ETFs explained
In short: an exchange-traded fund (ETF) is a fund that holds a basket of investments — often every company in an index such as the ASX 200 — and whose units trade on the stock exchange like a share. One purchase gives you a slice of everything the fund owns, usually for a low annual fee.
What is an ETF?
An ETF is an investment fund whose units are listed on a stock exchange. The fund pools investors' money to buy a portfolio — shares, bonds, commodities or a mix — and each unit represents a small share of that portfolio. Most ETFs aim to track an index, so they hold the same companies in roughly the same proportions.
Buying one unit of an ASX 200 ETF, for example, gives you exposure to about 200 of Australia's largest companies in a single trade.
How do ETFs trade?
You buy and sell ETF units through a broker during market hours, at the price on the exchange, just as you would a company's shares. Market makers — firms appointed to trade the fund — keep the price close to the value of the fund's underlying holdings by quoting buying and selling prices throughout the day.
Because of that, an ETF's price rarely strays far from what its holdings are worth, though the gap can widen in fast markets or for funds holding hard-to-trade assets.
How do ETFs compare with shares and managed funds?
ETFs combine the diversification of a managed fund with the trading of a share. Like a managed fund, one ETF spreads your money across many investments; like a share, it is bought and sold on the exchange through a broker at a price that changes all day, rather than directly with a fund manager at a single daily price.
| Single share | ETF | Unlisted managed fund | |
|---|---|---|---|
| What you own | Part of one company | A slice of a portfolio | A slice of a portfolio |
| How you buy | Through a broker, on the exchange | Through a broker, on the exchange | Directly with the fund manager |
| Price | Changes all day | Changes all day | Set once a day |
| Diversification | None | Usually broad | Usually broad |
| Typical cost | Brokerage only | Brokerage plus a low annual fee | Annual fee, often higher |
What do ETFs cost?
ETFs charge an annual management fee, taken from the fund's assets whatever it returns, so you never see a bill. Broad index ETFs on the ASX commonly charge well under 0.3% a year. On top of the fee come brokerage on each trade and the bid-ask spread — the small gap between buying and selling prices on the exchange.
See choosing low-cost ETFs for how to compare funds on cost, size and tracking.
How are ETF distributions taxed?
Most Australian ETFs are trusts, so they pass their income to investors as distributions, usually quarterly or half-yearly. A distribution can include Australian dividends with franking credits, foreign income, interest and capital gains. You are taxed on your share of that income each year, even if you reinvest it rather than take cash.
The fund sends an annual tax statement breaking down each component, which you use for your tax return. Selling units can also create a capital gain or loss.
The types of ETF
- Broad index funds — a whole market, such as the ASX 200 or the S&P 500.
- Sector and thematic funds — one industry or theme, such as technology or clean energy. Usually more concentrated and more expensive.
- Bond funds — government or corporate bonds, for income and lower volatility.
- Commodity funds — gold or other commodities.
- Active ETFs — a manager picks the holdings rather than tracking an index, typically for a higher fee.
The risks
- Market risk. An index fund falls when its market falls; diversification does not prevent that.
- Concentration. Some funds hold a few large companies at heavy weights — check the top ten holdings.
- Currency. International funds move with exchange rates unless they are currency-hedged.
- Tracking error. A fund can lag its index by more than its fee.
Frequently asked questions
Are ETFs safer than shares?
An ETF holding many companies is diversified, so one company's failure has a small effect, which makes it less risky than holding a single share. But a broad ETF still falls when the whole market falls, and narrow sector or thematic ETFs can be as volatile as individual shares. Diversification reduces company risk, not market risk.
How much money do you need to buy an ETF?
You can buy as little as one unit, subject to your broker's minimum first purchase, which is commonly around $500 on the ASX. Because brokerage is charged per trade, very small regular purchases can cost a large percentage in fees, so compare the brokerage with the amount you plan to invest each time.
Do ETFs pay dividends?
ETFs pay distributions rather than dividends. A distribution passes on the income the fund received — dividends from the companies it holds, interest from bonds, and sometimes realised capital gains — usually quarterly or half-yearly. Australian share ETFs can pass on franking credits too. Many funds let you reinvest distributions automatically instead of taking cash.
Sources
- ASIC Moneysmart, Exchange-traded funds (ETFs) — the Australian regulator's guide.
- ASIC Moneysmart, Choose your investments.
This information is general in nature and does not take into account your objectives, financial situation or needs. ShareSift is not a financial adviser and does not hold an Australian Financial Services Licence. Read a fund's Product Disclosure Statement and consider seeking independent advice before making an investment decision.