Exchange Traded Funds (ETF) have become popular with investors in recent years, with the global ETF market expected to increase 63% to US$15 trillion in 2027.

In this guide, we explore what ETFs are, their pros and cons compared to traditional investment products such as shares, index funds and managed funds, types of ETFs, how to choose an ETF and tips when buying and selling ETFs.

What is an Exchange Traded Fund (ETF)?

An exchange traded fund (ETF) is an investment fund that is traded on a stock exchange just like an ordinary share.

ETFs can hold multiple types of assets, including popular asset classes like stocks and bonds, as well as harder-to-access ones such as debt, derivatives, currency and commodities.

The majority of ETFs are passively managed, which means they track the performance of a specific market index like the S&P/ASX 200, S&P500, Dow Jones Industrial Average or Nasdaq Composite. However, a growing number of ETFs tracking an actively managed portfolio of investments are becoming available (see Types of ETFs for more).

Are ETFs a Good Investment? ETF Pros and Cons

Like any investment product, ETFs may or may not be right for you depending on various factors. These include your investing goal, personal investing preferences, how much you have to invest and much more.

ETFs can offer several benefits, including:

  • Easy to buy and sell - ETFs can be purchased with an online stockbroker just like shares.

  • Easy way to diversify your portfolio – ETFs provide an easy way to gain exposure to a variety of asset classes and investment strategies, especially if you have a smaller balance

  • Access markets, asset classes and strategies that would be otherwise be out of reach, such as debt, derivatives, currency and commodities.

  • Comparatively low-cost - The management expense ratio (MER) charged by ETF providers is generally less than that of managed funds.

  • Transparency - Unlike managed funds which may only disclose a portion of their holdings every quarter, ETFs typically disclose their full portfolios on free websites every day.

  • Tax-efficiency relative to managed funds - ETFs can allow investors to defer the realisation of capital gains taxes.

However, ETFs can have some drawbacks for certain investors, including:

  • Trading costs – In most cases, investors must pay brokerage fees whenever they purchase additional ETF units. On the other hand, managed funds often allow you to invest as little as $50 each time and avoid paying brokerage fees. For investors making smaller, regular investments, this can make a significant difference to overall return.
  • Potential deviation from value of underlying portfolio – Since ETFs are bought and sold on the secondary market (stock exchange), if there is a short-term imbalance in supply and demand, the market price of an ETF can temporarily deviate from the value of the underlying assets.
  • Voting rights – Unlike shareholders who own the underlying security, ETF investors generally do not have voting rights. This could be changing however, with providers like BlackRock set to allow ETF holders voting rights at shareholder meetings.
  • Less control – Shares provide investors with more control and flexibility than ETFs. With shares, investors can decide which specific companies, sectors and weightings they want in their portfolio. This can help them achieve better returns, diversification or alignment with personal values compared to ETFs.
  • Behavioural risk – As ETFs are traded on an exchange, it can be tempting for investors to buy and sell their assets if they are nervous about volatility. There are low barriers to trade and can often lead to poor investor behaviour.

When considering ETFs, it’s important to consider all these qualities and how they fit into the way you invest and your goals.

Comparing ETFs, Shares & Managed Funds

Comparing ETFs, Shares & Managed Funds

How to choose the best ETFs for you

If you decide that ETFs are right for you, the next step is to choose an ETF.

But with so many ETFs available, where do you start?

At Morningstar we take an investor-focused approach, rather than an investment-focused approach.

Start with your goals for investing, then work backwards to identify what ETFs are aligned with that goal.

Here are three steps you can follow:

Step 1 – Determine your goals and calculate your required rate of return

A) Determine your net worth

Start by taking stock of where you are starting off from and assess your assets and debt levels using our handy Net Worth Worksheet.

Net Worth Worksheet

Our Net Worth worksheet helps give a snapshot of your current position

B) Create a personal cash-flow statement

A personal cash-flow statement provides a point-in-time snapshot of what income comes into your household from your job and/or any other sources, as well as what you’re spending and saving.

This helps you determine whether your spending and savings patterns align with your long-term goals.

Here’s a template you can use to create your personal cash-flow statement.

Personal Cash-Flow Statement

Find out what's happening with your money with our Personal Cash Flow Statement

C) Document your financial goals

Define and estimate the cost of each of your goals. For short- and even some intermediate-term goals, this should be straightforward.

Estimating the cost of multiyear, long-term goals like retirement is trickier. The big wild card is inflation: While it’s currently quite low by historical standards, it is reasonable to assume at least a 2 per cent to 3 per cent inflation rate for longer-term goals. At Morningstar we have a 2.6 per cent yearly inflation estimate.

Complete the Goal Planning Worksheet to give you an idea of your different goals, when you hope to achieve them and how much they are likely to cost.

Goal Planning Worksheet

Write down your investment goals in our Goal Planning Worksheet

D) Calculate your required rate of return

Calculate what you need to earn to meet your goals using the numbers from the three steps above and the required rate of return calculator found inside Morningstar Investor (Sign up for a FREE 4-week trial^ here to get access. No credit card needed).

Required Rate of Return Calculator

Calculate your required rate of return with the calculator found in Morningstar Investor

Your required rate of return will give you an indication of the level of investment risk that you need to take to meet your goals and any lifestyle changes you may need to make to ensure you reach your long-term goals.  

It can also help you understand whether your goal is feasible based on historical average returns that have been generated from different investments.

For example, if you complete these steps and your required rate of return is 50% - dramatically higher than average historical returns for major asset classes – then it may be time to re-evaluate your goals.

Step 2 – Select an asset allocation that is right for you

There are many other asset classes which investors can and should include in a diversified portfolio. And ETFs allow you to easily gain exposure to them all.

These asset classes include ‘growth’ assets such as equities, property and infrastructure, which are assumed to achieve higher returns on average over the long time, but have higher volatility associated.

They also include ‘income’ or ‘defensive’ assets, such as cash, government bonds and corporate credit, which are assumed to have lower average returns but with lower volatility.

While most retail investors focus on what individual investments will go into their portfolio, the combination of asset classes you select has an enormous influence on your returns.

And what asset allocation you select should be influenced by your required rate of return.

The higher your required rate of return, the more growth assets need to be in your portfolio.

To determine what percentage to allocate to each asset class takes a little nuance. We provide Morningstar Investor members with 5 pre-defined asset allocation models based on different risk and return profiles (Sign up for a FREE 4-week trial^ here to get access. No credit card needed).

Asset Allocation

Five pre-defined asset allocation models based on different risk and return profiles are available inside Morningstar Investor.

Step 3 – Choose ETFs

Now that you’ve determined how much of your investment portfolio should be made up of different asset classes, it’s time to choose ETFs that achieve that target asset allocation.

You can think of your ETF investments as building blocks. One approach is having core holdings make up the majority of your portfolio’s assets. Once those positions are filled, you can choose to add noncore holdings that play a smaller role in your portfolio. This is called a core-satellite approach, and is used by many investment professionals and advisers.

Core investments should be broadly diversified, low-cost ETFs that cover the major asset classes.

You can further diversify by adding other asset classes or sub asset classes, but a portfolio made of core holdings can stand on its own. Still, even simple diversification can reduce the risk in your portfolio by lowering the chances that all your investments lose value at the same time.

Whether a key building block in your portfolio or a niche addition, there are ETFs that fit nearly every role.

Regardless, you will want to outline the approach you want to take to reach your goal and selection criteria for ETFs.

Outline your approach and selection criteria

For example, you may be looking to invest for income and want to focus on ETFs that have a certain distribution yield.

Or you may be investing for capital growth and want exposure to undervalued sectors and subsectors to boost your returns over time.

Or you may want to prioritise Environmental, Social and Governance (ESG) sustainability factors in your ETF selection.

(Skip to ‘Investing in ETFs: What are your options?’ to learn about what categories and criteria are available when selecting shares)

Our Investment Policy Statement tool inside Morningstar Investor (Sign up for a FREE 4-week trial^ here. No credit card needed.) can help you document this and keep it top of mind to help you stay on track when selecting ETFs and managing your portfolio.

Investment Policy Statement

The Investment Policy Statement tool inside Morningstar Investor helps you focus on your goal and what’s important to you

Once you’ve done this, you can start searching for ETFs aligned with your goals, approach and criteria.

Investing in ETFs: What are your options?

There are more than 200 ETFs that trade on the Australian Securities Exchange (ASX) alone, and many more on global exchanges.

This makes it hard for investors to make informed decisions as not all ETFs are created equal.

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

Active vs Passive ETFs

ETFs that track market indices are called passive ETFs. Managers who oversee passive ETFs take a hands-off approach, simply ensuring that their ETFs replicate their designated indices. For example, an ETF that tracks the ASX/200 would invest in the top 200 stocks in Australia by size.

Active ETFs on the other hand, are run by a manager or a management team that attempts to outperform their designated index. Outperformance is not guaranteed; sometimes an ETF can do better than its index, but sometimes it can do worse.

Passive ETFs tend to work best in efficient and liquid markets such as large-cap stocks and developed markets. Active ETFs tend to work best in inefficient and illiquid markets such as small cap stocks, fixed interest and emerging markets.

Examples of passive ETFs include Vanguard Australian Shares Index ETF (ASX:VAS) and iShares S&P 500 ETF (ASX:IVV).

Examples of active ETFs include the Hyperion Global Growth Companies ETF (ASX:HYGG) and Morningstar International Shares Active ETF (ASX:MSTR)

Australia vs International ETFs

The Australian equity market is skewed towards financial services and resource companies. Therefore, investing in global markets can help investors sensibly diversify their portfolio.

There are a range of ASX-listed ETFs which offer broad market exposure to global equity markets, including the iShares Global 100 ETF (ASX:IOO), Vanguard MSCI Intl ETF (ASX:VGS) and Vanguard All-World ex-US Shares ETF (ASX:VEU).

These ASX-listed ETFs fit the needs of the most investors looking to get broad exposure to the asset classes needed to form the core of a diversified portfolio.

However, now that investing in ETFs overseas has become more accessible for investors, it’s opened up a range of options for those looking at more niche offerings. In the US alone there are over 3,000 listed ETFs versus 200-odd ETFs listed in Australia.

For investors that are interested in purchasing an ETF listed on a global exchange there are several considerations, as we explore in this article.

Sector ETFs

Sector ETFs allow investors to buy into companies in a specific sector. For example, BetaShares Technology Asia Technology Tigers ETF (ASX: 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).

Income ETFs

If your primary objective is to generate income from your portfolio, consider income ETFs. There are a range of equity, fixed income, infrastructure, multi-asset income ETFs now available to investors.

Examples include the BlackRock Flexible Income ETF (ARCA:BINC), the BetaShares Global Income Leaders ETF (ASX:INCM) and the JPMorgan Equity Premium Income Active ETF (ASX:JEPI).

Thematic ETFs

The popularity of thematic ETFs has exploded in recent years, with investors lured in by the prospect of getting in on the next big thing - such as artificial intelligence or the electric vehicle revolution.

A thematic ETF offers investors exposure to a trend by holding a basket of investments exposed to that given theme.

These trends can be broad, such as the move towards energy transition, or hyper-niche areas like e-sports or the Metaverse.

However, investors should be aware as the lack of diversification thematic ETFs present creates investing risks. See ‘Thematic ETFs: Are they a good investment option?’ and 'Use caution when investing in a trend’ for more on how to use thematic ETFs in your portfolio.

Examples of thematic ETFs include the Global X Battery Tech & Lithium ETF (ASX:ACDC) and BetaShares Global Robotics and Artificial Intelligence ETF (ASX: RBTZ).

Bond ETFs

Exchange-traded funds focused on fixed-income securities can be excellent ways for investors to get exposure to bonds. Here are a few reasons: 

  • Many ETFs are transparent—they track indexes with very specific duration and credit-quality traits—and offer few surprises. 
  • The best ETFs are low-cost, which is even more important when investing in bonds than in stocks: Every extra point paid in expenses is one less point in return, and returns are typically tougher to come by with bonds than with stocks.  
  • ETFs are easy to buy and sell.

 Bond ETFs can be categorised into three main groups: core bond funds, short-term bond funds, and specialised bond funds.

Core bond funds such as the iShares Core Composite Bond ETF (ASX:IAF) invest in high quality, investment-grade bonds including government, corporate and securitised debt. Core bond funds are good choices to anchor the bond portion of an investor’s portfolio, assuming the goals for the money are more than five years away.

Short-term bond funds such as the Vanguard Short-Term Corporate Bond ETF (NASDAQ:VCSH) invest primarily in corporate and other investment-grade U.S. fixed-income issues and have durations of one to 3.5 years (or, if duration is unavailable, average effective maturities of one to four years). These portfolios are attractive to fairly conservative investors, because they are less sensitive to interest rates than portfolios with longer durations.

Specialised bond funds such as the JPMorgan Inflation Managed Bond ETF (BATS:JCPI) are what we’d call “satellite” holdings in a bond portfolio. In other words, they aren’t core holdings, but an investor might hold these ETFs to round out a bond portfolio, to make a tactical move, or to serve some other specialized interest.

Property ETFs

Property ETFs invest primarily in real estate investment trusts of various types. REITs are companies that develop and manage real estate properties. There are several different types of REITs, including retail, office and industrial REITs. Some portfolios in this category also invest in real estate operating companies.

Examples of property ETFs include the SPDR® S&P/ASX 200 Listed Property ETF (ASX:SLF) and the SPDR Dow Jones Global Real Estate ESG ETF (ASX:DJRE).

Sustainable ETFs

Investors seeking ETFs that align with their personal values relating to environmental, social and governance (ESG) factors, now have a range of options to choose from.

Sustainable ETFs such as the Vanguard Ethically Conscious International Shares ETF (ASX: VESG), exclude companies involved in alcohol, tobacco, adult entertainment, fossil fuels, gambling, weapons and nuclear power.

Currency ETFs

Currency ETFs such as the Betashares US Dollar ETF (ASX:USD) typically 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 ETFs 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.

ETFs now make it possible for individuals to gain direct exposure. For example, BetaShare's Crude Oil Index ETF-Currency Hedged (synthetic) (ASX: 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.

Alternative ETFs

Alternative ETFs let investors gain exposure to alternative asset classes and strategies such as managed futures, cryptocurrency, private equity, infrastructure, long-short equity and option writing.

Examples include the VanEck Bitcoin Strategy ETF (BATS:XBTF), and the Goldman Sachs Defensive Equity ETF (ARCA:GDEF).

Multi-asset ETFs

Multi-asset ETFs help investors gain access to a range of asset classes in a single trade and can be used to build complete portfolios.

There are a range of multi-asset ETFs available designed to suit different investor objectives and risk profiles.

Examples include the iShares Balanced ESG ETF (ASX:IBAL) and the Vanguard Diversified High Growth ETF (ASX: VDHG).

Physical vs Synthetically backed ETFs

A physical ETF replicates the performance of the index by physically holding all or part of the index constituents.

Meanwhile, a synthetic ETF replicates the performance of the index via swap agreements. This normally means that the synthetic ETFs hold a basket of securities which may not be related to the index they track. And what they do is exchange the performance of this basket for the performance of the index via a swap contract with a counterparty, which in most cases, is an investment bank.

Synthetic ETFs are exposed to counterparty risk, however they also benefit from lower costs, lower tracking errors and potential tax advantages.

ETF providers will explicitly disclose whether an ETF is physical or synthetic in their Product Disclosure Statement (PDS).

The VanEck Global Carbon Credits ETF Synthetic (ASX:XCO2) is an example of a synthetic ETF.

Find high quality ETFs faster

We recommend starting your selection process by reviewing a fund’s Morningstar Medalist Rating. This forward-looking, qualitative rating helps investors find funds that are likely to outperform their peers over a full market cycle, after accounting for fees and risk, through a market cycle.

Medals (Gold, Silver, and Bronze) indicate that analysts expect an ETF to outperform its peers over a full market cycle; Neutral and Negative ratings mean that analysts aren’t confident in a fund’s ability to do so.

An ETF’s rating is based on an assessment of the fund managers’ approach to their investment strategy (Process), the individuals who manage the fund (People), and the asset manager that offers the fund (Parent). These pillar assessments also account for other factors like Price and Performance.

See Best Rated Medallist ETFs

See our best rated ETFs inside Morningstar Investor. Sign up for a FREE 4-week trial^ to see medallist active, passive, Australia, international, income, sustainable, property, emerging market, equity, fixed interest and infrastructure ETFs.

Best Rated Medallist ETFs

ETF Screener

Screen our database of over 300 ETFs to find investments that meet your criteria. Filter by Morningstar Medalist rating, management style, yield, total cost ratio and more. Sign up for a FREE 4-week trial^ of Morningstar Investor now to access our premium ETF screener.

ETF Screener

Buying and selling ETFs

How to choose a broker

Like shares, ETFs are sold via financial professionals known as brokers who will take your order and execute the trade on your behalf. Online trading has made buying ETFs simple. You can do the whole thing from your smartphone.

But with tens of brokers on the market, how do you know which one to choose? Every broker offers a different level of service, priced accordingly, and you must choose the one that best suits your needs. The best platform for you might not be the best platform for someone else.

Broadly speaking, there are two types of brokers:

1. Full-service brokers – before there were smartphones and high-speed internet, broking typically happened over the phone. You'd call up your broker, chat to them about what you wanted to trade; they would offer advice (for a fee) and execute your trade on the market.

Full-service brokerages such as this still exist and offer advice on security selection, provide research, access to new investment opportunities like initial product offerings, and advise on portfolio construction. A good broker will also contact you if something big has changed in your portfolio, or if they spot an opportunity. However, all this comes at a price. Commissions for full-service brokers are much higher than online brokers.

2. Online discount brokers – Online brokers – or share-trading platforms – allow you to execute the trade yourself. They offer simple, online, no-frills access to ETF trading. The major banks have broking websites that allow you to use the funds in your bank account to buy ETFs. Several non-bank brokers such as Interactive Brokers, IG Markets, CMC Markets, SelfWealth and Bell Direct compete with the big banks with offers of better service at cheaper rates.

Although the service is much cheaper than using a full-service broker, you may need to separately buy investment insight and research to give you guidance about which ETFs to purchase. Some discount brokers now offer services such as portfolio management, market data, reporting tools and research for an additional fee.

In this article, we'll focus on choosing an online broker.

Investment Options

Before you set up an account, consider what you plan to invest in. Once you know that, focus on those firms that have the broadest array of that investment type at the lowest possible cost.

For example, you may invest heavily in certain international markets, and want a broker who can provide you with access to them.

Trading Commissions

Consider the charges you'll pay to buy and sell. Bear in mind your own trading style because that will determine how much importance to place on trading commissions.

If you're a frequent trader, you'll want to find the cheapest price out there. (Just be sure to stay attuned to whether you're actually adding or subtracting value with that frenetic strategy.)

But if you plan to keep it simple and just let your investments ride, then commissions may not matter as much. Other considerations, such as breadth of the investment line up and ongoing account fees should be more important.

Account size also plays a role when determining the importance of commission rates. The smaller your trade, the more significant any commissions will be, in percentage terms.


In addition to fees to trade securities, be sure to read the fine print to identify any additional charges. These fees can run the gamut--maintenance, activation, monthly fees, custodial fees, conversion fees, transfer-out fees, as well as inactivity and termination fees. Keep in mind, too, that some discount brokerages charge a fee for dividend reinvestment.

Share ownership

Most brokers offer CHESS Sponsored ETFs. This means that when you trade ETFs, the exchange has a record of you owning those ETFs directly. This is tracked via your unique Holder Identification Number. However, some brokers operate under a custodian model, meaning that they hold the ETFs on your behalf.

User Interface

Online brokerage firms may allow you to print out portfolio reports to view your account balance as well as any realized and unrealised gains, and dividend records. If the firm offers online trading and/or a mobile trading platform, make sure that it is easy to use and navigate. For those who aren't as technologically savvy, it may be counterproductive to sign up with online brokerage firms that boast a ton of bells and whistles but require some tech-savvy to manoeuvre.

Buying ETFs as an individual, company or trust

Tax is part and parcel of investing and making profit and income. It is also a large determinant of your total return outcomes, as it can take away almost half of the return from investments.

Superannuation is one of the most tax effective ways of investing and saving for retirement. What about investors who have investments for goals outside of retirement?

Outside of investing as an individual, there are two main vehicles that you can invest through that have differing tax implications – trusts and companies. Deciding which vehicle to invest in can have major ongoing cost and tax implications. The major differences to consider before deciding to invest in a different vehicle are explored below.


This structure is simply putting your investments under your own name and paying personal income tax and capital gains.

This structure is relatively straight forward and requires you to include your investment income and capital gains in your tax return annually. The amount that you pay will be determined by where you sit on the marginal tax rate ladder.

Investing as an individual gives you limited to no flexibility to redistribute income, which is one of the main benefits of a trust structure. You are able to seek a tax professional for income tax advice, but you are also able to be a self-advised individual which involves no cost or set up fees.


A trust is a person or organisation that holds assets for the benefit of beneficiaries.

Trust structures can help redistribute income, and therefore tax obligations, amongst multiple people. The most common use of trusts is for families, where income from investments can be distributed to lower income earners.

For example, there are four people in a trust. There are two high income earners on the highest marginal tax rate, and two individuals who are full time students with no income. The investment income would be better redistributed across all trust members.

Although it can distribute income, it cannot distribute any losses. The only way that these losses can be distributed is by offsetting them against gains. These losses can be offset in the same year, or carried forward to offset against future income.

Trusts can still utilise the 50% capital gains tax discount after holding an asset for 12 months.

To set up a trust, you would in most instances seek the advice of a tax professional. Trusts have set up costs, administration costs and ongoing costs.


Investment companies are also known as ‘bucket’ companies. The major difference of setting up a company is that it is a distinct, separate entity. The profits and debts that are held by the company in the process of investing do not become the profits and debts of the individuals.

The tax rate is also 25% or 30% (dependent on circumstances), which is preferable to the higher marginal tax rates. The main circumstances that determine whether you are eligible for the 25% tax rate are:

the company’s aggregated turnover for the income year is less than $50 million; and

80% or less of the company’s assessable income for the year is ‘base rate entity passive income’.

We encourage long-term investing over trading. Long term investors will receive the 30% tax rate for companies.

Companies are not eligible for a CGT discount like individuals and trusts.

To set up a company, you would seek the advice of a tax professional. Companies have initial set up costs, ongoing advice and administration costs.

Sometimes, investors utilise a structure with both a trust and a company. Trusts can own the shares in an investment company, and this allows flexibility for the on flow of income/profit to all trust members. This is not just useful for a case where there are large disparities in income and therefore tax rate. It can be especially useful for individuals who may have career breaks due to caring responsibilities where income may be redistributed.

The other case is when the trust distributes profits to the company, and the company pays the 25% or 30% tax rate. This cash is then used to invest in assets, and can provide franked income in the future.










Set up costs 








Ongoing administration 


Yes, can be undertaken by yourself 


Yes, usually undertaken by a professional 


Yes, usually undertaken by a professional 


Ongoing costs 


Yes, minimal 






Tax rates 


Income tax rate 


Distributed to beneficiaries who pay their income tax rate 


Company tax rates 


Legal entity 




Not a separate legal entity 


Separate Legal Entity 




Personal liability 


Personal Liability 


Limited liability 


ETF distributions

ETFs do not technically pay dividends and instead provide investors with distributions. The difference in terminology has implications.

A distribution includes any dividends generated by the underlying shares held in an equity ETF. It also includes any capital gains generated from selling appreciated assets held in the ETF.

There are several scenarios where capital gains can be generated in an ETF.

In an active ETF where a portfolio manager is responsible for making buy and sell decisions it can happen based on those decisions.

In a traditional passive ETF that follows a broad index it can happen when there are index changes.

For example, if an ETF follows the ASX 200 it will invest in the 200 largest companies in Australia as measured by market capitalisation. If the 201st largest company becomes more valuable than the 200th the index will change and the ETF will follow suit.

These changes do occur, but the impact is generally muted because these broad indexes are market capitalisation weighted. That means the smallest positions are the ones that are often moving into and out of the index.

The place that investors can run into trouble when selecting ETFs for their distribution yield is with ETFs that don’t track broad based indexes, such as thematic ETFs and factor ETFs. These ETFs likely change holdings more frequently and are more likely to have rebalancing. These changes can trigger capital gains in rising markets.

Some investors may argue that this doesn’t matter. A distribution is after all cash that is deposited in your account and the tax treatment in Australia between dividends and capital gains is the same.

However, many investors use an income investing strategy because they want - or need - to spend the cash generated by their portfolio.

Since the capital gains component can swing wildly based on market performance using certain types of ETFs in your income portfolio is problematic.

As market conditions change the expected income from some ETFs may fail to materialise and there may be more volatility in income from even sound strategies.

ETF fees, expenses & costs

Exchange traded fund managers charges fees and costs to cover expenses associated with running their business (for example, staff costs, rent, and technology) and the costs of operating the fund (for example, legal fees, audit fees, and custodian fees). It also normally includes a profit margin.

Here are some common numbers you will find in an ETF prospectus:

  • Gross Expense Ratio - The gross expense ratio is the percentage of fund assets expected to be paid over a year for operating expenses, management fees, and interest and dividend expenses. 
  • Net expense ratio - The net expense ratio takes the gross expense ratio and removes any contractual fee waivers and reimbursements.

Not all types of transaction costs are required to be reported in the expense ratio. For example, portfolio transaction fees, or brokerage costs, as well as initial or deferred sales charges are not included in the expense ratio.

It is possible for two funds to obtain substantially similar economic exposures using different instruments with different consequences for their expense ratios. This means they aren’t an especially helpful tool for comparing ETFs.

For example, ETFs that short physical securities or enter reverse-repurchase agreement transactions are required to report interest expense, whereas ETFs that employ futures, swaps, TBAs, and forwards are not required to report the cost associated with those instruments as interest expenses.

Morningstar’s Total Cost Ratio (TCR) helps investors make meaningful comparisons. It is a single figure encompassing the total nondiscretionary fees and costs (“fees”) associated with managing a fund in Australia.

The TCR includes management or investment fees, performance fees, administration fees and any other fees for underlying funds or similarly outsourced fee arrangements.

There are two versions of the TCR:

1. Prospective TCR represents the forward-looking fees published in a Product Disclosure Statement.

2. Realised TCR represents the actual fees charged over the course of the financial year, as seen in a financial statement.

The Prospective TCR is best applied for assessing the fees that investors are likely to be charged, whereas the Realised TCR is best applied to research the historical experience of investors in the fund.

Why ETF fees matter

Investment management fees are charged regardless of how the fund performs. It is in investors’ interest that the asset manager is able to cover their costs—especially salaries for good staff—and remain solvent.

However, it is important that fees are kept as low as possible for investors. Let’s look at two hypothetical funds to fully understand what a difference a high investment management fee can make to your return over 30 years.

ETF Fees

In this example, a 0.5% different in fees changes the final outcome by over $87,000 of your initial investment amount.

Fees can make a material difference to the ultimate outcome, so it definitely pays to be aware of them.

Why do ETF expense ratios vary?

Fees on actively managed funds are typically higher across the board. The difference between active and passive investment management fee rates is largely due to the costs associated with investment research staff and, in some cases, what the manager thinks it can get away with charging based on past success or effective distribution networks.

If the fund's asset base is small, its expense ratio can be high because the fund must pay these various costs from this smaller asset base. Conversely, as the net assets of the fund grow, the expense ratio should ideally decrease as costs are spread across the wider base.

Fees also tend to vary depending on the asset class—funds investing in defensive assets are generally cheaper than those investing in growth assets.

Emerging markets typically have very high investment fees. As with small companies, there is a diverse and fragmented opportunity set and the markets are also geographically vast, complex (politically and culturally), and generally more expensive to trade in. For active managers, covering this takes substantial time and resources, and you would expect your emerging-markets manager to have a global team, either with staff located around the emerging markets or prepared for frequent travel—both of which can be expensive.

A fund with a more complex investment strategy may also charge a higher investment management fee.

How the price of an ETF is determined

Morningstar uses Net Asset Value (NAV) Per Share to reference the price of an ETF unit.

NAV is the complete value of an investment after expensing its liabilities from its assets. Liabilities include management fees, salary expenses, and other costs associated with managing a mutual fund or unit investment trust.

To calculate Net Asset Value Per Share, we divide the NAV figure by the number of outstanding shares. The end value represents the current market value of each ETF unit.

Because ETFs are traded on an exchange like stocks, their market price can be above NAV (trading at a premium) or below NAV (trading at a discount).

How are my funds safeguarded in an ETF?

Many legal protections, regulatory bodies and safeguards help to ensure your funds in ETFs are protected from misappropriation. When you invest with a professional manager, your funds are held with an independent third-party custodian, instead of directly with the manager. Custodians offer a level of separation between your funds and the professional manager, so you can be confident the funds are unlikely to be misappropriated.

An example of this is iShares S&P 500 ETF (ASX:IVV). If you invest in this ETF, your funds are held in custody with their chosen custodian – J.P Morgan Chase Bank. They hold the assets on behalf of BlackRock (iShares) and satisfies the regulatory requirements for keeping your money safe.