Exchange Traded Funds: a guide for beginners

By WMIA


Posted on May 30th, 2017 at 11:01 AM by WMIA



Exchange Traded Funds (or ETF’s as they’re commonly known) are rapidly becoming the favourite investment vehicle for……… everyone. This isn’t just a flash in the pan trend.

A recent study provides strength to this claim suggesting that 44% of Financial Planners in Australia are now recommending them. In the same study the two biggest reasons why people didn’t get involved in ETF’s was lack of knowledge closely followed by not knowing how to access them.

So what are ETF’s, why are they becoming so popular, and how do you access them?

What are ETF’s?

In its simplest form ETF’s are a group or basket of shares that are combined to make an ETF. Each ETF is tradable just like a single share - so in essence when you trade an ETF you can trade 100’s to 1000’s of shares in a single transaction.

ETF’s aren’t limited to just shares - they can be currencies, commodities and bonds. Each share, currency, commodity or bond is known as a holding (collectively called holdings). As mentioned previously, some ETF’s have 1000’s of individual holdings.

ETF Themes

Quite often an ETF will run in a theme: that is the shares contained within the ETF have something in common. Take the Vanguard Australian Property Securities Index ETF for example; all the holdings are Australian based retail property development companies such as Scentre Group or Westfield. Another example would be the iShares Global Consumer Staples ETF in which all the holdings are consumer staples (consumer staples are goods that people are unable or unwilling to cut out of their budgets regardless of their financial situation). Companies such as Nestle, Coca-Cola, Philip Morris and Pepsico are all examples of consumer stables. This is a massive advantage of ETF’s as never before have investors had the ability to target such specific sectors. Some other themes are, but not limited to, property (International and local), technology, telecommunications, emerging markets, energy, precious metals and commodities.

In addition to themes there are numerous ETF’s that track and mirror popular indexes such as the S&P ASX 200 (or ASX200 for short). The ASX200 index tracks the 200 biggest companies within Australia.

Who makes ETF’s?

There are now numerous ETF providers such as iShares/Blackrock, Betashares, Vanguard, Van Eck, SPDR, JPMorgan, Barclays’s, Russell Investments, Market Vectors and ANZ to name a few. Not only are existing providers adding more and more ETF products but providers are also growing rapidly. When you see an ETF listed quite often the format will be [ETF Provider] [ETF name]. For example iShares (provider) Global Consumer Staples (ETF name) or BetaShares (Provider) Agricultural ETF (ETF name). Some others are: ANZ ETFS Physical Gold ETF, iShares Global Healthcare ETF, Market Vectors Australian Emerging Resources ETF, SPDR Dow Jones Global Real Estate ETF etc.

How do you trade ETF’s?

ETF’s can be bought and sold on an exchange like any other ordinary share. Just like shares you can go to a broker or an online trading platform (such as Smartwrap, Netwealth, HUB24, CommSec or ETrade) and pick and trade ETF’s yourself. The most popular way to trade ETF’s at present is to have a professional do it for you.

Case study: Share Portfolio vs ETF portfolio

John and Jill Smith want to invest some inheritance they’ve received and both have different ideas on how to go about it. Both agree that Shares are the best way to go but John being more traditional would rather a broad share portfolio whereas Jill, being a little savvier, wants to invest in ETF’s. Both agree to split the inheritance and invest in their respective interests. Both are limited to what’s available on the local stock exchange (The ASX - Australian Securities Exchange (Formally the Australian Stock Exchange)):

John Jill
Portfolio Commonwealth Bank
Westfield
Westpac Banking Corp
Woolworths Ltd
Wesfarmers Ltd
Coca-Cola Amatil
CSL Limited
Fairfax Media
Macquarie Group
Santos
Tatts Group
Suncorp Group
SPDR S&P World Ex Australia Fund
iShares Global Healthcare ETF
Vanguard Australian Property Securities Index ETF
Vanguard Australian Government Bond Index ETF
iShares Core S&P/ASX 200 ETF
Holdings 12 1,937
Transactions to execute 12 5

From the above it’s obvious who has the advantage. Jill’s portfolio only requires 5 transactions but has over 1,900 holdings whereas John only has 12 holdings and has to complete 7 additional transactions. Each transaction will incur a fee so Jill’s portfolio is going to be much cheaper to execute. Jill’s portfolio is more diverse than John’s and therefore should it be a bad year Jill’s portfolio should fare better. Now let’s compare real-life performance of these portfolio’s using 2016 year-to-date figures and see how they compare:


John Jill
Portfolio Commonwealth Bank -7.70%
Westfield +9.78%
Westpac Banking Corp -9.39%
Woolworths Ltd -8.16%
Wesfarmers Ltd +2.79%
Coca-Cola Amatil -4.02%
CSL Limited +6.24%
Fairfax Media +2.75%
Macquarie Group -14.70%
Santos +10.97%
Tatts Group -10.78%
Suncorp Group +7.88%
SPDR S&P World Ex Australia Fund -3.52%
iShares Global Healthcare ETF -4.32%
Vanguard Australian Property Securities Index ETF +9.21%
Vanguard Australian Government Bond Index ETF +2.42%
iShares Core S&P/ASX 200 ETF +0.47%

All prices as of 26/05/2016.

Once again Jill’s portfolio is the clear winner. The rocky start to 2016 is reflected in both portfolios. Despite Jill’s portfolio containing the same holdings within the ETF’s as John’s – Jill’s portfolio has far out-performed Johns. This is due to the diversity of Jill’s ETF’s.

Another advantage that you may not have noticed is that Jill’s portfolio contains international shares within the ETF’s whereas John’s doesn’t. Once again this adds to the diversity of the portfolio and ultimately the better return.

Should I choose ETF’s myself or get someone to do it for me?

Generally speaking there are no 100% right answers here. Trading ETF’s yourself is not hard - anyone can open an account and be trading within 2-6 business days, however, there’s time considerations in researching ETF’s (just as you would in shares).

A professional will often take asset allocation into consideration. Asset Allocation refers to the common practice of financial planners ensuring clients have the right mix of investments: Australian shares, international shares, fixed interest (bonds), Australian property, international property, commodities, cash and currencies. There are ETF’s in every one of these asset classes. In most cases, a professional will take into consideration asset allocation whereas an individual probably wouldn’t.

As mentioned earlier, the biggest reason why people don’t trade ETF’s is lack of knowledge. As ETF’s are a relatively new industry, consumer knowledge is often limited. This is why having someone else trade ETF’s has been the most popular option amongst investors.

Conclusion

In this very simple guide we’ve been a little technically inaccurate for the sake of keeping it simple. There’s way more to ETF’s than what we’ve covered here but this should have given you some insight as to what ETF’s are and why they’re so popular. Some areas that haven’t been covered that could also be considered as advantages are weighting, equal weighting, dividends and currency hedging to name a few.


If you'd like to know more information -


See also