An Introduction to ETFs

posted on June 6th, 2011 by David

An ETF is a managed fund or unit trust that is quoted and traded on a stock exchange such as the ASX. ETFs are built like managed funds, but trade like shares, meaning that pricing is transparent and that the products can be bought and sold throughout any trading day just like ordinary shares. ETFs generally aim to track as closely as possible the performance of a given index or asset class. They are transparent, liquid, cost-efficient and flexible investment tools – designed to be attractive to both individuals and institutional investors.

ETFs are one of the fastest growing categories of investment products in the world, with over US$1 trillion of assets managed in ETF products globally.

One of the primary reasons for their popularity is that they have all the advantages of stocks, such as being easy to trade and liquid, along with the benefits of index funds, such as diversification and lower costs. With ETFs, it is possible to get a diversified exposure to a large number of securities or an otherwise difficult to access asset class via a single trade and at the same time avoid ‘active manager’ fees.

The Global Market for ETFs

Globally, the market for ETFs has grown exponentially. The graph below shows the growth of the ETF industry in the largest two geographies for ETFs globally, the United States and Europe.

ETFs-chart1

The Australian ETF industry, while comparatively small, has recently grown dramatically. We expect this to continue due to new product innovation and increasing acceptance of ETFs as an asset class in the Australian marketplace

ETFs-chart2

What are the key benefits of ETFs?

Depending on the asset class or index that is being tracked, ETFs can be an ideal long term or short term investment tool. ETFs are widely used globally by both individual and institutional investors.

Simplicity
ETFs help investors gain exposure to a range of investment strategies that can be implemented as simply as buying a share.

Liquidity
ETFs are open-ended funds, meaning the number of units on issue can be increased or decreased in response to daily demand. Units can be bought and sold at any time throughout the trading day. Multiple market makers and Authorised Participants enhance this daily liquidity and provide robust bid-offer spreads. ETFs have similar liquidity characteristics to the underlying shares that comprise the relevant index.

Transparency
ETFs aim to closely track the performance of a specified index or asset class. They have a transparent fund and cost structure. Information on index constituents and assets held by the ETF is published on the issuer websites, giving investors an up-to-date view of the index and assets underlying the ETF.

Cost-effectiveness
Because ETFs aim simply to track the performance of an index or asset class, there are no in-built “active management” fees and ETFs therefore have significantly lower fees than actively managed mutual funds.

How do investors use ETFs?

ETFs can be used by investors for a wide range of investment strategies. Set out below are some of the most common:

Portfolio Construction & Asset Allocation
ETFs can be used as core holdings in a portfolio and as building blocks for portfolio construction. For example, sector ETFs offer diversified exposure to a particular industry sector that could otherwise only be achieved by buying all the stocks in the relevant index.

Core/Satellite Strategy
ETFs are often used in active investment strategies to improve the risk/return of a portfolio. ETFs can be used to build a core portfolio of broadly diversified indices. Single individual stocks can then be added as alpha generating ‘satellites’.

Cash Equitisation
ETFs can be used as a substitute for cash pending individual stock selection. This is used to avoid ‘cash drag’ and as an efficient place to ‘park’ cash while investment decisions are being made.

Pairs Trading
ETFs offer a number of opportunities for pairs trading e.g. going long an index and shorting some of the constituents.

Alternative to Sector Swaps
Investors can use Sector ETFs as an efficient alternative to a sector swap. Using Sector ETFs will mean that investors are not tied to one counterparty for exit and entries and have limited counterparty risk, and they are easier to trade and administer than swaps.

Hedging
Since our products are traded on the ASX, investors can short the ETFs as they would any stock, subject to availability of stock lending.

How to Invest in ETFs

ETFs are traded on the Australian Securities Exchange. As such, they can bought or sold like any share through a stockbroker, financial adviser or online broker. There is no need to open a separate trading account. ETFs can be traded at any time during normal market hours, using all the trading techniques applicable to shares (e.g., market orders, limit orders, stop orders).

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Prepared by Betashares



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