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Investing basics: navigating the ETF universe

Emma Rapaport  |  18 Apr 2019Text size  Decrease  Increase  |  
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Since exchange-traded-funds (ETFs) began trading in Australia 20 years ago, there has been a proliferation of different types.

Today, more than 200 exchange-traded products trade on the Australian Securities Exchange, some tracking broad market indexes, while others offer exposure to popular trends such as cybersecurity.

This plethora of competing products is making it harder for investors to make informed decisions for not all ETFs are created equal.

Following is a guide to the different types of ETFs so you can select the right funds for your portfolio.

Passive ETFs

ETFs that track market indices are called passive ETFs. Managers who oversee overseeing passive ETFs will take a hands-off approach, simply ensuring that their ETFs replicate their designated indices. A manager will not intervene if an index takes a turn for the worse. In other words, the manager is being passive.

Active ETFs

While the vast majority of ETFs are categorised as passive, a handful of active ETFs have now become available to investors. Active ETFs are run by a manager or a management team that attempts to outperform their designated index. But outperformance is not guaranteed; sometimes an ETF can do better than its index, but sometimes it can do worse. For example, an investor holding an active ETF that tracks the S&P 500 would experience slightly different returns from the returns of the S&P 500 index because management is actively using strategies to try to outperform the index.

Smart Beta ETFs

To manage risk in a portfolio, some investors have turned to indexing strategies that ignore market cap in favour of other factors such value, dividends, low-volatility, momentum and quality. In a sense, factor-based indexing mimics strategies that many active fund managers use. But rather than a human deciding on which stocks to buy and sell and when based on his analysis, factor-based indexing automates the process by applying a model that determines what goes in the portfolio. This makes them "smart". This eliminates the need for an active manager and thus helps reduce fees. However, factor-based funds and ETFs still tend to charge more than market cap-weighted index funds and ETFs. You might think of factor-based indexing as a hybrid approach that combines the strategic advantages of active management with the lower investment costs offered through indexing.

Asset class ETFs: Stock ETFs, Bond ETFs, Property ETFs

Stock ETFs – also known as equity or share ETFs – are the most common type of ETF you'll come across. Stock ETFs track the performance of a specific market index. For example, if you want to invest in the overall ASX 100 Index, you can buy an ETF that will mimic its movements. You can also buy ETFs that track other benchmark indices such as the ASX 300, the S&P 500 or the NASDAQ 100, or smaller niche indices.

The Vanguard Australian Shares Index ETF (VAS) is one of the most popular Australian ETFs, as viewed by Morningstar readers. It seeks to track the returns of the 300 largest listed Australian companies by market capitalisation – known as the ASX 300. The top 10 holdings of VAS comprise about 44 per cent of the ETF's net assets.

Bear in mind that when you invest in international ETFs, you also take on currency risk. You can't buy a foreign company without also buying that company's currency and that can expose you to currency losses.

You can also buy ETFs that will give you exposure to other asset classes such as bonds and property. Like buying a traditional bond, a bond ETF will still give you interest/coupon payments.

Currency ETFs

Most currency ETFs track the performance of a currency such as the US dollar or euro. You'll make money if the Australian dollar slumps, or if the other currency soars. But in the reverse situation, you'll lose money. Currency ETPs are often used by speculators who want to bet on the macro, political, and economic events that drive currencies. They can also be used to hedge against risks such as the cost of future financial outlays or to take a longer-term investment view on currency.

Commodity ETFs

Yes, you could physically buy gold bars or barrels of oil and keep them in your garage, but is that practical? There’s insurance and storage to worry about, and some soft commodities like corn aren't going to hold up too well over the years. Exchange-traded products have now made it possible for individuals to gain direct exposure. For example, BetaShare's Crude Oil Index ETF-Currency Hedged (synthetic) (OOO) allows investors to gain exposure to the performance of the crude oil included in the S&P GSCI Crude Oil Index Excess Return without the need to invest in the futures market or take physical delivery of the commodities.

Multi-asset ETFs

Index ETFs traditionally offer exposure to a single asset class – e.g. large-cap Australian equities or Emerging Market Shares – but in 2017 Vanguard launched a series of multi-sector ETFs. In a single trade, investors can gain access to a diversified portfolio of stocks, bonds and cash. The four diversified options – Conservative, Balanced, Growth and High Growth — are designed to suit different investor objectives and risk profiles.

Sector ETFs: Consumer staples, technology

Sector ETFs allow investors to buy into companies in a specific sector. For example, BetaShares Technology Asia Technology Tigers ETF (ASIA) seeks to track the price movements of a portfolio containing the top 50 technology and online retail stocks, by free float market capitalisation, which have their main area of business in Asia (excluding Japan).

Thematic ETFs

These funds seek to capitalise on the growth of popular trends such as cybersecurity or the spending habits of millennials. They access investors’ collective fascination with a range of niche topics, offering the potential to capitalise on the growth of something popular or trendy. Examples include ETF Securities’ Global Robotics and Automation ETF (ROBO) and BetaShare's global cybersecurity ETF (HACK), global healthcare ETF (DRUG) and global robotics and artificial intelligence ETF (RBTZ).

Green/Ethical ETFs

The ethical fund industry is expanding to accommodate the growing number of investors seeking to put their money in companies they feel do the right thing. Vanguard has launched two new ESG exchange-traded funds: Vanguard Ethically Conscious International Shares Index Fund and ETF (VESG), and Vanguard Ethically Conscious Global Aggregate Bond Index Fund (VEFI). These remove companies involved in alcohol, tobacco, adult entertainment, fossil fuels, gambling, weapons and nuclear power.

is a reporter for Morningstar.com.au

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