There has been growing interest in ETFs and Harvest has been asked a number of times recently, “what is an ETF?”

The Australian securities Exchange (ASX) defines ETFs as “investment funds, traded on an exchange, that invest in a basket of securities or other assets that generally seek to track the performance of a specified benchmark (e.g. indices such as the S&P500 or ASX 200) …. .investors hold units in a unit trust rather than shares in a company that operates the investment fund. Each ETF security (or unit) represents an interest in a portfolio of securities, currencies or commodities”.

The first ETF was launched on the ASX in 2001 and today, there are over 40 ETFs available on the ASX. ETF’s have a collective market capitalisation of over $5 billion (as @ 30 June, 2011)[source: Morningstar research].

ETFs are not structured as a company, so are quite different in this regard to Listed Investment Companies (see Harvest’s article on this website on Listed Investment Companies [LICs]). Rather, ETFs are structured as trust vehicles and investors buy “units”. They are “open ended” funds which means that the number of units on offer are not fixed but can increase (or decrease) depending on investor demand. Essentially, ETFs are like a “managed fund” based on an index but the “managed fund” is listed on a stock exchange.

ETFs seek to replicate the investment performance of a cetain index. For example, the iShares S&P/ASX Small Ordinaries fund seeks to track the S&P/ASX Small Ords index. The SPDR S&P/ASX 50 seeks to track the performance of the top 50 listed companies on the ASX (i.e. the S&P/ASX50). The Aii S&P 200 Resources fund seeks to track the performance of the top 200 Resource companies listed on the ASX (i.e. the S&P/ASX 200 Resources).

There are also international ETFs that track the performance of specific countries or broad regional markets.  The IShares MSCI Japan fund for example, tracks the performance of the Japanese market (i.e. the MSCI Japan); whilst there are other ETFs that track the performance of the combined markets of Brazil, Russia, India & China (the iShares MSCI BRIC Index Fund for example).

There are even ETFs that track sectors like Global Healthcare stocks (i.e. iShares S&P Global Healthcare) or currency ETFs which seek to replicate the performance of a particular currency (e.g. BetaShares U.S. Dollar ETF tracks the performance of the Australian dollar against the US dollar). There are also ETFs for the Euro and British Pound.

Some ETFs are classed as synthetic. Synthetic ETFs do not necessarily invest directly in the securities included in an index or benchmark (unlike conventional ETFs), but seek to do so “synthetically”. They do this by holding financial instruments like swap agreements or futures contracts (collectively referred to as ‘derivatives’) to “simulate” the investment performance of the index or benchmark.

Exchange Traded Commodities (ETCs) track the performance of an underlying physical commodity or commodity index like G0ld, Silver or Palladium. The ETFS Physical Precious Metals Basket tracks the performance of a basket of precious metals. ETCs allow investors to gain direct exposure to the underlying asset without the need to trade futures or take physical delivery of the commodity.

Why use an ETF ?

  • Flexibility – ETFs and ETCs are traded on the ASX and this means that you can buy and sell at any time during ASX’s trading hours, at prices that you specify,
  • Low cost – ETFs and ETCs are not “actively managed”. Rather, they simply seek to track an index. As such, they are generally able to achieve lower operating costs. Management fees (commonly referred to as MERs – Management Expense Ratios) are significantly lower than other managed funds,
  • Returns from capital appreciation and income – an ETF or ETC will change in value as the underlying portfolio of assets changes in value. Depending on the benchmark being tracked, investors can earn returns through capital appreciation and/or distributions. Investors may also enhance after tax returns from franking credits.
  • Fair value – ETFs and ETCs are designed to ensure that they trade close to their underlying value. This provides the investor with certainty that the on-market price will closely reflect the value of the underlying assets held in the fund. This is commonly referred to as trading at net asset value (NAV).
  • Taxation advantages – the turnover of the underlying portfolio tends to be low with the constituents of ETFs changing only when there is a rebalancing of the index. This means that the level of capital gains tax that needs to be paid by the fund and its investors can be greatly reduced.

Key risks and disadvantages of ETFs include:

  • Market risk – market conditions can make trading difficult (e.g. liquidity can be limited when markets are volatile),
  • Counterparty risk – risk of the issuing party not meeting their transaction obligations,
  • Tracking error – risk that return deviates significantly from the appropriate index.

ETFs and ETCs have their place in any well structured investment portfolio but it is always recommended that investors seek professional advice before employing them.

[source: Morningstar Research and the Australian Securites Exchange]

Note: the ETFs referred to in the article are examples only and do not constitute a recommendation from Harvest. Harvest are able to provide advice and guidance on ETFs on request.