What are exchange traded funds?

Exchange Traded Funds are a type of investment that’s popular due to their diversification, low fees and flexibility. In Australia, there’s more than 20 billion dollars invested via ETFs.

An ETF is essentially an investment fund that owns a large amount of individual shares, bonds, real estate or commodities, and then are sold in small parcels.

Why are ETFs popular?

Often when people think of investing, they think of two options:

• Buying shares in a company
• Buying into a managed fund

ETFs are a third option. They combine some of the best features of each: the accessibility and transparency of shares, and the diversification of a managed fund.

Confused? Here’s an example:

Let’s say you want to invest in the Australian stock market. You could pick and choose shares, and tie your fortune to the performance of a few companies. Or, you could buy a single ETF that tracks the ASX200, and then own a small part of the top 200 companies on the Australian Securities Exchange. Instant diversification! That’s the power of an ETF.

Key Advantages of ETFs

The fees are relatively low

Low fees are one of the most significant advantages of ETFs. Fees are one of the most important variables you can control. Investment performance can be up or down but fees keep coming through, regardless of the performance.

Traditionally managed funds cost up to 2% a year in fees². ETFs are a fraction of that, typically between 0.15% p.a. and 0.40% p.a. in Australia.

The reason that ETFs have much lower fees is because of their passive tracking nature. ETFs don’t have to pay huge salaries for multiple investment managers who try to pick a winner and constantly buy and sell (which leads to higher fees).

ETFs are fully transparent

Transparency is another significant benefit of ETFs. The majority of ETFs publicly disclose their full holdings on a daily basis, offering full transparency of their underlying assets. This is a benefit that traditional managed funds don’t have — they usually only disclose their top 5 or 10 holdings in their monthly report.

In the post-GFC world where trust in traditional financial institutions is at an all-time low, the ability to confirm holdings daily is not only comforting; it also allows anyone to ensure that the ETF manager is doing exactly what they are supposed to do.

ETFs are easy to access

Buying and selling ETFs is easy and affordable. Because they’re traded on exchanges, buying a unit of an ETF is just like buying a share. And if you want to sell, you’re not locked in to anything more than a share sale.

They’re also quite tax efficient

ETFs offer significant tax advantages over traditional managed funds. Because ETFs tend to be passive, most ETFs tend to have lower levels of portfolio turnover as compared to actively managed funds with similar investment strategies.

In addition to lower turnover, most ETFs are able to take advantage of a unique mechanism called an “in kind creation/redemption process” where shares in each ETF can be created or redeemed by market makers to balance supply and demand, without the underlying securities in the ETF portfolio having to be sold, resulting in fewer tax payments.

Is there anything to be cautious about?

Yes. While ETFs have many advantages over traditional managed funds, there are a few things you should be aware of before investing in ETFs:

Choosing the right ETFs is hard

ETFs are a type of investment vehicle, and by no means guarantee that the underlying assets are a good investment. For example, just because an ETF for oil exists, it doesn’t mean oil is a good investment. At Clover, we examined 124 different ETFs, ultimately choosing only 20 for our approved product list.

There are still fees

While significantly cheaper than managed funds, ETFs still have management fees associated with them. You should also be aware that buying and selling ETFs, like any listed instrument, involves some explicit costs, such as brokerage and settlement fees, and an implicit cost known as buy/sell spreads.

Summary

At Clover, we’re advocates for low-fee, index-based investing. ETFs are a great way to facilitate this type of investing, and we’re proud to offer ETFs as the basis for all of our investment recommendations.

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Sources:
1 Abc.net.au Exchange traded funds surge in popularity as investment option
2 Canstar.com.au Managed Fund fees


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