Exchange traded funds have become one of the fastest growing financial instruments in the world, but why? In this article, we explain ETFs and other exchange traded products and their benefits.
Exchange traded funds (ETFs) have become one of the fastest growing financial instruments in the world. ETFs are similar to traditional managed funds, but traded just like a share on the stock exchange. They are an easy to use, liquid and cost-effective way to diversify investments.
There are a number of features that make ETFs unique.
Traded on the stock exchange
ETFs, firstly, are traded on the ASX and can be bought and sold at any time of the day using a broker trading account. Each ETF is identified by its own ticker code. Investors can quickly adjust their portfolio, efficiently turning a cash position into an equity position.
Passively managed index exposure
ETFs are generally passively invested: they aim to track the performance of an index, such as the S&P/ASX200, and deliver investors the index return, less any fees. ETFs are available for domestic and international equity indexes, sectors, fixed income, and currencies.
ETFs are liquid – easy to buy and sell – because they can create more units to meet demand, should investor demand exceed supply. Similarly, units can also be cancelled should supply exceed demand.
The market price of an ETF – the actual price that you can buy and sell the ETF – generally tracks the ETF’s net asset value (NAV), the market value of the ETF’s holdings.
The NAV is calculated daily. But because ETFs are traded throughout the day, most issuers of ETFs also produce an iNAV (indicative net asset value), an intra-day and real-time indication of net asset value.
A regulated unit trust structure
ETFs are generally registered managed investment schemes and are therefore subject to all the usual requirements for registered schemes under the Corporations Act.
ETFs issuers contract ‘market makers’ – third parties to keep the market price close to the NAV.
What are the benefits of investing in an ETF?
ETFs provide investors with a number of benefits:
Liquidity and transparency: They can be bought and sold through the day at live pricing through a broker
Simplicity: ETFs don’t require detailed paper work. Investors need an existing share brokerage account to trade ETFs. Unlike managed funds that require investors to fill in forms to make an investment, no additional paperwork is required for an ETF.
Low-cost: Many ETFs are typically cost less than traditional managed funds because they are passively managed.
Tax efficiencies: ETFs can deliver tax benefits because of their low turnover.
Diversification: ETFs allow investors to access a diversified portfolio of holdings in equities, fixed income, currencies, and more in just one trade.
No minimum investments: While many managed funds require investors to invest at least a certain amount in the fund, ETFs do not have minimum investment requirements. Investors can trade smaller amounts as dictated by capacity and investment strategy.
However, like all investments, ETFs involve risks including that the value of the ETF’s underlying investment may fall (market risk), fluctuations in the value of the Australian dollar may affect the ETFs value where underlying investments are international (currency risk), there may not be a liquid market for the ETF (liquidity risk), and that ETFs can experience mispricing and divergence from the NAV.
What are the other types of exchange traded products?
Exchange traded products (ETPs) are traded on the stock exchange just like shares, which provide investors with benefits including ease of buying and selling, competitive cost, and diversification.
Investors now have access to a greater diversity of ETPs with four major types of ETP structures now trading on the ASX, including ETFs and Active ETFs. Listed Investment Companies (LICs) and mFunds are two other types of ETPs.
Listed Investment Companies (LICs)
LICs have been trading on the ASX for almost 100 years, making them the oldest ETP category. Like other ETPs, they are traded on market on the stock exchange. They are similar to Active ETFs because they are actively managed: an internal or external investment manager is making buy and sell decisions.
But there are a number of elements that make them different. They are incorporated as companies (other ETPs have a regulated unit trust structure). They are only required to disclose net asset value (NAV) each month.
And they are closed-ended: they have a fixed number of shares and thus all trades on market are between buyers and existing shareholders (sellers). This closed-ended structure means LICs can trade at either a discount or premium to NAV because a new supply of shares can’t be created to meet demand. Like any company listed on the market, therefore, the price will oscillate based purely on demand.
mFunds offer a way to buy and sell unlisted managed funds and access a broad range of diversified strategies and instruments. Like traditional managed funds, mFunds are not traded on exchange via a live intraday price. Instead, they are bought and sold directly from issuers.
The trading is executed using the ASX’s electronic systems (the mFund Settlement Service), which streamlines the process and makes trading and record keeping easy. Investors can use brokers and advisers for mFund, and unlike traditional managed funds, they don’t have to fill in application forms.
mFunds are held electronically using the same Holder Identity Number (HIN) investors utilise for other ASX traded securities, which means they are consolidated in the same place as shares making portfolio management easy.
mFunds are bought and sold on an end of day basis. The price at which an investor buys and sells is therefore the same as the true value (the net asset value, NAV) of the underlying assets of the fund.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.