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What is an ETF?

 

Offering low cost access to almost every corner of the market, Exchange Traded Funds (ETFs) have exploded in popularity in recent times, appealing to the smallest to the largest investors. This is our first article in ETF University, offering an insight into what an ETF is.

First a look at managed funds

ETFs have their roots in traditional managed funds. It’s worth first looking at what managed funds are to understand the basic mechanics behind ETFs.

Imagine you and your neighbours all want to invest in some shares. You could all go and do the research yourself and find a bunch of shares to buy. But it’s a lot of work for each of you to understand the market and what is a good company to buy. Additionally, the cost of buying enough companies to properly diversify your portfolio will erode each investor’s returns.

It makes much more sense for you and your neighbours to band together, find a professional to do the research on which companies to buy and using your pooled money benefit from economies of scale to reduce your trading costs. This is the essence of managed funds, where investors pool all of their money together and have a fund manager manage this for a fee.

Each investor then gets allocated some units (or shares) in the fund and the fund manager reports regularly (usually daily) the price of these units. Investors can then work out how much their total investment is worth (by multiplying the number of units by the unit price), and choose to add more money if they want or redeem their investments.

Managed funds are not limited just to shares, with managed funds out there that track just about every asset class, including Australian and international shares, fixed income, property, commodities and cash.

Thanks to our compulsory superannuation system, the Australian managed fund industry is one of the largest in the world, and it is highly likely the majority of your superannuation is invested in this manner.

What about ETFs

That was a nice lesson on managed funds, but this is a site about ETFs. Well, ETFs share pretty much all of the same characteristics with managed funds. They are a pooled bunch of investments operating under a trust structure, and offer diversified exposure to a particular market. There’s one key difference and it the name says it all. ETFs are Exchange Traded and this differentiates them from traditional managed funds.

What does exchange traded mean?

Going back to managed funds briefly. To buy a managed fund, an investor needs to fill out an application form, provide 100 points of ID, send off the application form to the fund manager, who may have a minimum investment amount. The fund manager will then action the application, often on a weekly basis. To see what their holdings are worth the investor may need to wait until annual reports are provided by post, or may have access to an online portal provided by the fund manager. To redeem investments, it might involve posting a redemption form to the fund manager and wait a week or so to receive the redemption.

If the above sounds complex, it is! This is where the ‘exchange traded’ element of ETFs removes the barriers to investors.

To buy an ETF an investor simply needs to open a brokerage account, and buy units or shares in the ETF in the exact same way that you would buy any other shares. Popular brokers like Commsec, E-Trade or ETF Watch partner Saxo can all be used to buy ETFs.

This also allows you to buy ETFs whenever you want. Unlike managed funds, where fund managers generally only take new investments at the end of day, or sometimes even weekly, and there may be delay between sending off application forms and having them actioned. The share market in Australia is open from 10am to 4pm and ETFs can be purchased whilst ever the market is open.

In summary an ETF is a tool allowing you to access a diversified range of investments across many markets with a single trade using a traditional brokerage account.

In the next lesson in ETF University, we take a look at the different management types available for ETFs, another key differentiator of ETFs compared to their managed fund cousins.

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