The Complete Beginner's Guide to ETFs

Once you understand the basics, you’ll find this a simple and convenient strategy to invest your savings and build long-term wealth.

What is an ETF?

An ETF is a fund that is listed on an exchange. Local investors purchase ETFs in the same way they purchase shares, bonds and real estate trusts through the Australian Securities Exchange (ASX). 

Growth of exchange traded products in Australia. Source: ASX

The ETF holds a basket of securities on behalf of the unit holder (ie the investor). Some ETFs own shares, others invest in bonds while some are made up of property. There is a long menu of choices, with well over 200 ETFs listed on the ASX.

Each ETF is different and mimics the performance of an underlying index. The index will prescribe inclusion requirements, methodology and the weighting of each security within the ETF. You can think of the index as the template, which the ETF then seeks to follow. 

How do ETFs Work?

To illustrate ETFs in action, we will use a simple case study. Sally is a new investor who has $3,000 to invest. Sally decided to buy the iShares S&P/ASX 200 ETF (ASX: IOZ), which is a basket of the 200 largest companies in Australia. In January, Sally purchased $3,000 worth of IOZ units. One unit costs $30, so she owns 100 units.

Underneath the ETF provider will have allocated her $3,000 across the 200 companies in the index. For example, per the underlying index, Commonwealth Bank has a weighting of 8.3%, so each unit will represent $2.49 of the bank’s shares. Because Sally owns 100 units, in total she will own $249 of Commonwealth Bank shares. The rest of the savings are allocated per the weighting of the other 199 companies.

When Sally opens her trading account, she won’t see $249 invested in Commonwealth Bank. All she will see is the 100 units of IOZ and the market value of those units.

The market value of the ETF is determined by the 200 underlying shares. So if Commonwealth Bank shares increase in value, and all other 199 companies stay equal, the ETF will increase in value.

How are ETF Fees Charged?

You do not directly pay ETF fees. Instead, the fees are deducted automatically throughout the year from units.

Sticking with our example, the fee for IOZ is 0.05% per annum, charged daily. Assuming the IOZ ETF returns 10% during the year, Sally will pay around $1.60 in fees.

What are the Different Types of ETFs?

The most popular and common ETFs are passive funds that track the performance of a particular exchange or region. These ETFs are super low cost with fees from as little as 0.05% per annum ($0.50 for every $1,000 invested).

• S&P 500 – the 500 largest companies located in the United States
• ASX 200/300 – the 200/300 largest companies located in Australia
• NASDAQ 100 – the 100 largest companies located on the NASDAQ, which is dominated by US technology companies
• MSCI World Index – over 1,500 companies located in 23 developed markets

Then there are thematic ETFs, which focus on particular a market niche. This can include global megatrends, ethical or sustainable funds and sector-specific exposures. These ETFs are generally more expensive, between 0.40% to 1.00% per year ($4-$10 for every $1,000 invested). Investors can also opt for active ETFs, which are managed by a fund manager and do not track a specific index.

• Ethical – Betashares Global Sustainability Leaders ETF (ASX: ETHI)
• Megatrend – GlobalX Battery Tech & Lithium ETF (ASX: ACDC)
• Sector – iShares Global Healthcare ETF (ASX: IXJ)
• Active – Alphinity Global Equity Fund (ASX: XALG)

What are the Most Popular ASX ETFs?

The top 3 ETF providers locally are Vanguard, iShares and Betashares. Each business offers a smorgasbord of ETFs which can be viewed on their websites and bought and sold on the ASX.

Australian investors generally prefer low-cost index funds that track diversified local and overseas indexes. As of December 2023, the ten most popular ETFs on the ASX are:

1. Vanguard Australian Shares ETF
2. Vanguard International Shares ETF
3. iShares S&P 500 ETF
4. SPDR S&P/ASX 200 ETF
5. iShares S&P/ASX 200 ETF
6. VanEck International Quality ETF
7. Betashares Australia 200 ETF
8. Betashares NASDAQ 100 ETF
9. Vanguard US Total Market Index ETF
10. Betashares Australian High-Interest Cash ETF

What are the Benefits of ETFs?

There are several reasons ETFs have grown in popularity among Australian investors. Chief among them is the convenience of purchasing one fund that provides broad exposure to a range of securities.

This is particularly helpful when investing overseas. Using an ETF avoids onerous tax forms and the need for overseas trading accounts. For those concerned about currency movement, several hedged ETFs remove the impact of foreign exchange fluctuations.

ETFs are simple to research, especially when compared to individual shares or bonds, with a fact sheet providing the main details. There is no minimum investment amount, which means you can start investing with a relatively small initial sum.

ETFs are low-cost and substantially cheaper than actively managed funds, with around 85% failing to beat their respective index.

Investors benefit from high levels of liquidity. Funds can be bought and sold from 10 AM to 4 PM every weekday.

Finally, ETFs offer the same valuable tax advantages such as the 50% discount on capital gains when the fund is held for more than 12 months. Then there are indirect advantages including franking credits that flow through to investors directly via regular distributions.

What are the Risks of ETFs?

The main risk associated with ETFs is tracking errors. The ETF issuer charges a fee to administer the ETF, which includes buying and selling securities at the right time and to the correct weightings. While this risk is mitigated by choosing funds from established ETF providers, investors should check the fund closely tracks the specified index.

Depending on the underlying securities, the ETF will have varying degrees of market risk. Cash and term deposits are considered the lower risk but historically offer the least upside. Conversely, shares and property offer higher potential returns but have higher volatility. The onus is on investors to choose investors that align with their risk tolerance.  

How do I Invest in ETFs?

1.    Online Broker

Investors can purchase ETFs, and for that matter shares or bonds, directly on the ASX via an online broker. The big four banks all offer this service, as well as independent brokers who generally offer more competitive commissions.

For new investors, investing directly through a broker can be somewhat daunting. It requires you to deposit funds in advance, place orders and manage portfolio administration such as taxes yourself.

2.    InvestSMART

Instead of investing in individual ETFs, we’ve crafted ready-to-go portfolios to meet your investment goals and objectives. Each portfolio has several ETFs inside providing diversified exposure across asset classes such as bonds, shares and property.

Best of all, we have an investment committee overseeing each portfolio. This takes the hassle away of researching and trading ETFs yourself and provides a simple solution for beginner investors. Other features include:

• Bank-level security keeps your information safe and secure (for the geeks out there, that’s our 256-bit SSL/TLS certificate)
• Automated contributions and rebalancing with dividends deposited directly into your account
• Easy-to-use tax reporting, including an annual tax statement and monthly portfolio update
• Fees start as low as $55 per year and are capped at $550
• Investments are held safely in your name

Our portfolios require a minimum of $10,000 to begin, but we do have a fundlater offering for people to get started with as little as $4,000. 

3.    Micro-investing

Micro-investing apps provide users with simple and low-cost ETF products. These platforms are typically lower cost because they use a custodian rather than a Holder Identification Number (HIN).

Put simply, HIN means the securities are registered in your name. Conversely, custodians hold your investments on your behalf, however, this can potentially expose investors to any issues that arise with said custodian or broker.

For that reason, HIN is our preferred ownership model. 

Finishing Thoughts

We hope after reading this guide you now have the confidence to take the next step in your ETF investment journey. If you’d like to learn more, feel free to chat online or give us a buzz at 1300 880 160 to speak with one of our investment experts.

You can also use our free comparison tool that provides the annual returns of every fund ETF on the ASX. Alternatively, find the right portfolio for you with our rapid questionnaire.

Disclosure: IOZ is held in InvestSMART Portfolios.