ETFs, short for exchange-traded funds, are investment funds that trade on a stock exchange. They can let you invest in a basket of assets in a single transaction, often with lower management fees than actively managed funds and with some diversification, depending on what the ETF holds.
We're going to get into the nitty-gritty, but a simple way to think about ETFs is to compare them to a Spotify playlist.
An ETF is like a playlist made up of particular investments that have to meet certain criteria to earn their place, such as being part of the same industry, reaching a particular market cap, or sharing another characteristic. Think of it as listening to a pre-made Top 40 playlist, or hits of the 90s, or — a favourite around our office — the Divorced Dads Playlist. (Really.) Investing in an ETF is like pressing play once and listening to all the songs. Buying your own stocks would be like finding, choosing, and playing each song one by one.
This article contains general information only and doesn't take into account your objectives, financial situation or needs. Before investing, consider the relevant PDS and TMD and seek financial advice if appropriate.
Now let's dive a little deeper.
In this guide:
- What is an ETF?
- How do ETFs work?
- Why do people invest in ETFs?
- ETFs vs stocks vs managed funds
- What are the risks of investing in ETFs?
- How to invest in ETFs in Australia
- Other ways to diversify your investments
- Frequently asked questions
What is an ETF?
ETF stands for exchange-traded fund. It's an investment fund, which means it's a collection of assets, that you can buy and sell on a stock exchange, similar to shares. You invest in the performance of this fund as a whole, rather than the individual assets, such as shares, commodities, or bonds, that might make it up.
How do ETFs work?
ETFs start with an ETF manager who creates the fund based on what they want the fund to include. Typically, they'll choose a specific sector or market index to track, for example the gold price or the largest companies in a particular country.
Once the ETF is created, the ETF manager will list it on its relevant stock exchange so investors can buy and sell it. For example, ETFs that track the S&P/ASX 200 Index, which represents around 200 of the largest companies listed on the ASX, are available to investors through the Australian Securities Exchange (ASX).
Investors purchase units of the fund, each representing a portion of everything the ETF is made up of.
Behind the scenes, the ETF issuers and market makers help keep the ETF's trading price close to the value of the assets it holds. However, an ETF can still trade slightly above or below that value, especially during volatile markets or when the underlying assets are harder to trade.
In general, because ETFs are traded on stock exchanges, their prices update multiple times per day.
Why do people invest in ETFs?
In general, it can be cheaper to hold a 'basket' of assets as a collective than to buy and sell those things individually. If we go back to our playlist analogy: it's easier to play Top 40 songs than to create your own playlist.
ETFs also give investors access to assets that have traditionally been a bit trickier to trade. For example, instead of buying gold bullion, or shares in a gold mine, investors can buy into a gold ETF that tracks that performance as a whole.
ETF management fees can also be lower than those of many actively managed funds.
ETFs vs stocks vs managed funds
ETFs are just one of many investment choices individual investors have. So what makes someone choose one over alternatives such as managed funds and individual stocks?
Some of the biggest differences between ETFs, stocks, and managed funds include who picks them, why they pick them, and how often the price updates.
Let's take a closer look.
| Feature | Shares (stocks) | ETFs | Managed funds |
|---|---|---|---|
| What you own | A piece of a single company | Units in an investment fund | Units in an investment fund |
| How you buy it | On a stock exchange using an app or broker | On a stock exchange using an app or broker | Directly from the fund manager, through their app or another platform |
| Active or passive? | Depends on your individual strategy | Often passive, but some are actively managed | Can be active or passive, depending on the fund |
| Fees | Generally, brokerage on each trade | Brokerage plus a management fee | Management fees and other costs may apply |
| Price updates | Continually during market hours | Continually during market hours | Generally once per business day |
Fees are only one consideration. Each product has different risks, features, and tax treatments, and it's worth reading the relevant PDS and TMD before deciding what's right for you.
In general, managed funds have a team of investors buying and selling the assets that go into them based on their investment thesis. For example, at Spaceship, the Spaceship Voyager investment team buys and sells stocks for the Spaceship Voyager portfolios based on the PDS and TMD.
Managed funds don't tend to be traded on stock exchanges, and their prices get updated once per day. The price of a managed fund unit is a reflection of the value of the assets that make it up.
So, if an ETF is like a top 40 playlist, a managed fund is like a handpicked mixtape, and a stock is like an individual song.
Interested in exploring the differences in more depth? Here's a Spaceship Learn breakdown of stocks vs shares vs managed funds.
What are the risks of investing in ETFs?
All investing comes with risk.
Examples of risks specific to ETF investing include:
- Market risk — If the broader market your ETF tracks falls, the value of your ETF is likely to go down with it. For example, if the US stock market falls, an ETF tracking the S&P 500 will fall too.
- Currency risk — If you invest in an ETF that invests in international assets, a change in the exchange rate between the two currencies will impact the value of your investment. For example, let's say you bought an ETF in Australian dollars, but the underlying assets are US based. If the Australian dollar increases against the US dollar, the value of your ETF could fall in value.
- Liquidity risk — If you can't sell your ETF for a fair price. For example, let's say there aren't enough orders to buy the ETF you're trying to sell. While many ETFs are actively traded, others have low turnover, making buying and selling them for a fair price harder.
- Tracking risk — An ETF may not perfectly match the performance of the index, commodity or asset it aims to track. Fees, trading costs and market conditions can all affect returns.
- Concentration risk — Some ETFs may appear diversified but still have heavy exposure to a small number of companies, sectors, countries or currencies.
Keep in mind, diversification can reduce some risks but doesn't eliminate them.
Before investing, make sure you read your prospective ETF's PDS and TMD closely so you can make sure it suits your goals, financial situation, and needs. Consider seeking personal financial advice if you need to.
How to invest in ETFs in Australia
If you decide you want to invest in an ETF, here are some general steps you might follow. This is not a recommendation to invest in ETFs.
1. Research and narrow down your options
The first step to investing in ETFs is to figure out the type of ETF you want to invest in.
Here are some common ones:
- Equity funds: These are generally made up of shares, and track indexes or sectors. Examples of these include the Vanguard MSCI International Shares ETF (VGS) and the Vanguard S&P 500 ETF. These are examples only and are not recommendations.
- Fixed-income funds: These are generally made up of bonds and debt securities. They may provide income, but they still carry risks, including interest-rate risk, credit risk and market risk.
- Commodity funds: These are generally made up of investments in raw materials and primary agricultural products, and can include assets such as gold, silver, oil, and gas.
2. Choose your ETF
Once you know what the ETF landscape looks like, the next step is to make a choice.
One way to do this could be to assess your shortlist against considerations such as:
- Your personal investment goals, such as what types of investments you want in your portfolio
- Your risk appetite, such as whether you want low, balanced, or high risk options
- Your investment horizon, which is how long you expect to hold your investment
- Fees, which will vary according to the fund you buy, and the way you access it
3. Beware of the risks
Like all investments, ETFs aren't risk-free, though they can offer benefits that lower your risk, such as diversification.
4. Find a broker or investment platform
When you've identified the ETF you wish to purchase, it's time to find a way to invest in it.
Some funds let you invest with them directly. Others are only available for buying and selling on the stock market. This means you need to find a stockbroker or investing service that will allow you to make investments that meet your needs.
If you're unsure of an offer, check to see if they're on MoneySmart's Investor Alert List. It won't guarantee your investment safety, but it does show you which sites may be missing the licences or permission required to offer investments in Australia.
Other ways to diversify your investments
If you're interested in investing in multiple companies in one go, but aren't sure if ETFs are for you, another option you have is a managed fund.
Managed funds are similar to ETFs in that one unit will buy exposure to a collection of assets; however they'll be chosen based on the preferences of the fund manager.
For example, the Spaceship Universe Portfolio is made up of companies the Spaceship Voyager Investment Team thinks align with the Where the World is Going (WWG) methodology while meeting other requirements. Every investment has risk and returns aren't guaranteed.
Frequently asked questions
What does ETF stand for?
ETF stands for exchange-traded fund, which means it's an investment fund traded on a stock exchange.
What's an ETF in simple terms?
In simple terms, an ETF is a collection of investments you can buy and sell on a stock exchange in one transaction. Buying one unit will gain you exposure to everything the fund holds.
What are ETFs and how do they work?
ETFs pool your money with other investors' money to buy a collection of diversified assets. The fund is listed on a stock exchange and other investors can trade it. The price of the ETF depends on the value of everything it holds.
Are ETFs good for beginners?
ETFs can be lower cost and more easily accessed than other types of investments. They can also offer instant diversification. However, all investments come with risk and whether it's a good choice for you will depend on your personal circumstances.
What's the difference between an ETF and a managed fund?
Both ETFs and managed funds are pooled funds: while ETFs are bought and sold on stock exchanges, managed funds tend to be directly bought from the fund manager and are more often actively managed.
What is a Vanguard ETF?
Vanguard is a large ETF provider. A Vanguard ETF is an ETF issued by Vanguard. Australian examples include the Vanguard Australian Shares Index ETF (VAS) and the Vanguard MSCI Index International Shares ETF (VGS).
Can you lose money in an ETF?
All investing comes with risk, including the risk that you'll lose money. The best way to protect yourself is to do your research, have an investment plan, and only make investments in assets that align with your personal circumstances, including risk tolerance and desired timeframe.
What is a hedged ETF?
A hedged ETF is structured to reduce the impact of currency fluctuations on the unit price. They typically include international assets that can otherwise be impacted by exchange rate movements.
