Main menu

Pages

What are exchange-traded funds, or ETFs, and should you invest in them?

 Maxim has already invested in Australian stocks and bonds, and now he wants to buy securities of foreign companies. But he does not know what securities to invest in and how best to do it. Maxim found out that there is a special financial instrument - an exchange-traded fund. We tell you what it is and whether an exchange-traded fund is suitable for novice investors.

What are exchange-traded funds, or ETFs, and should you invest in them


Securities of foreign companies can be purchased through an Australian broker or trustee. But these investments have drawbacks


  • There are thousands of companies in the world whose papers can generate good income. But only a small part of it is traded on Australian stock exchanges.
  • Foreign papers are quite expensive. For example, one share of Amazon is worth well over $1,000. To collect a serious portfolio of different securities, large investments will be required.
  • It is difficult to manage this portfolio on your own - you need to monitor the state of companies and events in foreign stock markets. And if you entrust investments to a trustee , you will have to pay him a significant commission - 2-3%, and sometimes up to 5% per year of the amount of money deposited.

You can avoid these shortcomings by investing in exchange-traded funds. These are ready-made portfolios of securities or other assets. You can buy a share of such a fund - a share in its portfolio.


Initially, exchange-traded funds were invented by foreign investment companies and banks. Such funds are called Exchange Traded Funds (ETFs).


Some ETFs are traded on the Australian Stock Exchange. They "packed" the securities of German, American, Japanese, Chinese and other companies. Part of the ETF combines bonds of leading Australian companies that were issued for the Western market in euros and dollars. In some funds, government bonds of different countries are collected.


Since 2015, Australian management companies have begun offering exchange-traded mutual funds. This is the domestic equivalent of foreign ETFs. They can also include any assets.


What is an exchange-traded fund?

The term "exchange fund" was chosen because a private investor can buy or sell a share of such a fund only on the exchange. In this case, most often the price of a share is tied to one of the exchange indices.


A stock index consists of a certain set of securities or other assets. For example, the S&P 500 is an American stock index. It shows how, in total, the value of the shares of 500 leading US companies changes. FXIT is an index of American IT companies such as Apple, Microsoft, Google, Facebook, Visa. The Australian Exchange has created theS&P/ASX 200  index, which includes shares of leading Australian companies.


An exchange-traded investment fund invests in the same assets and in the same proportion as in the selected stock index. Investors can buy a share of such a fund - a small piece of this basket. The value of the share will change in the same way as the total value of the entire basket. And the value of the basket directly depends on the fluctuations of the index.


This means that Maxim can buy, for example, an ETF share on FXIT and immediately invest in all the shares that are included in the US IT sector index. If the value of these shares (and hence the index) rises, the price of its shares will rise in exactly the same way.


There are hundreds of indices and exchange-traded funds in the world. In Australia, on the Australian Stock Exchange, many foreign ETFs as well as ETFs are listed.


According to the principle of operation, exchange-traded funds are similar to open-end mutual funds, that is, mutual funds, the shares of which can be bought and sold on any day. But they also have significant differences.

What is the difference between exchange-traded funds and mutual funds?

What is the difference between exchange-traded funds and mutual funds?


Portfolio composition

Through ETFs and BPIFs, you can invest in foreign securities, and open-ended mutual funds often consist of Australian assets. At the same time, the management companies of open mutual funds usually determine the exact structure of the fund's portfolio themselves, decide when and which assets to buy and which to sell.


ETF managers simply invest money in a predetermined list of assets in a strictly defined proportion - these will be the same assets, in the same proportion as in the index to which the ETF or BPIF is linked.


Transparency

The portfolio structure of ETFs and BPIFs is absolutely transparent. At any time, you can see which securities your money is invested in. These are the same securities as in the selected stock index. If you have chosen an index that includes shares of leading IT companies, then the shares of unknown companies with an unclear future will definitely not be included there.


Open mutual funds fully disclose the composition of assets only once a month. The rest of the time you can focus only on the investment declaration. It states, for example, what part of the assets is invested in shares, and what part is invested in bonds. The specialization of companies whose securities are included in the fund's portfolio can be indicated: for example, mining companies, Australian IT companies or foreign shares. But from the declaration it is impossible to find out the exact details - what part of the money was invested in the securities of which companies.


Liquidity

Units of ETFs are traded on the stock exchange like ordinary shares . A large volume of transactions with exchange-traded funds takes place on exchanges every day, their quotes change continuously throughout the day. This means that you can buy and sell them at a fair market price at any time through your broker.


Shares of open mutual funds can be redeemed on any day, but usually only through the fund management company or its agent. In this case, you will have to pay a commission, which is almost always higher than when selling shares of exchange-traded funds through a broker. And the money for a share of an open mutual fund will not be returned to you immediately: according to the law, the calculation should take no more than 10 business days. Typically, this takes three days.


Commission The

commission of ETFs for managing an investment portfolio is usually 0.2–0.8% per annum, and the commission of an open mutual fund is from 1 to 5%. Therefore, even if the portfolios of the exchange-traded and open-end mutual funds are the same, for example, they consist of bonds of Australian companies, the financial result of your investments in ETFs will be better.


Risks

Since the value of exchange-traded fund units is usually tied to a certain index, the risk of errors by the management company when choosing assets for investment is minimized. Its job is simply to follow the index.

But there is also no chance to get a higher profitability than the selected segment as a whole shows. Experienced experts of the management company of an open mutual fund can earn more thanks to the "manual control" mode.


Choice

Only a few exchange-traded funds are officially represented on the Australian market - their shares can be bought on the Australian Exchange . The choice of open mutual funds is a hundred times larger.

But with the help of ETFs, you can invest in foreign assets: in shares of companies in Germany, Great Britain, China, Japan and other countries, in US treasury bonds, as well as Eurobonds of Australian companies. Portfolios of Australian open mutual funds also sometimes include foreign stocks and bonds, but the range of these securities is much more modest.


Do they pay dividends and coupons on securities that are included in the portfolio of an exchange-traded fund?

Do they pay dividends and coupons on securities that are included in the portfolio of an exchange-traded fund


There are two options.


In world practice, some funds pay dividends and coupons to stockholders in a certain percentage. For example, the fund's portfolio includes 100 shares of Company A. The fund owns 1,000 shares. That is, one share represents 1/10 of Company A's stock. At the end of the year, Company A paid out a dividend of $100 per share. The owner of the stake will get 1/10 of this return - $10.

But much more often, funds reinvest payments on stocks and bonds. That is, new securities are bought with this money - in exact accordance with the selected stock index. Thus, the amount of money in the fund and the price of its units grow. If we take the previous example, then in the case of refinancing after the payment of dividends, the price of each share will increase by exactly $10.

You can find out in advance how the exchange-traded fund distributes dividends and coupon income. As a rule, this is indicated on the website of the management company and in the background information about the fund on the website of the exchange.

At the beginning of 2020, all ETFs traded on the Australian Exchange will reinvest payments on shares and bonds.


How can you buy an ETF?

The easiest way is to buy shares of foreign ETFs and Australian exchange-traded funds through your  broker  or  trustee . In this case, your rights as an investor are protected by the laws of our country, and the broker or manager will automatically calculate and pay taxes for you.

In addition, when buying units of exchange-traded funds, including foreign ETFs, on the Australian stock exchange, you can invest money in them through  an individual investment account (IIA) . In this case, you can count on a  tax deduction .

There is another option - to buy foreign ETFs on foreign exchanges. But it's much more difficult. Almost none of the Australian brokers work abroad. On top of that, for such transactions, you will need to use a separate account - IIS will not work.

You can also find yourself a foreign broker or manager. But if he violates your rights, you will have to sue him outside of Australian according to the laws of another country.


Are all ETFs available to novice investors?

All investors, even beginners, are free to buy :
  • shares of any Australian exchange-traded mutual funds;
  • shares of foreign ETFs from the  first and second quotation lists of Australian stock exchanges;
  • ETF units with a yield tied to  leading foreign exchange indices , but on the condition that the founder of the fund has signed an agreement with the Australian stock exchange, according to which he undertakes to sell and redeem his units at any time at the request of investors.
Units of all other ETFs that are traded on Australian stock exchanges will be available to novice investors.
During testing, for example, it is checked whether the investor understands how the price of an ETF is formed or how to calculate the income on which you need to pay tax in Australian. In order for the result to be credited, it is necessary to answer all the questions without errors.
Free testing can be done at the broker's office, on its website or in a mobile application for exchange trading. It is enough for one broker to pass the test once. But if you decide to change the intermediary, you will have to pass the test again.
Before testing, it is better to tighten up knowledge. How to prepare for the test, read the article  "Where to learn to invest" .
If ETF units are not traded on Australian 
ian exchanges,  only qualified investors can purchase them .


Advantages of exchange-traded funds

  • You get access to international financial markets using Australian tax incentives.
  • It is possible to invest in securities of foreign companies, even if you do not have special investment experience.
  • Investments do not require large sums. The cost of shares of exchange-traded funds starts from 500$.
  • By investing part of your funds in securities issued in foreign currencies, you reduce the risks from fluctuations in the dollar exchange rate. Some ETFs can be bought with dollars and euros.
  • The structure of the investment portfolio of an exchange-traded fund is absolutely transparent. You can check it at any time.
  • ETF liquidity is very high. The prices of shares of exchange-traded funds are recalculated continuously - as stock quotes, and not at the end of the day - as in open mutual funds. You will receive money from the sale of ETFs immediately, and upon redemption of units of open mutual funds - within a few days.

Cons of ETFs

  • Investing in exchange-traded funds does not guarantee returns. For example, if the price of gold falls, the price of gold-linked ETF units will fall by the same proportion. If, due to some kind of global turmoil, the value of the shares of the entire sector or even companies of the entire country goes down, the price of the ETF, which includes these shares, the final yield will also depend on exchange rate fluctuations.
  • But in general, fluctuations in the value of a unit of an exchange-traded fund are usually significantly less than the price of shares of an individual company. After all, even if something happens to one company and the price of its shares changes significantly, this will not greatly affect the price of the entire block of shares that are included in the exchange-traded fund.
  • The Australian exchange has a rather modest selection of ETFs, the offer of open mutual funds is much wider.
  • Money on brokerage accounts is not insured by the state. If the broker goes bust, there is a chance of losing money. But this applies not only to shares of exchange-traded funds, but to all securities. Read more about the risks of working with a broker in the article " Broker: how to choose it and how to work with it ".
Weighing all the pros and cons, exchange-traded funds are a good way to diversify your investments with foreign assets. But don't invest all your free money in ETFs. Firstly, the movements of indices are unpredictable: one can either win due to the growth of the index or lose part of the investment. Second, most exchange-traded funds are priced in foreign currencies. The share price depends not only on fluctuations in the index, but also on the exchange rate.

Comments

table of contents title