What Is an ETF and How to Invest in ETFs in Australia?
Exchange Traded Funds (ETFs) are a simple and cost-effective way for Australian investors to grow their wealth. They allow you to earn returns similar to an index, a segment of the market even or a commodity, and they can potentially help you diversify your investments or reduce risk. With ETFs, you can invest in a wide range of assets without the need to pick individual stocks or commodities, making it easier to build a balanced portfolio.
One of the biggest benefits of ETFs is that you can buy and sell them just like regular shares through a stockbroker, which means you have the flexibility to manage your investments easily and efficiently. With the growing popularity of ETFs on the ASX, Australian investors have more options than ever to build a robust and diversified investment strategy.
What is an ETF (Exchange-Traded Fund)?
An Exchange-Traded Fund (ETF) is an open-ended investment fund that you can buy or sell on the Australian Securities Exchange (ASX), just like a stock. Unlike traditional managed funds, ETFs aim to closely track the performance of a specific index or underlying asset, providing returns that mirror those benchmarks, minus any fees and costs.
ETFs offer access to nearly every corner of the market and cover all major asset classes. This makes them one of the fastest-growing investment products globally. Their ease of trading and cost-effectiveness make ETFs an appealing option for Australian investors looking to diversify their portfolios efficiently.
How do ETFs Work?
When you invest in ETFs on the Australian Securities Exchange (ASX), you're buying units in the fund rather than directly owning the underlying shares or assets. The ETF provider manages the actual portfolio of investments, allowing you to gain exposure to a diversified range of assets through the simple purchase of ETF units.
To match investor demand, ETF units can be created or redeemed. This unique feature helps ensure that the price of the ETF units stays close to the net asset value (NAV) of the underlying assets. This is different from investing in individual company shares or units in a Listed Investment Trust (LIT), where prices can vary more significantly based on supply and demand dynamics.
In the Australian market, by purchasing ETF units, investors can easily gain access to a broad array of assets, be it stocks, bonds, or commodities, without the need to manage multiple individual investments This makes ETFs an appealing option for both new investors looking for simplicity and experienced investors seeking efficient market exposure.
Types of ETFs
There are several types of ETFs available on the Australian Securities Exchange (ASX), each designed to suit different investment objectives and strategies. Here are some of the most common types of ETFs:
Passive ETFs: Passive ETFs aim to replicate the performance of a specific index by holding the same, or a representative sample, of the securities in that index. These ETFs are designed to provide broad market exposure with low management costs. Examples include ETFs that track the ASX 200 or S&P 500. They are popular among investors looking for long-term growth with minimal trading activity.
Active ETFs: Active ETFs are managed by portfolio managers who actively make investment decisions to outperform a specific benchmark. Unlike passive ETFs, these funds do not simply track an index but instead rely on the expertise of the fund managers to select securities they believe will achieve higher returns. Active ETFs may have higher fees due to the active management involved.
Bond ETFs: Bond ETFs invest in a portfolio of bonds, such as government, corporate, or municipal bonds. These ETFs provide income through interest payments and can offer lower volatility compared to equity ETFs. They are often used to diversify a portfolio and provide a stable income stream.
Stock ETFs: Stock ETFs, also known as equity ETFs, invest primarily in stocks. They can track broad market indices, specific sectors, or regions. These ETFs are suitable for investors looking to gain exposure to the stock market without having to pick individual stocks.
Sector ETFs: Sector ETFs focus on specific sectors or industries, such as technology, healthcare, finance, or energy. These ETFs allow investors to target particular areas of the economy they believe will outperform the broader market. They can be useful for thematic investing or sector rotation strategies.
Commodity ETFs: Commodity ETFs invest in physical commodities like gold, silver, oil, or agricultural products. These ETFs provide a way to gain exposure to commodity markets without the complexities of buying and storing physical commodities. They can be used to hedge against inflation or diversify an investment portfolio.
Currency ETFs: Currency ETFs invest in foreign currencies or currency futures. These ETFs allow investors to gain exposure to currency movements and can be used for hedging currency risk or speculating on currency fluctuations. They track the performance of a single currency or a basket of currencies.
Bitcoin ETFs: Bitcoin ETFs aim to provide exposure to the price movements of Bitcoin, the leading cryptocurrency. These ETFs invest in Bitcoin or Bitcoin futures and offer a regulated way for investors to gain exposure to cryptocurrency markets without directly buying and storing Bitcoin.
Inverse ETFs: Inverse ETFs are designed to profit from a decline in the value of an underlying index or asset. They use derivatives to achieve their objective and are often used by investors to hedge against market downturns or to speculate on market declines. Inverse ETFs are typically used for short-term trading.
Leveraged ETFs: Leveraged ETFs aim to amplify the returns of an underlying index, often by using financial derivatives and debt. These ETFs can provide two or three times the daily performance of the index they track. While they offer the potential for higher gains, they also come with increased risk and are generally used for short-term trading strategies.
International ETFs: International ETFs provide exposure to foreign markets, allowing investors to diversify their portfolios beyond domestic assets. These ETFs can focus on specific countries, regions, or global indices. They are convenient for gaining international exposure without dealing with foreign exchanges.
Dividend ETFs: Dividend ETFs focus on stocks that pay high dividends. These ETFs aim to provide a steady income stream alongside potential capital appreciation. They are popular among income-focused investors seeking regular payouts as well as long-term growth.
Market-Cap Index ETFs: Market-cap index ETFs track indices that are weighted by market capitalisation, meaning larger companies have a greater representation in the index. Examples include the ASX 200 or the S&P 500. These ETFs provide exposure to the overall market performance, with a focus on larger, more established companies.
Smart Beta ETFs: Smart Beta ETFs use alternative weighting strategies rather than traditional market capitalisation. They may focus on factors such as dividends, volatility, earnings, or other financial metrics to construct their portfolios. These ETFs aim to provide better risk-adjusted returns compared to standard index-tracking ETFs.
Pros and cons of ETFs
Before diving into ETF investments, it's important to weigh their pros and cons carefully:
Pros of ETFs:
Diversification: ETFs provide exposure to a wide range of assets within a single investment, reducing the risk associated with individual securities.
Transparency: Most ETFs disclose their holdings daily, allowing investors to know exactly what they own.
Cost-effective: ETFs generally have lower expense ratios compared to mutual funds due to their passive management style.
High liquidity: ETFs can be bought and sold on the stock exchange throughout the trading day, offering flexibility and ease of access.
Easy to trade: Like stocks, ETFs can be traded using standard brokerage accounts, making them simple to buy and sell.
Cons of ETFs:
Sector risk: ETFs focused on specific sectors can be highly concentrated and may suffer if that sector underperforms.
Currency risk: International ETFs expose investors to foreign currency fluctuations, which can impact returns.
Liquidity risk: Some niche or low-volume ETFs may have lower liquidity, leading to larger bid-ask spreads and potential difficulty in trading.
Tracking errors: ETFs may not perfectly mirror the performance of their underlying index due to management fees, transaction costs, or other factors.
How do ETF fees work?
Like all managed funds, ETFs come with fees and associated costs. However, they are generally more cost-effective compared to traditional managed funds. This is mainly because most ETFs are passively managed, meaning they aim to replicate the performance of an index rather than actively selecting individual investments. As a result, they avoid the high management fees typically charged by actively managed funds.
How are ETFs taxed in Australia?
Exchange Traded Funds (ETFs) are one of the most tax-efficient investment options available in Australia. This tax efficiency is one of the key reasons why ETFs are becoming increasingly popular among investors.
Why are ETFs tax efficient?
1. Lower Share Turnover: ETFs generally buy and sell shares less frequently compared to managed funds and Listed Investment Companies (LICs). Because they trade less often, ETFs generate fewer capital gains that need to be distributed to investors, which means you are less likely to face capital gains tax (CGT) during tax time.
2. Franking Credits: When ETFs distribute dividends, they may include franking credits, which can be used to offset your tax liabilities and potentially increase your after-tax returns.
3. CGT Discounts: If you hold ETF units for more than 12 months before selling, you may be eligible for a 50% discount on any capital gains tax, further enhancing tax efficiency.
4. Listed Funds: As listed securities, ETFs can be bought and sold on the stock exchange, providing transparency and liquidity while simplifying tax reporting compared to unlisted managed funds.
5. Redemptions with Market Makers: ETFs often use market makers for redemptions, which means shares are bought and sold on the open market without triggering taxable events for the remaining investors in the fund.
How does this benefit you?
Tax Efficiency: By holding ETFs, you can benefit from their tax-efficient structure, which means you keep more of your investment returns.
Simplified Tax Reporting: With fewer taxable events, your annual tax reporting becomes simpler and potentially less costly.
Long-Term Savings: Over time, the tax savings from investing in ETFs can add up, enhancing your overall investment returns.
ETFs are designed to be passive investments with low turnover, making them a smart choice for tax-conscious investors looking to maximise their returns while minimising their tax liabilities.
ETFs vs Mutual Funds vs Stocks
When comparing ETFs with mutual funds and individual stocks in the Australian market, it's important to understand the unique benefits and differences of each. In Australia, ETFs and mutual funds differ from stocks due to the management fees they typically carry, which have been trending lower in recent years. Generally, ETFs tend to have lower average fees than mutual funds.
Additionally, ETFs offer several benefits for Australian investors, including lower investment costs, better diversification, and an increasing number of options on the ASX, making them an attractive choice for many.
Here are some of the key differences between ETFs, mutual funds and stocks:
ETFs | Mutual Funds | Stocks | |
Type | A type of index fund that tracks a basket of securities. | Pooled investments into bonds, securities, and other instruments. | Securities that provide returns based on performance |
Fees | Average equity ETF expense ratio: 0.15%. | Average equity fund expense ratio: 0.42%, plus any additional fees. | Commission fee: Often $0, but can be as high as $5. |
Trading | Traded during regular market hours and extended hours. | Can be redeemed only at the end of a trading day. | Traded during regular market hours and extended hours. |
Cost | Some ETFs can be purchased commission-free and are generally cheaper than mutual funds because they do not charge marketing fees. | Some mutual funds do not charge load fees, but most are more expensive than ETFs because they charge administrative and marketing fees. | Can be purchased commission-free on some platforms and generally do not have charges associated with them after purchase. |
Ownership | Do not involve actual ownership of securities. | Own the securities in their basket. | Involve physical ownership of security. |
Diversification | Diversify risk by creating a portfolio that can span multiple asset classes, sectors, industries, and security instruments. | Diversify risk by creating a portfolio that can span multiple asset classes, sectors, industries, and security instruments. | Risk is concentrated in a stock’s performance. |
Redemption | Trading generally occurs in-kind, meaning they are not redeemed for cash. | Shares can be redeemed for money at the fund’s NAV for that day. | Bought and sold using cash. |
Tax Efficiency | Most tax-efficient among all three types due to in-kind share exchanges. | Offer tax benefits when they return capital or include certain types of tax-exempt bonds in their portfolio. | Taxed at either ordinary income tax rates or capital gains rates. |
How to buy ETFs in Australia?
Investing in exchange-traded funds (ETFs) in Australia is a straightforward process that can be accomplished with a few simple steps. Here's a guide to help you get started:
Find a broker
To make ETFs investment in Australia, you'll first need to find a broker. Online brokers are generally more cost-effective and convenient compared to full-service brokers. They offer lower fees and provide easy-to-use platforms that allow you to trade from the comfort of your home. Popular online brokers in Australia include Moomoo, CommSec, and NAB Trade. These platforms provide a wide range of tools and resources to help you make informed investment decisions.
Open an account
Once you've chosen a broker, you'll need to set up an ETFs investment account. This typically involves filling out an online application form and providing identification documents such as your driver's license or passport. Most online brokers have streamlined this process, allowing you to open an account quickly and easily. Be sure to link your bank account to your investment account to facilitate easy transfers of funds for trading.
Research your ETFs
Before buying ETFs, it's crucial to conduct thorough research to ensure you choose the right funds for your investment goals. Consider factors such as the ETF's underlying index, management fees, performance history, and the sectors or asset classes it covers. Many online brokers provide research tools and resources, including analyst reports and market data, to help you evaluate different ETFs. Websites like ASX (Australian Securities Exchange) and Morningstar also offer valuable information and comparison tools for ETF research.
Buy the ETFs
With your investment account set up and your research complete, you are ready to buy ETFs.
Log in to your broker's platform and navigate to the trading section.
Enter the ticker symbol of the ETF you wish to purchase.
Specify the number of units you want to buy
Choose your order type (market order or limit order).
Review the details and confirm your purchase.
Your broker will execute the trade, and the ETF units will be added to your investment account. Keep an eye on your investments and periodically review your portfolio to ensure it aligns with your financial goals.