Asset test: What are ETFs, and should you invest in them?

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When it comes to the world of investing, there’s no denying there are a lot of acronyms. Like, a lot. You can’t take two steps without running into an EBITDA or a CAGR, plus every single company has its own three or four letter ticker to keep track of, like CBA or BHP (though to be fair, these aren’t all acronyms).

But there’s one that pops up more than most: ETF. Standing for exchange-traded fund, these are an immensely popular form of investment that have risen to prominence over the past decade. In Australia alone, investors hold more than $200 billion in ETFs, with around $25 billion added every six months. Worldwide, the total value of ETFs is expected to reach $US14 trillion by the end of the year.

ETFs can be a low-risk and easy way to invest, giving access to a diverse range of shares in one purchase.Credit: Michael Howard

So what are they? Basically, an ETF is a pool of assets all bundled together into one fund, giving investors access to a diverse range of shares (or commodities or another type of asset) in one purchase that can be bought and sold on the stockmarket just like regular company shares.

Say you wanted to increase your portfolio’s exposure to Australian banks. You could buy shares in each of CBA, NAB and Westpac, etc, or you could buy shares in an ETF that holds some of each. Think of it like an acronym with a bunch of other acronyms inside it.

What’s the problem?

ETFs are everywhere, offering exposure to all sorts of different sectors from the good old ASX, to international shares, tech stocks and even commodities and cryptocurrencies. Their popularity is understandable, as ETFs are generally considered a fairly low-risk and novice-friendly way to invest, providing exposure to a larger portfolio of assets without the need for a huge investment.

What you can do about it

If you’re considering jumping onto the $200 billion bandwagon and investing in some ETFs, here are some things to consider:

• Understand the risk: As mentioned before, ETFs have gained a reputation among traders as being a relatively safe and low-risk investment, at least in the grand scheme of things. David Currie, director and financial advisor at Wealthy Self, says that reputation isn’t completely unwarranted, but notes investors shouldn’t take it at face value. “It is a bit of a misconception that these funds are low risk. All it is, essentially, is a more diversified risk,” he says. “A lot of it depends on what ETF you actually invest in.” Buying an ETF that tracks the top 200 companies on the ASX will be different to buying one that invests in specifically robotics companies, he says, and investors still need to grasp the risks of whatever asset class their chosen ETF is investing in. Taking the time to dive into the particular underlying assets in an ETF (which providers are required to disclose) should help you understand what you’re getting yourself into, Currie says.

• Consider your goals: It feels like this is almost a perennial point in this newsletter, but it really is important. ETFs are excellent for diversification, especially for international shares or assets such as infrastructure, property, or cryptocurrencies that can be difficult, or risky, to invest in directly. However, they won’t suit everyone. If you want to be very involved in your investments, such as for a self-managed super fund, then the broad-based approach of an ETF may not suit you. ETFs, like most market-based investments, also tend to suit longer timeframes where you can ride out price fluctuations – as such they may not suit some older investors or those likely to need to cash-out their investment at a particular time when the market is down.

• Costs: ETFs have a range of associated fees, starting with the brokerage fee – same as what you’d incur when buying or selling any other stock. Then they have management fees, which can be as high as 1 per cent or more, depending on the type of fund and the complexity/variety of the underlying assets. A “passive” ETF tracking an index, such as the ASX200, will tend to have minimal fees, with some as low as 0.04 per cent, whereas an active fund, where a fund manager tries to outperform the market, will generally have higher management fees.

• Tax: Finally, a quick note on tax. ETFs are treated the same as other investments, meaning you’ll incur capital gains tax when you sell, and any dividends you receive from them will also be subject to tax, even if they are reinvested. If you purchase international shares via an ETF, some providers will also require you to self-certify and confirm your tax residency to ensure you don’t get taxed more than you should.

Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.