A beginners guide to understanding ETFs

If you like the idea of investing in a lot of listed shares at low cost, with a modest investment outlay, and the potential to achieve good returns, you owe it to yourself to check out what are called ETFs (Exchange Trade Funds).

One of the greatest financial innovations to come to market in the last 20 years, an ETF is essentially a basket of shares. When you buy an ETF, you’re typically buying a microscopic version of a particular share market index.

What an ETF is designed to do is track the price movement of a basket of shares on either a local or international share markets.

How they work

If you invest $500 in an ETF that’s linked to a certain (share market) index, like Australia’s S&P/ASX 200 Index, your $500 is split up to ‘fully replicate’ ( ~mirror) the largest 200 companies on the Australian Securities Exchange (aka the ASX). How much of your $500 is invested in each underlying company (~aka a listed stock) depends on the weighting of each stock on the actual S&P/ASX 200 Index.

For example, if biotech giant CSL Ltd accounts for 10 percent of the S&P/ASX 200 Index by market capitalisation (~ how much the company’s listed share are worth), then 10 percent of your $500 is invested in this stock, and so on according to the weighting of the other 199 stocks on this index.

Low cost, diversification and tax breaks

You may also wish consider buying an ETF that instead of passively tracking the performance of a share market index, tracks either currency exchange rates, asset classes (like property, bonds and shares), or the price of a single commodity. You can also invest in ETFs that are focused on certain sectors or an investment strategy theme, for example, like Australian growth stocks, ethical stocks, Asian tech-stocks, cybersecurity or healthcare sectors - to name a few.

Regardless of which ETF you choose, they expose you to a much broader spread of stocks - that would be too expensive to buy individually - and without you needing to have overseas or multiple trading accounts. The costs associated with ETFs tend to be substantially lower than actively managed funds, most of which constantly fail to beat the index.

Another good feature of ETFs is that you know what the price (~ based on net asset value) is in real-time and you can decide to buy and/or sell your ETFs, without entry or exit fees, any time the share market’s open. This is usually referred to as having good liquidity.

As an investor in ETFs, you’ll also receive valuable tax breaks under the capital gains tax (CGT) discount rules. Then there are indirect advantages including franking credits that flow through to investors directly via the quarterly distributions.

How can you invest in ETFs?

As listed entities on the ASX, ETFs can be bought or sold just like any other listed company. Alternatively, you can open an investment account with InvestSMART which will buy and professionally manage an InvestSMART ETF Portfolio of your choice for you.

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Frequently Asked Questions about this Article…

What is an ETF and how does it work?

An ETF, or Exchange Traded Fund, is a financial product that represents a basket of shares. When you invest in an ETF, you're essentially buying a small portion of a share market index, like the S&P/ASX 200. Your investment is spread across the companies in the index according to their market capitalization.

Why are ETFs considered a good investment option for beginners?

ETFs are popular among beginners because they offer low-cost diversification, allowing you to invest in a wide range of stocks without needing multiple trading accounts. They also provide real-time pricing and liquidity, meaning you can buy or sell them anytime the market is open.

What types of ETFs can I invest in?

You can invest in ETFs that track share market indices, currency exchange rates, asset classes like property and bonds, or even specific sectors such as Australian growth stocks, ethical stocks, or Asian tech-stocks. There are also ETFs focused on investment strategy themes like cybersecurity or healthcare.

How do ETFs provide tax benefits?

ETFs offer tax advantages through capital gains tax (CGT) discount rules. Additionally, investors can benefit from franking credits that are passed on through quarterly distributions, potentially reducing your overall tax liability.

How can I buy or sell ETFs?

ETFs can be bought or sold on the ASX just like any other listed company. You can also open an investment account with platforms like InvestSMART, which can manage an ETF portfolio for you.

What are the cost benefits of investing in ETFs?

ETFs generally have lower costs compared to actively managed funds, which often struggle to outperform the index. This makes ETFs a cost-effective way to gain exposure to a diversified portfolio of stocks.

What does it mean for an ETF to have good liquidity?

Good liquidity in ETFs means you can easily buy or sell them at their current market price without incurring entry or exit fees. This flexibility allows you to react quickly to market changes.

Can ETFs track assets other than stocks?

Yes, ETFs can track a variety of assets beyond stocks, including currency exchange rates, commodities, and different asset classes like property and bonds. This allows investors to diversify their portfolios across different types of investments.