SMSF Investing Education & Strategies

Exchange Traded Funds (ETFs)

Exchange traded funds (ETF's) are one of the fastest growing investment products in the world today. The start of ETF's in the U.S. came about in 1993 with the launch of the S&P 500 Depositary Receipts (SPY) by State Street Global Advisors. The “Spyders,” as they are called, gave investors a low-cost way to own the S&P 500 without having to buy shares in all 500 companies or buy a managed fund that mimics the S&P 500 index.

Since then, ETF's have grown massively in popularity, in size and volume, and in the number of different ETF's that are available to investors. In the U.S. and U.K. in particular, ETF's are well known with a lot of investment choice available. And although there have been a few ETF's available in Australia for some time, it is only now that they are growing in presence & popularity here with the increase in the number of providers and ETF's available.

What are ETF's ?

ETF's are a type of investment that are traded on a stock exchange just like an ordinary share, however they represent an ownership in a basket of underlying assets. These baskets can represent any number of different assets, including a specific index (ASX 200 Index, Nasdaq 100), a segment of the market (small caps, large growth stocks), sectors (financial's, retail), or foreign countries (China, Japan). Apart from underlying stock markets, ETF's can represent holdings in bonds, gold, silver, or other commodities. They can also enable you to trade the market short, via "inverse" ETF's (which increase in value if the underlying assets go down in value) or take a leveraged position via a geared ETF. The value of the ETF is linked directly to the value of the underlying securities and assets.

Now if this is sounding familiar, its because this is just like a managed fund, which most investors know well. However, there are a number of important differences. ETF's are traded on stock exchanges throughout the trading day just like stocks, so you can buy and sell very easily whereas managed funds are very clunky in terms of transacting. ETF prices change throughout the day, whereas managed funds are priced at the end of the day. Most ETF's will mirror an index, and hence they are passively managed and therefore have lower expense fees. You do pay brokerage however when you buy and sell them through a broker. And just like stocks, you can trade ETF's using market, limit, and stop-loss orders, with no minimum for ETF purchases.

The bottom line is that ETF's offer the diversification advantages of managed funds or indices, with the flexibility and liquidity of stocks. What they don't offer however is access to fund managers who can outperform their relevant index.

Other benefits of ETF's

Diversification

The number one benefit of ETF's is that, similar to managed funds, you are not invested in just one company or asset. If your bullish on the technology sector, for example, you would look at a number of companies within that sector. However, after doing all your research and choosing which stocks will be the best for this exposure, your chosen stocks could still fall badly by a poor earnings report, analyst downgrades, or management problems/departures etc.

Macro theme investing

Following on from the benefit above, ETF's allow you to do what is called "macro theme" investing, whereby you can take positions based on big themes (e.g. bullish on oil or gold, bearish on stocks etc) without taking single stock risk. For some investors, this type of big picture investing can make a lot more sense to them, and provides them with comfort that no one single stock or fund manager can blow them up.

Portfolio transparency

For investors that like to know exactly what they are buying (or holding), ETF's provide transparency by listing their holdings and the weighting of the holdings. Managed funds, on the other hand, typically provide an update of only their top ten holdings in a quarterly review. This transparency helps ETF's avoid a situation where they can blow up as they’re generally tied to indices.

Taxation advantages

With ETF's generally tied to indices or set underlying assets, the turnover of the underlying portfolio will generally be low. There can be some activity when there is a re balance of the underlying index, but this is minimal compared to an active fund manager. The result is that the level of realised capital gains from portfolio turnover will generally be quite low.

Options available (international)

Another benefit worth mentioning is the fact that many internationally listed ETF's, unlike managed funds, have options available. For those that understand options, this can open up a whole new aspect of trading that allows hedging and leveraging of an ETF position. Any of the option strategies that you would normally use for your stocks you can also use on these ETF's as well. This includes buying put options to protect an ETF position, buying call options for a limited loss but leveraged position, and more advanced spread trading.