The complete beginner's guide to ETFs

Thinking about investing but not sure where to start? Exchange-traded funds (ETFs) can be a great way for you to start your investing journey. They are a simple, low-cost option that can help you build long-term wealth. Let's take a look at the ins and outs.

What is an ETF?

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

The ETF holds a basket of securities on behalf of the unit holder (i.e. 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 roughly 350 ETFs listed on the ASX.

How do ETFs work?

To illustrate ETFs in action, we will use a simple hypothetical 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. Sally purchases $3,000 worth of IOZ units. One unit costs $30, so she owns 100 units.

The ETF provider will have allocated her $3,000 across the 200 companies in the index. Assuming Commonwealth Bank has a weighting of 8.3%, each unit will represent $2.49 of the bank's shares. Because Sally owns 100 units, in total she will own $249 worth of Commonwealth Bank shares. The rest of her money is allocated based on 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.

What are the different types of ETFs?

There are two main types of ETFs: passive and active. Passive ETFs, which are designed to track the performance of an index, are the most common. 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. 

Examples of an index would be the ASX 200, which consists of the  200 largest companies in Australia, or the S&P 500 which is made up of the 500 biggest companies in the United States.

Other indices can be sector or asset class specific. Examples include bonds, infrastructure, financials, mining or even cyber security.

Active ETFs aim to outperform an index and are actively managed by professionals. The number of active ETFs on the ASX has been growing. 

What fees are charged by ETFs?

ETFs charge annual management fees, commonly referred to as a Management Expense Ratio (MER). These start as low as 0.03% but can be as high as 1.89%. The average MER is around 0.55%. Passive ETFs tend to charge lower fees than their active counterparts.

How do ETF fees work?

You do not directly pay ETF fees. Instead, the fees are deducted automatically throughout the year from units. Sticking with our earlier 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 benefits of ETFs?

• Diversification

Purchasing a single ETF can provide exposure to hundreds, even thousands, of different investments in one transaction which is an easy way to spread your money and reduce your risk.

• Low fees

Passive ETFs traditionally offer much lower management fees as the investment strategy does not require as much intense research. 

• Accessibility

They can be purchased through a brokerage account during trading hours and can provide access to assets that may otherwise be difficult to acquire such as bonds or international shares.

• Transparency

ETFs are required to publicly disclose their full list of holdings and allocations to each investment on a regular basis, unlike traditional managed funds which do not provide the same level of detail and commonly only disclose their largest holdings or best-performing holdings.

• Income generation

ETFs can provide income streams for investors with varying frequencies of payments, and any dividends, interest or capital gains accrued (including franking credits) are passed on.

What are the risks associated with ETFs?

• Tracking errors

An ETF's return may differ from the index it's designed to track. There are a number of factors that can cause tracking errors including fees, taxes and management decisions. While this risk can be mitigated by choosing funds from established ETF providers, it's a good idea to check that the fund closely tracks the specified index.

• Liquidity

While the majority of ETFs have guaranteed liquidity by employing third-party organisations called market makers, some may not, which can make trading more difficult at times.

• Currency risk

ETFs can provide a simple way to gain exposure to overseas investment opportunities, but this can also open the possibility that changes in the value of the Australian dollar or other overseas currencies can impact performance both positively and negatively. You can avoid this risk by selecting ETFs that hedge against currency fluctuations, but this usually results in higher fees to cover the costs involved.

• Market risk

All investments have an associated level of risk and ETFs are subject to these risks. If the index falls, for example, then the value of the ETF will also fall. If you invest in an Active ETF, the ability of the investment manager can also add risk, in addition to general market conditions.

How do I invest in ETFs?

There are four main ways to invest in ETFs.

1. Use an online broker

You can purchase ETFs via an online broker. The big four banks all offer this service and there are also a number of independent brokers. You will have to pay a brokerage fee which typically ranges from $5 to $15. For an ASX-listed ETF most brokers will have a minimum initial investment requirement of $500. 

2. Buy from the ETF provider

You may be able to buy units in an ETF directly from the ETF provider. Currently, Betashares and Vanguard offer this option. The advantage is that they don't charge brokerage fees on purchases. Vanguard does, however, charge a flat $9 fee on sales. The minimum initial investment is $10 with Betashares and $200 with Vanguard.

3. Buy a diversified portfolio 

Instead of investing in individual ETFs, you can buy a readymade portfolio such as those offered by InvestSMART. Each portfolio includes several ETFs providing diversified exposure across asset classes such as shares, bonds and property. Investments are held safely in your name.

Fees start at $55 per year and are capped at $550. Our portfolios require a minimum of $10,000 to begin with, but we have a fundlater offering that lets you get started with as little as $4,000. 

4. Micro-investing

Micro-investing platforms provide users with simple and low-cost ETF products and you may be able to get started with as little as $5. Fees vary depending on the provider. 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 you to any issues that arise with said custodian or broker.

Disclosure: IOZ is held in InvestSMART Portfolios.

Want to compare ETFs? Check out our handy online ETF filter tool. It can help you narrow down your options based on filters such as investment category or InvestSMART's star rating. If you'd like help selecting the right InvestSMART ETF portfolio for you check out our free statement of advice quiz. It will show you which one may best suit your goals and investment timeframe.