Understanding ETFs
In recent years, Exchange Traded Funds also known as ETFs have surged in popularity. Whether you are new to investing or looking to build a more diversified portfolio, ETFs can offer a simple and cost-effective way to access a broad range of markets.
In this blog we will explain what an ETF is, how they work, and what should you know before investing in one. We will also explain the basics of ETFs, why they are often used in long-term investment strategies, the benefits they offer and some of the risks involved.
What Is an ETF?
An Exchange Traded Fund (ETF) is an investment product that combines features of both shares and managed funds. Like shares, ETFs are listed and traded on stock exchanges such as the ASX (Australian Securities Exchange). Like managed funds, they can offer access to a diversified portfolio of investments such as shares, bonds, or other assets bundled into a single investment vehicle.
When you buy an ETF, you’re buying units in a fund that holds a basket of underlying investments. This could include anything from the top 200 Australian companies (ASX 200), international shares, property, fixed interest, or even specific sectors like healthcare or technology.
Why Do People Invest in ETFs?
ETFs are often used by individual investors, financial advisers, and fund managers because of their simplicity and flexibility. We will now consider some of the main reasons why investors include ETFs in their portfolios.
1. Diversification
Diversification is a key principle in investing, it involves spreading your money across different assets with the aim to reduce risk. ETFs help achieve this because they typically include dozens or even hundreds of individual securities in one investment.
For example, an ETF that tracks the ASX 200 provides exposure to 200 different Australian companies. This means that if one company underperforms, it may be offset by others that perform better. Diversification can help to reduce the impact of any single investment’s poor performance on your overall portfolio. However, diversification is not a guarantee that a portfolio will not be impacted by poor performance.
2. Access to a Broader Investment Market
ETFs allow investors to access a wide range of markets and asset classes that might otherwise be difficult or expensive to invest in directly. This can include:
International markets (e.g., U.S., Europe, Asia)
Specific industries or sectors (e.g., technology, energy, healthcare)
Bonds and fixed income
Commodities (e.g. gold)
Sustainable or ESG-focused investments
Instead of needing to research and purchase individual assets from each category, investors can gain exposure through an ETF.
3. Tailored Portfolios
ETFs can also help investors tailor their portfolios to specific goals or preferences. Want a portfolio with a focus on ethical investing? Want more exposure to Australian small-cap stocks or global infrastructure?
Because of the wide variety of ETFs available, investors can construct a portfolio that reflects their values, time frame, and risk tolerance.
4. Professional Management
Most ETFs are passively managed, meaning they track a specific index rather than trying to outperform it. This passive approach can have several benefits:
Lower fees: Passive ETFs usually have lower management costs compared to actively managed funds or ETFs
Transparency: You can usually see what the ETF holds
Simplicity: They aim to replicate the performance of an index rather than beat it, which can make them easier to understand and manage
There are also actively managed ETFs, although these typically come with a different investment approach and different fees.
How Do You Invest in an ETF?
Investing in an ETF is similar to buying shares. They can be accessed via a share trading platform (or a financial adviser who can place trades on your behalf).
It’s important to check the product disclosure statement (PDS), understand the fund’s structure, costs, and risks, and ensure it aligns with your overall investment goals before investing.
What Are the Risks of Investing in ETFs?
While ETFs can be a valuable part of a long-term investment strategy, they do carry risks just like any investment. Understanding these risks is essential and below are some to consider.
1. Market Risk
Because ETFs track the performance of a market index or sector, their value can rise or fall depending on market conditions. If the overall market declines, the value of your ETF is likely to drop as well.
2. Liquidity Risk
Some ETFs are more liquid than others. Well-known ETFs that track major indices tend to have higher trading volumes, meaning they’re easier to buy and sell. Others, such as niche ETFs, might be harder to trade or could have wider spreads between the buy and sell price.
3. Tracking Error
Most ETFs aim to closely follow the performance of an index, but there may be small differences due to fees, timing, or how the fund is managed. This difference is known as the tracking error. While usually minor, it’s something to keep in mind.
4. Overconcentration Risk
While ETFs offer diversification, it’s still possible to be overexposed to certain sectors or countries. For example, many broad-market international ETFs have a high weighting toward large technology companies or banks. Understanding the ETF’s holdings is essential to make sure your overall portfolio remains balanced.
What to Consider Before Investing in ETFs
Before investing, below are a few questions to consider:
What is the ETF’s investment objective?
What index or sector does it track?
What are the largest holdings?
What are the fees (e.g., management fees, trading costs)?
Is the ETF suitable for my time frame and risk tolerance?
What are the tax implications?
It’s also worth noting that while ETFs can simplify investing, they’re still not entirely set and forget. Reviewing your investments regularly, especially as your financial situation changes, remains important.
ETFs have become a popular investment due to their simplicity, low cost, and diversification benefits. Whether you’re just starting your investment journey or looking to enhance your existing portfolio, understanding how ETFs work can help you make more informed decisions.
By offering access to a broad range of assets through a single investment, ETFs can be a useful tool for building wealth over time. However, like all investments, they carry risks and require thoughtful consideration.
If you’re interested about how ETFs might fit into your overall investment plan, consider doing your research, reading the PDS carefully, or speaking with a licensed professional to discuss your options.
After working as an advisor for a decade, Joel founded Unified Wealth.
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