so their value tends to rise and fall in line with share market fluctuations. Further, risks tend to vary based on the risk profiles of the underlying assets. Some example risks are detailed below
- Market risk -This is the most common risk. This is where price fluctuations occur in line with the value of the underlying securities and assets.
- Currency risk – It applies to ETFs that track international funds or non- currency-hedged assets. Hence, the value of international ETF portfolios would be positively or negatively affected by fluctuations in currency exchange rates between the relevant foreign currency and the Australian dollar.
Do ETFs pay dividends?
ETFs are investments in underlying assets and securities. Therefore, they pay distributions based on the assets or securities that the units represent. Distributions are made monthly, quarterly, half-yearly, or annually, depending on the ETF. Depending on the ETF’s investment strategy, the distribution could be made up of dividends, interest, and/or capital gains realised by the ETF.
Franking credits
ETFs that invest in Australian Shares are eligible to receive their portion of the dividend at the end of each distribution period, including Franking credits. When Australian resident companies distribute their after-tax profits through franked dividends, franking credits are attached to dividends.
Dividends and franking credits associated with the underlying assets are normally passed on to investors. It may be noted that dividends that arise out of shares held by the ETF will still be assessable for tax in the hands of the investor.
Distribution eligibility
Eligibility to receive the distribution is similar to that associated with being eligible to receive dividends from shares. All unitholders registered with a fund on the fund’s ‘record date’ are eligible to a share of the distributable income of the ETF for the specific periods associated with the distribution.
Capital gains
ETF distributions can include realised capital gains. The fund could realise capital gains or losses in the year when the underlying assets are sold. Capital gains from the sale of underlying assets are separate from capital gains or losses from the sale of units. Any associated net capital gain is also passed on to investors responsible for any tax implications.
Some ETFs invest in other assets to generate interest income. Any interest accrued in the process is passed on to the investor and is interest income.
How are management fees paid on ETFs?
There are running expenses involved in managing the ETF, which translate into the costs borne by investors. The typical costs include the management fees and the fees payable to service providers. Transaction costs, such as brokerage, are also associated with buying and selling the ETF’s underlying investments.
Calculation of expenses
Expenses are calculated and deducted from the value of the fund. This ultimately reflects in the NAV of the fund.
What are the other costs of investing in ETFs?
- Brokerage fees – Brokerage fees are levied by the broker in line with their pricing structures and are not payable to the fund managers.
- Buy-sell spread is the difference between the prices you could buy and sell your ETF units vs. its NAV per unit.
Can I use ETFs in a self-managed super fund (SMSF)?
The popularity of the ETF as an investment vehicle of choice could, in part, be attributed to the way Self-Managed Super Funds (SMSFs) have embraced ETFs over the past few years, among other factors. SMSFs use ETFs for diversification. Another reason why SMSFs utilise ETFs is the flexibility and control that they provide to SMSF trustees.
What are the differences between passive and active ETFs?
As more and more investors worldwide embrace the liquidity, flexibility, cost and tax efficiencies offered by ETFs, another stream of this investment vehicle is breaking new ground and growing into another mainstream investment vehicle – Active ETFs.
Quest for Performance
Pursuing market-leading performance leads investors to demand actively-managed funds, giving rise to investment vehicles such as Active ETFs. Active ETFs aim to outperform a given benchmark and rely on the investment manager’s skill to do so.
At Progressive Financial Solutions, our investment financial advisors believe in the powerfulness of compounding returns and long-term wealth effects of a successful investment plan. View our Investment services here.