How ETFs work

An ETF is a managed fund that you can buy or sell on an exchange, like the Australian Securities Exchange (ASX).

In Australia, most ETFs are passive investments that don’t try to outperform the market. The role of the fund manager is to track the value of:

• an index, for example the ASX200 or S&P500
• a specific commodity, such as gold

The value of the ETF goes up or down with the index or asset they’re tracking.

The ASX ETF investor course can help you learn more about how ETFs work.

Types of ETFs

ETFs can be either physically-backed or synthetic.

Physically-backed and synthetic ETFs

• Physically-backed ETF – invests in all the securities in the index or a sample of the securities in the index.
• Synthetic ETF – hold some of the underlying assets and use swaps to copy the movements of an index or asset. If an ETF is synthetic, it must use the word ‘synthetic’ in its name. Synthetic ETFs have an additional risk that the counterparty in the swap agreement could fail.

When you invest in an ETF, you don’t own the underlying investments. You own units in the ETF and the ETF provider owns the shares or assets.

What you can invest in through an ETF

ETFs are available for a range of asset classes and individual assets.

These include:

• Australian shares
• international shares
• sectors of the Australian or international share market, such as mining or financials
• fixed income investments like bonds
• precious metals and commodities
• foreign currencies

Visit the ASX website for a list of ETFs you can invest in.

What’s not an ETF

Some products track an index or asset and ‘look’ like an ETF. But they’re not ETFs and they can be riskier. These products include:

• exchange traded commodities
• exchange traded notes
• exchange traded certificates
• exchange traded securities

There are also exchange traded managed funds and exchange traded hedge funds. With these, the investment manager tries to outperform an index and may use high risk trading strategies.

Pros and cons of investing in ETFs

Weigh up the pros and cons before you invest in ETFs.

Pros

• Diversification – ETFs allow you to buy a basket of shares or assets in a single trade. This can help to diversify within an asset class. ETFs also allow you to invest in markets or assets it can be difficult or expensive to access. You can also diversify across ETFs so there’s less chance of loss if an ETF provider collapses.
• Transparency – ETFs publish the net asset value (NAV) daily on the ASX. This can help you track how the underlying asset are performing and if the price of the ETF is close to the NAV. 
• Low cost – a lot of ETFs have a low management expense ratio (MER). They’re usually cheaper than most actively managed funds.
• Easy to trade – you can buy and sell ETFs during the trading hours of the exchange.

Cons

• Market or sector risk – while ETFs can help you diversify, the market or sector the ETF is tracking could fall in value. For example, if the ASX200 declines, the value of your ETF investment will also fall.
• Currency risk – if the ETF invests in international assets, you face the risk of currency movements impacting your returns. Some ETFs are ‘currency hedged’ which removes this risk.
• Liquidity risk – some ETFs invest in assets that are not liquid, such as emerging market debt. This can make it difficult at times for the ETF provider to create or redeem securities.
• Tracking errors – an ETF’s price can move away from the value of the index or asset it’s designed to track. This can be due to illiquidity of the underlying assets, fees, taxes and other factors. This means you could buy or sell when it’s not trading at the net asset value(NAV).

How to buy and sell units in ETFs

You can buy and sell units in an ETF through a stockbroker. It’s the same as buying and selling shares.

Settlement of trades takes place two business days after you buy or sell the ETF. You have to pay brokerage fees when you buy or sell an ETF.

Compare the price and NAV

You can check if an ETF is fairly priced by comparing its price on the ASX with the NAV. The NAV is calculated by taking the assets of the fund, subtracting the liabilities and dividing this by the number of units in the fund.

ETF providers give updates of the NAV:

• on the ASX at the end of the day
• generally on the ETF provider’s website

The price you can buy and sell an ETF at should be close to the NAV per unit. But at times the price may move away from the NAV.

Most ETFs also provide real-time NAV updates. These are called indicative or intraday NAV (iNAV). You can use an iNAV as a reference point during the day to understand if an ETF you’re buying or selling is at or close to the NAV per unit. You can see the latest iNAV from your broker by adding ‘Y’ before the ETF ticker. For example ‘YABC’ for the ETF ticker ‘ABC’.

When to buy and sell ETF units

To get an ETF price that trades closer to the NAV, place your trades at least 30 minutes after the market opens.

It’s also better to buy or sell ETFs when the market for the underlying asset is open. For example, if you’re an ETF that tracks Asian shares, place your orders when the Asian sharemarket is open.

Check the product disclosure statement before you invest

A product disclosure statement (PDS) contains a lot of information you’ll need to know about an ETF. It includes information on:

• what index, sector or asset the ETF returns aims to replicate
• the fees and costs
• the risks of investing in the ETF
• how to complain if you have a problem with the ETF

If you have questions about an ETF you can contact the fund manager or get financial advice. You can also check recent market announcements for new information on an ETF.”