Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.

This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.

Edition 53

A lot of investing discourse revolves around hunting for so called ‘bargains’. Maybe it’s a decent stock that’s been smashed by an earnings miss, or simply something the market hasn’t got quite right. We’ll happily debate whether a stock is cheap, but the moment the conversation shifts to ETFs, the valuation lens tends to disappears.

I think part of it is behavioural. If you’re dollar-cost-averaging into an ETF every month, you want to believe it’s always a good time to buy. We certainly don’t approach individual stocks with that same mindset, so the contrast can feel odd.

It’s easy to look at an ETF that’s down maybe 2-3% on the day and assume you might be exploiting some kind of opportunity. Unfortunately, that’s not really how ETFs work. They don’t ‘dip’ in a valuation sense like individual stocks. ETF prices don’t wander off from fair value the way individual stocks can. The real valuation story sits inside the basket it owns rather than the ticker.

How ETF pricing works

Many investors trade ETFs like stocks, so it’s easy to see where the confusion comes from. Their prices move in real time, meaning I can buy and sell a handful of units within minutes of each other.

One thing that often gets lost in conversation is that ETFs technically carry two reference points. There’s the market price you see on the ASX which is what buyers and sellers are trading it for. And then there’s the net asset value (NAV), which reflects the value of the underlying holdings.

The NAV is the market price of all the underlying securities (asset-weighted) divided by the number of units on issue. It’s calculated once at the end of a trading day and published by the issuer. On the other hand, there’s also the iNAV which is an intraday estimate that updates throughout the day to provide a running sense of what the ETF’s holdings are worth at a given time.

The price you see on screen isn’t just whatever the market feels like paying. ETF structure is designed to keep the trading price tightly aligned with the value of the basket it holds. This is where the creation and redemption conversation comes in.

Large institutional players referred to as authorised participants (APs) can create or redeem ETF units. If the ETF starts trading above the value of its basket, APs can buy the underlying shares, hand them to the ETF issuer who will distribute new ETF units which can then be sold by APs at the higher price. If the ETF trades below the value of the basket, APs can buy ETF units and redeem them for shares to sell instead. Either way, the gap closes quickly because there’s a profit to be made in the difference.

This ability to constantly create or redeem units keeps supply and demand in balance. It’s also why ETF prices don’t drift away from their underlying value. There is always someone ready to step in when the ETF price and the value of the basket diverge. To be clear, it is not out of goodwill, but because the structure gives them an arbitrage opportunity.

In other words, if you’re trying to value an ETF by hunting for a discount to NAV, you’re basically trying to outrun institutional arbitrage desks who do this for a living and also do it faster than you can refresh your app.

What does valuation mean for an ETF?

If an ETF’s trading price is almost always sitting around net asset value, then what exactly are you supposed to analyse? The answer is relatively straight forward. The inherent valuation lies in what it actually owns.

If the underlying companies are ‘expensive’, the ETF is expensive. If they’re ‘cheap’, the ETF is cheap. This is the part investors can forget. We buy ETFs to avoid thinking about valuation and because they’re marketed to us as safe, diversified and low‑maintenance compared to individual companies. But that doesn’t mean valuation risk disappears. It just becomes less visible.

And that hidden valuation risk is often what catches people out. If you want to know if an ETF is ‘good value’, you need to look past the ticker and the day-to-day price moves.

How to assess a ‘cheap’ or ‘expensive’ ETF

A good starting point is looking at the weighted average valuation metrics published by ETF issuers. Take the price/earnings (P/E) ratio as an example. This looks at a company’s share price relative to its earnings per share and gives you a gauge for how ‘expensive’ or ‘cheap’ not only the stock is, but also the overall market, relative to its earnings.

Our fund research provides an aggregate P/E by taking the weighted average of the ratios of the stocks in its portfolio. The individual P/E ratios of the stocks are based on trailing 12‑month earnings. If you like getting into the nitty gritty of valuation methodology, P/E is a useful starting point, but not the complete picture. One of the obvious limitations of a trailing ratio is that (as the name states) it’s backward-looking, meanwhile the things that ultimately drive returns occur in the future.

It also helps to compare an ETF’s valuation to the sector or index it tracks. For example, if you’re looking at a technology ETF, its P/E should sit somewhere near the broader tech sector’s valuation. When an ETF trades at a noticeable premium to its benchmark, it may be a sign that you’re paying extra for a theme, a narrative, or a particular methodology. Sometimes that premium is justified, but other times it’s just the cost of buying into a popular story.

A good local example is the BetaShares Australian Quality ETF AQLT. The ASX 200 trades on a trailing P/E of around 19x while AQLT sits closer to 21x. That gap isn’t necessarily a sign that the ETF is mispriced but reflects the type of companies AQLT selects. Its index screens for high return on equity, low leverage and stable earnings. These are things that naturally push the portfolio toward businesses that the market already values more than the average ASX 200 stock. It’s common for specific slices of the market to command higher multiples, however whether that premium is worth it is ultimately a question of what you believe you’re getting in return.

Concluding thoughts

I’ve sat through enough debates about individual companies to last me a lifetime. I’ve reconciled with the fact that stock analysis just isn’t where my curiosity lies. This is largely why I’ve ended up almost entirely in ETFs.

As someone whose long-term strategy is dollar-cost-averaging into funds without obsessing over every entry point, there is a point of contention that creeps in. The whole premise of dollar‑cost-averaging is that you keep buying through good and bad markets without trying to time anything. Yet the moment you start thinking seriously about valuation, that discipline gets harder and passive mindset doesn’t feel as neat. But that’s why it’s important to be clear about what valuation means in an ETF context. They aren’t products that make valuation risk disappear and certainly aren’t places to hunt for mispricing or bargains.

But even if you prefer the simplicity of buying a basket of securities, ETFs aren’t shortcuts that make valuation risk disappear. They also aren’t where you hunt for mispricing or bargains. Their structure keeps the market price and the value of the holdings almost perfectly aligned, so the ticker rarely tells you anything useful. The real question is whether the companies inside the ETF are trading at sensible valuations. That’s where the risk or opportunity actually sits.

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