Outline:

  • ETFs are a market-traded asset that hold underlying assets of a fund;
  • These assets could be shares, commodities, or bonds;
  • They track the overall performance of an index or a collection of assets, rather than one asset.

Some investors spend days, if not weeks, deciding whether to buy a stock. Most people’s goal is to find stocks that will provide good returns, but many people don’t have the time nor expertise to pick individual companies.

ETFs, or exchange-traded-funds, are investment funds that are traded on a stock exchange, similar to stocks.

ETFs that track an index are one alternative that provides diversification, at lower balances, lower transaction costs, and with flexibility. When investing in an index ETF, your returns usually depend on where the broader market goes, rather than individual stocks.

An ETF holds the underlying assets of the fund, which could be stocks, commodities or bonds as examples. And many ETFs will track an index, such as the S&P 500.

The S&P 500 is the 500 largest companies listed on the NYSE or NASDAQ. This means in one trade you are gaining exposure to 500 companies. Before ETFs, you would have to buy at least one share from each company or invest through managed investment schemes to have similar exposure. This would usually come with multiple brokerage fees or higher fees (for the managed investment scheme) than buying an ETF.

Further, many ETFs are what investors call marketable securities, which means they can be readily converted to cash at the market price. They are liquid financial assets. Liquid ETF are actively traded which means their prices can change daily as they are bought and sold.

The history and benefits of ETFs

The first successful ETF, the S&P 500 Depository Receipt (SPDR) was listed in January 1993. It is now traded under NYSE:SPY. The SPY remains popular, and is the largest ETF by assets under management ($US242 billion).

From 1993 to 2016, the number of ETFs has grown from only the SPY to 1,929 in 2016.

One of the reasons ETFs were adopted so quickly are the relatively low fees of index-based ETFs compared to actively managed funds and the fact that they can be purchased directly on the stock market rather than through a financial adviser.

Although, since 2014 mFund has allowed investors to buy managed funds via the ASX.

Index-based ETFs have another benefit as they give investors access to a diversified investment option with a lower balance than previously possible.

ETFs have given everyday investors access to diversification through one trade with one brokerage fee. Some ETFs track indices with hundreds of companies like the SPY.

Think about the S&P 500; to get exposure to a single share of Apple, you’d need $152.09. If you wanted an Amazon or Alphabet share, you’d be looking at around $US1,000 respectively (approximate prices as of July, 2018 )

Compare that to buy into the [SPY](https://us.spdrs.com/etf/spdr-sp-500-etf SPY?fundSeoName=spdr-sp-500-etf-SPY), which would give you exposure to all three. The current price is around $US270 (as of July, 2018). In a single fund share, you can invest in hundreds of stocks at once.

The risks of ETFs

Every investment has risk and ETFs are no different. According to the ASX, the main risks are:

  • Market risk — if the broader market your ETF tracks falls, the value of your ETF is likely to go down with it

For example, if the US stock market falls, an ETF tracking the S&P 500 will fall too.

  • Currency risk — if you invest in an ETF that invests in international assets and there is a change in the exchange rate between the two currencies.

For example, you bought an ETF in Australian dollars but the underlying assets are US based, if the Australian dollar increases against the US dollar, the value of your ETF could fall in value.

  • Liquidity risk — if you can’t sell your ETF for a fair price.

For example, there are insufficient orders to buy the ETF you are trying to sell. While many ETFs are actively traded, others have low turnover, making buying and selling them for a fair price harder.

ETF’s are not all the same. Just as there are lots of different fund managers and lots of different shares there are numerous ETF’s on the stock market each with different objectives and styles. Index ETF’s are just one type and you should carefully research what you are buying before assuming that an ETF automatically means access to the entire market in a single trade.

Also, capital gains made by the ETF are typically paid out annually. A regular share delivers capital gains by growing in value, you then choose when to sell the stock and declare the gain. ETF’s might not be as tax effective for this reason.

Summary

Many ETFs enable the individual investor to buy exposure to a large part of the sharemarket instead of an individual stock. For example, if you buy the SPY, you have exposure to the 500 largest stocks listed on the NYSE and NASDAQ.

The benefits of owning ETFs include potential returns from the performance of the index, low management fees compared to actively managed funds and access to diversified investment options at low balances.

Whereas, the risks include changes in the value of underlying assets, exchange rate movements or being unable to sell your ETF at a fair price.