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5 things to know before you invest in ETFs

Aditi Grover  |  21 Aug 2017Text size  Decrease  Increase  |  
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With the Australian exchange-traded fund (ETF) industry just shy of $30 billion in assets and ETFs now being more actively traded than stocks in the US, it's unsurprising that more investors are starting to adopt ETFs as core building blocks of their portfolios.


One reason this trend may be set to continue is that exchange-traded products have evolved from being more than just index-tracking strategies. They now additionally provide a simple way to add exposure to particular asset classes, such as gold.

They can also be used as a tool in a specific strategy, such as looking for share-market exposure but with reduced market volatility.

We're increasingly seeing less experienced investors turn to ETFs as a starting point for their portfolios. And for good reason: ETFs are low-cost, and offer instant diversification and transparency.

As a result, I thought I would take the time to write on the "ETF basics". The five below tips may help beginner ETF investors get started:

1) Understand an ETF's basic structure and liquidity before you start to trade

Unlike shares, the size of the ETF in terms of assets under management, the daily volume traded, and the volume of units quoted "on screen" is not indicative of an ETF's liquidity. This is because an ETF is an open-ended investment fund.

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An ETF's open-ended structure means units of an ETF can be created or redeemed by market makers, as opposed to company shares which, by definition, can only have a fixed amount of stock outstanding on any given day. As such, the supply on offer for an ETF can be adjusted to cater to the demand of the market.

Therefore, the ETF fund size, daily volume traded and "on screen" liquidity are not meaningful when assessing the liquidity of an ETF. An ETF's liquidity is mainly determined by the holdings of the fund.

This is demonstrated by the example below, in which the daily liquidity is reflected by the daily average volume of the underlying holdings for BetaShares FTSE RAFI Australia 200 ETF (ASX: QOZ).


The liquidity of ETFs... more than meets the eye



In terms of how to actually buy and sell ETFs, unlike traditional managed funds, you do not require an application form to purchase an ETF. Instead, once you have a brokerage account, you simply buy and sell units as you would any share on the ASX.

2) Using the indicative net asset value (iNAV) to determine the price to trade

To help determine a fair price to buy or sell an ETF you are able to refer to its indicative net asset value or "iNAV" (if available), as opposed to a traditional share in which you overlay your technical analysis of the stock with market depth on screen, that is, the queue of all the buyers and sellers on screen.

The iNAV is the estimated intra-day "fair value" of the ETF (which is the price per unit of the basket of underlying securities held by that particular ETF less any liabilities such as management fees) which updates multiple times per minute in real time.

INAVs bring intra-day pricing transparency to ETFs in contrast to unlisted managed funds, for which net asset values are determined daily (or sometimes less frequently) once the trading day ends.

INAVs for applicable BetaShares Funds can either be found on our website on the respective product page, as seen in the screenshot below (for our QOZ fund), or via an ASX code which is specified on our website for certain funds.


Pricing information 31 July 2017



3) Understanding bid & offer spreads

All exchange-traded and unlisted investment funds are subject to bid and offer spreads (known as buy/sell spreads for unlisted funds). In the case of ETFs, a bid/offer spread is the difference between the NAV of the ETP and the price at which the ETF can be bought or sold on the ASX.

A "spread" is a market maker's compensation for the time and financial risk they bear by making markets and enhancing liquidity, that is, acting as a buyer and seller of ETF units on the exchange and creating and redeeming units based on investor demand.

Spreads for each ETF vary as they are largely dependent on liquidity of the underlying securities. In general, the more liquid the security, the tighter the spread. Market makers also seek to maintain tight spreads to ensure they do not give their competition the potential to "arbitrage profits".

Bid/offer spreads for all BetaShares funds can be found on the BetaShares website, on the respective product page, as seen in the screenshot below:


Pricing information 31 July 2017



4) Know the difference between "market orders" and "limit orders"

When placing an order through your broker, whether it be for a share or an ETF, you have the option of placing your trade as a "market order," in which you are agreeing to bid on whichever price the market is willing to pay, or a "limit order" in which you determine the price you are willing to bid.

The risk with the market order is that if there are many orders placed at the same time, relative to the demand on offer (that is, a previous investor has placed a large order which momentarily depletes the volume offered at the current market price), your trade runs the risk of being filled with the next best market bid and this may be worse than the best price possible.

A volatile market may also cause the iNAV of the ETF to fluctuate and spreads to widen, which also may lead to bids being filled at undesirable prices.

To avoid this risk, you may wish to place a "limit order". Although you may run the risk of your order not being filled immediately, you still avoid the risk of getting worse than your desired price for the ETF.

5) Time when you buy/sell an ETF

Investors may also wish to avoid trading near the market open and close. This is because market makers can experience higher risk at these times, which may result in wider than normal spreads.

At the market open, market makers look to determine the accurate pricing of the ETF's underlying securities, taking into account the fact that only some, but not all, of the securities, have commenced trading and therefore have current prices available.

This occurs as companies commence trading on the exchange in tranches on a staggered basis, as shown in the diagram below:



Source: MarketIndex.com.au – how to buy shares


The higher risk is experienced by market makers when markets open and near market closing time, as prices of securities tend to fluctuate more at these times. This volatility occurs around the market close as the "matching period" approaches (all trades that take place on the close transact at a price determined by the market, regardless of what price an investor bids or offers).

Market makers bear a higher risk in pricing at this point, which can lead to wider than normal spreads. On this basis, investors should be mindful of trading around market open and close periods.

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Aditi Grover is a business development associate at BetaShares. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

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