Getting Started, Smart Investor, July 2011

You may well have read about ETFs recently. ETFs are exchange-traded funds, and they are among the fastest-growing areas of Australia’s – and the world’s – financial markets.

An ETF can be bought and sold on the ASX just like any other share. But instead of just representing a single company, an ETF usually represents an entire index, or a commodity, or some other broader market. They’re like getting a managed fund – generally a passive index fund – through a single share purchase.

Why buy an ETF? The idea is that they are a very easy way of diversifying a portfolio. One purchase gets you exposure to, say, the whole Australian stock market, or a US index, or the gold price. Some financial planners think that it makes sense to build a core portfolio out of ETFs, and then make more active bets – a particular stock you really like, or a fund you would like to try – around the edges. They are very cheap, too: they vary, but rarely cost more than 0.4% per year.

ETFs in this country began with the SPDR S&P/ASX200 fund launched by State Street Global Advisors in 2001. It represents the Australian stock market, and remains by far the most popular ETF today. State Street, which for years had the market to itself, then added an S&P/ASX 50 fund, and one for the S&P/ASX 200 Listed Property Index. Since then, more than 40 other ETFs have followed, most of them in the last few years.

Through iShares, for example, you can use ETFs to get exposure to international shares. There are 23 iShares products and 19 of them are international, from global equity and emerging market indices to single country funds based on, for example, China, Korea or Taiwan. Through Australian Index Investments, among others, you can buy particular sectors of the Australian market, such as resources, metals and financing, industrials or financials. Through ETF Securities, you can buy funds which mimic the behaviour of specific commodities: gold silver, platinum, palladium or a basket of all of them. And through BetaShares, in addition to some resource-related products, you can buy an ETF that tracks the value of the US dollar – the first currency ETF in Australia.

ETFs are becoming more popular. A couple of recent launches from Russell Investments and State Street don’t track a traditional index, but one the providers themselves have invented to filter for high yielding stocks. The idea of a fund like this is that it behaves in a steady way and produces a reliable income stream, particularly useful for retirees.

And in the future, they might become more complicated still. In some markets like the UK and the US, ETFs have been devised that are synthetic, rather than being backed by the things they represent; are inverse, meaning they perform in exact reverse to the underlying investment; are leveraged; or are based on derivatives, as is often the case for ETFs based on the oil price. Most of these ideas have not yet arrived in Australia but are probably not far away; it’s vital to understand how they work before investing in them.

Five years ago, listed funds like this tended to take a structure called a listed investment company, or LIC, but these days ETFs are much more popular. The main difference between them is that ETFs pretty much always represent the exact value of what they invest in – tracking an index precisely, for example – whereas LICs can end up trading at a discount or a premium to their holdings. This has to do with the way that units are issued in LICs and ETFs. ETFs are open-ended funds; the number of units on offer can increase or decrease according to supply and demand. Anyway, this doesn’t matter much for the new investor: the point is that if you buy it, you know it’s going to track very closely a particular index or commodity.

BREAKOUT

Who offers what? Australian providers and their ETFs

STATE STREET GLOBAL ADVISORS:

S&P/ASX 200, S&P/ASX 50, S&P/ASX 200 Listed Property, SPDR MSCI Australia Select High Dividend Yield Fund, S&P/ASX Financials ex-REITS, S&P/ASX 200 Resources, S&P/ASX Small Ordinaries

iSHARES:

S&P Asia 50, MSCI BRIC, Taiwan, South Korea, Hong Kong, Singapore, Russell 2000, China 25, Japan, MSCI Emerging markets, S&P Global 100, S&P 500, S&P Midcap 400, S&P SmallCap 600, MSCI EAFE, S&P Europe 350, MSCI Australia 200, S&P/ASX High Dividend Yield, S&P/ASX20, S&P/ASX Small Ordinaries, Global consumer staples, global healthcare, global telecommunications

ETF SECURITIES:

Platinum, silver, palladium, gold, precious metal basket

VANGUARD:

All-world ex-US Shares index, US total market shares index, Australian shares index, Australian property securities index

RUSSELL:

High Dividend Australian Shares, Australia Value

AUSTRALIAN INDEX INVESTMENTS:

S&P/ASX sectors for energy, financials, financials ex-REITs, industrials, metals and mining, and resources.

BETASHARES:

S&P/ASX 200 Financials Sector (synthetic), S&P/ASX 200 Resources Sector (synthetic), US dollar, gold (hedged).