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Exchange traded funds may trade like stocks, but under the hood they more resemble managed funds, which can vary greatly in terms of their underlying assets and investment goals. Similar to when you buy a car, you don’t need to know the full mechanics of how a car engine works, but it’s a good idea to know what engine the car has because it will impact performance and ongoing costs. And it’s the same with ETFs, you need to understand the engine, or structures used to build the ETF.
Index ETFs seek to replicate the performance of an underlying index, like the S&P/ASX 200. The vast majority of ETFs are index funds – also known as ‘passive’ funds – which typically trade less frequently and can therefore be more tax-efficient than traditional active managed funds.
Active ETFs seek to outperform a specific index – or achieve a specific outcome such as maximising income – by underweighting or overweighting certain securities relative to their index weighting. Both active and index ETFs are professionally managed, but active ETFs typically require more monitoring and trading by the portfolio managers, which can result in higher fees.
Equity ETFs invest in a basket of individual stocks. One of the largest equity ETFs is the iShares S&P 500 ETF (IVV), which aims to mimic the performance of the S&P 500. There are stock ETFs covering specific sectors, from technology and healthcare to consumer goods, as well as ETFs that provide exposure to international stocks, including regional, country-specific and sector-focused ETFs. In addition, there are equity ETFs that focus on size or a particular investing style, such as minimum volatility.
Bond ETFs, also known as fixed-income ETFs, provide investors access to thousands of bonds in a single trade. As with stock ETFs, bond ETFs trade on exchanges. Trading on exchanges provides greater liquidity, and transparency in pricing and execution, which is particularly beneficial to investors in the more opaque, over-the-counter bond markets.
Just like stock ETFs, bond ETFs come in a wide variety of flavours, or sub-sectors; these include Australian Government bonds and corporate bonds or international government debt, as well as specific sectors such as high yield corporate bonds, and emerging market debt.
Commodity ETFs track the price of physical assets such as gold, oil and wheat. Commodity prices are generally not highly related to prices for stocks and bonds. Commodities also tend to rise in tandem with inflation. For these reasons, investors often use exposure to commodities as a way to help diversify their portfolios, and to align with their views on inflation and the economic outlook.
Commodity ETFs offer convenient, affordable access to individual commodities such as gold or silver.
International ETFs provide investors exposure to stocks and bonds from individual countries, like China; regions such as Europe and Asia Pacific; and specific types of economies, including developed and emerging. As with domestic ETFs, international ETFs cover a broad range of specific sectors, investing strategies, factors and styles. Investing in international stocks and bonds can help investors reduce risk and potentially expose them to growth opportunities not available in Australian-only portfolios.
Sector ETFs offer investors exposure to a basket of companies in specific industries such as consumer staples or healthcare. Sector ETFs provide investors an opportunity to express their views on a particular industry while limiting their exposure to the risks of owning individual stocks.
There are two ways in which an ETF can gain exposure to the performance of the underlying assets. This can be achieved through physical or synthetic replication. Physical replication refers to gaining exposure to the performance of an underlying index by holding the underlying assets. And there are two types of physical ETFs – fully replicating and optimised. Those that hold all the underlying assets in proportion to their weightings in the index, are known as a fully replicating ETF.
Now, when we move into markets, like emerging markets or into the fixed income segment, it can be difficult to own all the underlying securities in an index. For example, many smaller stocks may be hard to trade, or the index may be made up of 1000s of underlying securities. Optimised ETFs are designed to track the underlying index as closely as possible without owning all the index constituents.
Synthetic exchange traded products (ETPs) on the other hand, don’t own the underlying assets and instead use derivative instruments, typically swaps, to replicate the index. This structure is generally used when it’s difficult to hold the underlying assets, for example, commodities including oil or wheat.
By using swaps, synthetic ETPs may introduce an additional layer of complexity and sometimes costs may not be transparent and may create a drag on performance. You need to be aware of these likely costs and potential risks when selecting synthetic ETPs.
Even though you may be investing in an index product, the choice of exposure you make is an active decision and will likely be a key driver of risk and return. This comes down to the most suitable index for your goals and understanding how an ETF is constructed and the associated benefits and risks.
This information has been provided by BlackRock Investment Management (Australia) Limited ABN 13 006 165 975, AFSL 230 523 (BIMAL) for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, us, we, our), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances. NAB doesn't guarantee the obligations or performance of its subsidiaries or the products or services its subsidiaries offer.
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