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Exchange traded funds (ETFs) have become a popular and affordable way to instantly diversify your investment portfolio. They can also help individual investors get exposure to previously inaccessible markets or investments.
In Australia, the choice of ETFs has expanded from just two products in 2001 to more than 360 as of October 2024.
What is an ETF?
An ETF is a bit like a managed fund. It gives you exposure to a basket of assets – shares, fixed interest, currencies and commodities – or investment themes such as renewable energy or technology.
Like managed funds, you don’t actually own the underlying investments. Instead, you buy and sell units in the ETF. The main way ETFs differ from managed funds is that you can buy and sell them on an exchange, such as the S&P/ASX 200.
Most ETFs attempt to replicate the performance of a particular index, such as the ASX 200. However, some ETFs are actively managed by professional fund managers.
What are the benefits of investing in an ETF?
They make it easier to diversify. One of the reasons that ETFs have become popular is they make it easier and more affordable for an investor to diversify their portfolio. With one trade, you can buy a basket of assets – including shares, commodities, currencies, fixed interest, real estate investment trusts (REITs) and more.
Exposure to a wide range of markets and assets. Through just one trade, you can gain exposure to a whole market – such as an international or emerging market – and assets including commodities, hedge funds and foreign currencies that otherwise can be difficult to access or expensive to invest in.
They’re affordable. Compared to other investments, ETFs often have lower management fees and cost less to operate.
They’re easy to buy and sell. Because ETFs are traded through an exchange, you can buy and sell them easily, as you would a share.
They’re transparent. Each day, investors can check to see the underlying investments in an ETF.
They enable you to invest thematically. If you hold the view that a long-term trend – such as artificial intelligence (AI), sustainability, cyber-security or healthcare for ageing populations – is likely to be a growth area, you can invest in an ETF that attempts to follow that theme.
What is an index fund?
Like many ETFs, an index fund tracks the value of a specific index – for example, the S&P/ASX 200 or Nasdaq. That means the value of fund fluctuates in line with the index it’s following.
Unlike ETFs, index funds are unlisted. That means you have to buy them from a fund manager rather than on an exchange like the ASX.
What’s the difference between an ETF and an index fund?
Here’s how ETFs differ from index funds:
• ETFs are bought and sold on a sharemarket exchange. This makes it easy to buy and sell during trading hours.
• Index funds are bought from a fund manager, so they’re not as flexible. You can only redeem units in them for the price at the end of trading day.
• After you sell an ETF, you usually receive your money within a few days.
• To redeem units in an index fund, it can take up to 10 business days to receive your money.
• If you sell the ETF and make a profit, you’ll have to pay capital gains tax.
• If someone in your fund sells their units, the fund manager has to sell investments to pay them out, and the capital gains tax payment is shared by everyone invested in the fund.
• You can usually start investing in ETFs with a lower minimum investment than index funds.
• Index funds usually have a higher minimum investment than ETFs.
• You decide when you want to buy and sell your investments, and pay a brokerage fee every time you trade.
• You can set up a direct debit to make a small, regular investment in your index fund to help grow your investment.
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Do ETFs pay dividends?
Dividends are cash payments or sometimes extra shares that companies regularly pay out to their shareholders from their profits. This can provide investors with extra income. Any ETFs that invest in companies that pay dividends will also pay out dividends to unitholders.
You can also choose to invest in ‘high yield’, ‘income’ or ‘dividend’ ETFs that focus on investing in underlying investments that pay dividends. These appeal to investors who want to receive income from their investments.
What are the different types of ETFs?
Passive ETFs: the most common type of ETFs. They work by tracking the value of a particular index or commodity. They don’t seek to outperform the index.
- Active ETFs: also called exchange traded managed funds, these are actively managed. In other words, a fund manager uses trading strategies to try to outperform the index that they’re tracking.
ETFs can also be:
- Physical: where the ETF holds some or all of the underlying assets that the index tracks. This means, for example, that if the ETF is following the ASX 200, it will either hold shares in all companies in this index, or a sample of the companies.
- Synthetic: where the ETF invests in derivatives or swaps instead of the actual physical asset – usually through an investment bank. These ETFs are higher risk.
There are a wide range of ETFs to choose from to gain exposure to a range of markets or assets. These include:
- Equity ETFs that invest in shares, such as Australian ETFs or international ETFs
- Sector ETFs such as energy, consumer, technology, financials, materials or healthcare
- Dividend ETFs, which focus on gaining exposure to companies that pay out dividends
- Bond or fixed income ETFs that focus on following an index of bonds such as government or corporate bonds
- Commodity ETFs, which track indexes of commodities – raw materials or goods such as gold, oil, crops or lithium
- Thematic ETFs that invest in indexes that follow mega trends such as cyber-security, sustainability, renewable energy, AI or advances in healthcare.
What are the risks of investing in ETFs?
Like every investment, ETFs have certain risks. These include:
Market risk: the risk that you could lose money due to events affecting the whole of the market. This could be, for example, rising or falling interest rates, a recession, war, pandemic or natural disaster.
Foreign investment risk: if you invest in international ETFs, there’s a risk that an economic, social or political event or a change in the exchange rate could affect the value of your ETF.
Liquidity risk: sometimes the market may become illiquid – in other words, it may be hard to sell your ETF when you want to, or could result in you losing money on the sale.
Regulatory or tax risk: the risk that the government or a regulator, such as the Australian Securities and Investments Commission (ASIC) or the Reserve Bank of Australia (RBA) change rules, which could affect the value of your ETF or the way your investment is taxed.
Getting started
You can buy ETFs on an exchange yourself, just as you would with shares. To do this, you’ll need to:
work out your investment goal
open a brokerage account
look for and compare a range of ETFs
choose the ETF(s) you’d like to invest in
place a trade.
You can also talk to a financial adviser who can help you determine your investment goals.
If you don’t have an adviser, our handy Find an adviser tool can help you find the right one for you.
What’s next?
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Avanteos Investments Limited ABN 20 096 259 979, AFSL 245531 (AIL) is the trustee of the Colonial First State FirstChoice Superannuation Trust ABN 26 458 298 557 and issuer of FirstChoice range of super and pension products. Colonial First State Investments Limited ABN 98 002 348 352, AFSL 232468 (CFSIL) is the responsible entity and issuer of products made available under FirstChoice Investments and FirstChoice Wholesale Investments.Information on this webpage is provided by AIL and CFSIL. It may include general advice but does not consider your individual objectives, financial situation, needs or tax circumstances. You can find the target market determinations (TMD) for our financial products at www.cfs.com.au/tmd, which include a description of who a financial product might suit. You should read the relevant Product Disclosure Statement (PDS) and Financial Services Guide (FSG) carefully, assess whether the information is appropriate for you, and consider talking to a financial adviser before making an investment decision. You can get the PDS and FSG at www.cfs.com.au or by calling us on 13 13 36.