What are ETFs and should you buy one?

One of the most important things for new investors to understand about the Australian Securities Exchange is that it is about so much more than buying and selling shares.

Sure, you can definitely do that on the ASX. Of the roughly 2300 entities listed there, about 2000 are companies in a traditional sense. You know, a group of people who have a business idea who decide to issue shares in their company to investors, which can be bought and sold on the sharemarket.

Exchange Traded Funds bring sharemarket diversity to an investment portfolio.Credit: James Davies

But the ASX is also home to a colourful grab-bag of 300 or so other entities with a dizzying array of acronyms, including REITs, LICs, mFunds and ETFs.

It’s this last acronym – ETFs, or Exchange Traded Funds – that all investors should know about before they start their first foray into the sharemarket.

To understand what they are, we need to go back – waaaay back – to the beginning of finance.

Basically, since the dawn of time, old rich blokes have been going around to other old rich blokes and saying: “Give me your money! I know how to invest it and return it to you as MORE money in the future!” And, by and large, they have.

Of course, this first group of old rich blokes has traditionally set aside for themselves a hefty chunk of any money they create, known as “management fees”, to compensate them for all their time and skill. And to buy Ferraris.

Finance 101, my friends.

Most of the time, these money managers have actively bought and sold investments to maximise returns. And they’ve charged fees in the order of about 1.5 to 2 per cent for the service.

Sometimes, however, the money wizards have put their wands away and simply promised to deliver the average return of a particular financial index, such as the Australian sharemarket benchmark S&P/ASX200. These types of funding pools are known as “index funds”.

For most of history, both “actively managed” and “index funds” operated by fund managers directly approaching and dealing with investors. However, throughout the 20th century, new ways were found for funds to interact with investors via the sharemarket.

So called “Listed Investment Companies”, or LICs, offered investors the opportunity buy units in a fund and pool their capital, together with an ability to enter and exit a fund via the sharemarket, by finding other willing buyers or sellers. There are still many LICs listed on the ASX today.

Fast forward to the early 1990s and the aftermath of the 1987 stock market crash, boring old index funds underwent something of a revival, particularly in the Northern Hemisphere. But with a special new twist.

Just like the LICs, the new index funds were also offered via the sharemarket. However, this time, anyone could join. These new ETFs were “open-ended” in that any number of people could buy any number of units they wanted. If more investors joined than left, the fund could simply expand its pool of underlying investments.

Similarly, people could leave the fund any time they wanted – no waiting around to find a willing buyer so you could cash out.

The initial fashion for ETFs was that they would, like index funds, simply replicate the returns of a particular index.

The first ETF listed on the ASX in August, 2001, offered to track the return of the S&P/ASX200.

Instead of having to buy individual slices of all the top 200 ASX companies that make up the index themselves, investors in the ETF could enjoy the same average capital gain and dividend payments by simply buying units in the ETF.

Today, there are upwards of 230 ETFs listed on the ASX, with more than $100-billion of funds invested. There are ETFs to track all manner of things, from particular market sectors, to commodities and currencies.

They typically have very low management fees, in the order of 0.1 per cent.

Andrew Campion, general manager of Investment Products for the ASX, says ETFs are a great way for beginner investors to get into the sharemarket.

“It’s a very efficient and simple way to start your investment. What an ETF does is give you diversification [or variety] cheaply,” says Campion. “We always say dip your toe in through a broad-based ETF to begin with. Track how that performs; see how it works. And, over time, you can do that with individual stocks.”

Campion is cautious about my plan to start buying shares directly.

“There’s nothing wrong with buying individual shares, I’m not saying that, but when you’re just starting out it’s always good to get diversification. Typically, people say to get diversification you need about 30 stocks.”

Choosing to start out with a single stock, or a handful, can expose new investors to a potential rollercoaster ride – if that particular stock underperforms, says Campion.

“It can be very scary. People can get quite panicky and pull their money out. You’re better off having a diversified portfolio that doesn’t have a lot of volatility. You don’t want to get the impression that it’s just a casino.”

Campion is also keen to remind younger investors that even ETFs are not without risk.

“As with any investment decision, you must do your research and read the fine print on the issuer’s website and read the product disclosure statement. If the market goes down you will lose money.”

Choosing which particular ETF to invest in can be tricky, too. Campion notes the rise of “actively managed” ETFs, which are not simply linked to index returns but also the opinions of managers that buy the individual stocks.

He also notes that choosing which particular ETF to invest in – for example an ETF linked to the performance of technology stocks – is an active decision that can impact overall returns.

“Every investment decision is an active decision and that’s why I don’t like the term ‘passive’ ETF – there’s no free lunch in terms of risk.”

Still, ETFs are something worth considering for the many people just beginning their journey of share ownership.

Big rollercoasters aren’t for everyone.

• Advice given in this article is general in nature and is not intended to influence readers’ decisions about financial products. They should seek their own professional advice before making financial decisions.

You can follow Jess’ money and mortgage adventures on Instagram @moneywithjess or subscribe to her email newsletter via the Age at newsletters.theage.com.au/moneywithjess or via the Sun-Herald at newsletters.smh.com.au/moneywithjess