A beginners guide to understanding ETFs

If you like the idea of investing in a lot of listed shares at low cost, with a modest investment outlay, and the potential to achieve good returns, you owe it to yourself to check out what are called ETFs (Exchange Trade Funds).

One of the greatest financial innovations to come to market in the last 20 years, an ETF is essentially a basket of shares. When you buy an ETF, you’re typically buying a microscopic version of a particular share market index.

What an ETF is designed to do is track the price movement of a basket of shares on either a local or international share markets.

How they work

If you invest $500 in an ETF that’s linked to a certain (share market) index, like Australia’s S&P/ASX 200 Index, your $500 is split up to ‘fully replicate’ ( ~mirror) the largest 200 companies on the Australian Securities Exchange (aka the ASX). How much of your $500 is invested in each underlying company (~aka a listed stock) depends on the weighting of each stock on the actual S&P/ASX 200 Index.

For example, if biotech giant CSL Ltd accounts for 10 percent of the S&P/ASX 200 Index by market capitalisation (~ how much the company’s listed share are worth), then 10 percent of your $500 is invested in this stock, and so on according to the weighting of the other 199 stocks on this index.

Low cost, diversification and tax breaks

You may also wish consider buying an ETF that instead of passively tracking the performance of a share market index, tracks either currency exchange rates, asset classes (like property, bonds and shares), or the price of a single commodity. You can also invest in ETFs that are focused on certain sectors or an investment strategy theme, for example, like Australian growth stocks, ethical stocks, Asian tech-stocks, cybersecurity or healthcare sectors - to name a few.

Regardless of which ETF you choose, they expose you to a much broader spread of stocks - that would be too expensive to buy individually - and without you needing to have overseas or multiple trading accounts. The costs associated with ETFs tend to be substantially lower than actively managed funds, most of which constantly fail to beat the index.

Another good feature of ETFs is that you know what the price (~ based on net asset value) is in real-time and you can decide to buy and/or sell your ETFs, without entry or exit fees, any time the share market’s open. This is usually referred to as having good liquidity.

As an investor in ETFs, you’ll also receive valuable tax breaks under the capital gains tax (CGT) discount rules. Then there are indirect advantages including franking credits that flow through to investors directly via the quarterly distributions.

How can you invest in ETFs?

As listed entities on the ASX, ETFs can be bought or sold just like any other listed company. Alternatively, you can open an investment account with InvestSMART which will buy and professionally manage an InvestSMART ETF Portfolio of your choice for you.