Exchange Traded Funds (ETF’s)

June 6, 2012

ETF Fundamentals

Exchange traded funds (ETFs) are one of the fastest growing investment instruments in the world because they offer investors a cost effective way to gain exposure to a range of domestic and international asset classes.

This article provides a summary of:

  • What an ETF is
  • The benefits if investing in ETFs
  • How ETFs compare to other investments

Exchange traded funds (ETFs) give investors the combined benefits of managed funds and listed shares in one convenient, liquid and easy to trade investment vehicle.

  • ETFs trade on the Australian Securities Exchange (ASX) exactly like shares, giving you the ability to diversify across an asset class in one easy transaction.
  • The underlying assets of an ETF are comprised of a diversified portfolio of securities across an asset class which typically track an index.

 Exchange Traded Funds

Why invest in ETFs?

There are 6 good reasons to consider investing in ETFs:

• Instant diversification
ETFs provide you with the ability to diversity across an asset class through the holding of a single security. This broad investment exposure helps you to avoid concentration risk, which can occur if your investment portfolio is not sufficiently diversified across and within asset classes.

• Liquidity
Like shares, ETFs give you the flexibility to buy or sell at any time during market hours – meaning you can respond quickly to take advantage of changes in market conditions. While daily volume is seen as an indicator of liquidity for shares, ETFs benefit from Market Makers providing liquidity.

• Transparency
To ensure transparency, a full list of the underlying holdings of the ETF is provided to the market each day. This list allows you to see the exact nature of the underlying exposure, making it easy to use the ETF to complement other investments in your portfolio.

• Lower cost
ETFs are a cost effective way to gain exposure to a diversified portfolio of securities across an asset class. Since ETFs are typically able to achieve lower operating costs, the management fees can be lower when compared to other forms of managed funds.

• Tax efficiency
ETFs generally have a lower level of portfolio turnover than actively managed funds, usually changing only when there is a rebalance of the index. As a result, ETFs are more tax efficient investments over the long term because they are less likely to generate high levels of realised capital gains. Since primary market investors, such as Market Makers, purchase a large number of ETF units directly from the Issuer and offer the ETFs for sale on the secondary market, the trading of ETFs in the secondary market does not increase portfolio turnover within the ETF and this helps to keep them tax efficient.

• Returns from dividends and capital growth
As the underlying portfolio of assets changes in value, ETF units will change in value. Investors benefit from capital appreciation of the value of the ETF units and may also receive distributions that have been paid by the underlying holdings, such as dividends. Depending on the underlying securities in the ETF, investors will also receive any associated franking credits.

Comparing ETFs to other investments

To meet your investment goals, you may choose a combination of investments in your overall portfolio, including exchange traded funds (ETFs), shares and managed funds. When deciding to invest it is important to understand the features of the various investment types.

How to use ETFs in a portfolio

ETFs can be used in a portfolio to help implement a variety of strategies for different investor types.

 

Strategic asset allocation
(Core and satellite)

ETFs can be used as

A low cost diversified core holding, with single stocks, actively managed funds or alternative asset classes as satellite holdings.

A satellite holding for more specialist investment strategies.

 

Tactical asset allocation

Can be used to tilt a portfolio to certain markets, strategies and sectors

Rebalancing and cash management

ETFs can be used to invest additional cash or to gain market exposure while identifying the next opportunity

Risk management

By adding a direct equities portfolio, ETFs help diversify the portfolio by reducing stock specific risk.

 

Speak with your financial adviser about whether ETFs are right for you.

Source: Russell Investments, March 2012.
 

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