X-Plained: What are ETFs?
Exchange-traded funds (ETFs) are a simple solution for investors just getting started or for those looking to expose their portfolio to a different part of the market. But what are they, and what do you need to know about them?
- What is an ETF?
- How do ETFs work?
- What can ETFs invest in?
- Why invest in ETFs?
- What to consider before investing in ETFs
What is an ETF?
Essentially, ETFs are a pre-packaged group of assets. Breaking down what ETF stands for is the easiest way to explain what they are.
- Exchange-traded: This means they are bought and sold (traded) on a stock exchange (like the Australian Stock Exchange).
- Fund: This is a pool of capital (money).
How do ETFs Work?
ETFs invest in indexes. Put very simply, an index is a list which is governed by rules. In the context of ETFs, a list of assets is put together using rules to meet a desired investment outcome. To name a few, these assets could be anything from local and international equities to physical gold or bonds.
For example, an ETF designed to track the performance of battery technology and electric vehicles will gather stocks involved in these industries and then apply a set of rules to make a basket of companies, also known as the index.
What do ETFs Invest in?
ETFs can help investors gain exposure to a wide range of asset classes. The table below outlines a few examples of the different kinds of investment opportunities ETFs can capture. Because there are so many kinds of ETFs on the market, an investor can consider a range of solutions to best suit their needs and investment goals.
Why Use ETFs?
Alongside being able to easily add an assortment of market and asset types to a portfolio, ETFs have a number of benefits in contrast to direct shares or other kinds of investment funds.
- Low Cost – ETFs charge a management fee to investors, enabling providers to create and effectively run a fund. Generally, these fees are lower than an actively managed fund or buying a selection of individual stocks.
- Liquidity – Because ETFs are traded on a stock exchange, they are easy to buy and sell as needed.
What Do You Need to Consider Before Investing in ETFs?
Like all investments, there are some things to consider about investing in ETFs. This includes market risk, which occurs because ETFs are subject to the price movements and performance of the asset they are tracking. Hence, if an asset’s market value drops, generally so does the ETF. Tracking risks can also occur if an ETF is not correctly following the price movements of the underlying assets they hold. However, this is where ETF providers step in to manage the fund and ensure it is performing correctly.
It is recommended to read the Product Disclosure Statement (PDS) and Target Market Determination (TMD) before making any investments and always do your own research. Then, if you have more questions, you can always contact an ETF provider directly to ask for further information.