If you want to learn how to invest, you’ll need to know about index funds and what it means to invest in ETFs.
In Australia, there are about 200 different ETFs you can buy on the ASX. There are so many options when it comes to investing in ETFs. For beginners, this can be a daunting task.
Because just like this hilarious iShares advert shows, not all nuggets are the equal…
This article answers whether we can actually say what the best ETFs in Australia are. And which ones are the most popular.
We’ll also talk about what happens to your voting powers when you buy ETFs instead of individual shares, why ETFs may or may not be a good fit for you and the one hidden cost of ETFs that your average Jane investor doesn’t know she paid.
- What are ETFs
- Are ETFs good for beginners
- Four fascinating facts you should know about ETFs
- Why are so many people investing in ETFs (pros)
- What are the downsides of investing in ETFs (cons)
- What are the risks of investing in ETFs
- Types of ETFs
- How to choose the best ETF
- What are the best ETFs in Australia
- Top three facts about ETFs revealed (summary)
What are ETFs?
An ETF is an investment asset that allows you to buy a collection of stocks, bonds or other assets in one bundle, kind of like a goodies hamper. You don’t actually own the stocks, but you own a share in the basket that carries them.
Now you know why I chose a set of packed lunches as the cover image.
It is a “fund”, because it pools the money of multiple investors, just like how you would team up with friends to bulk buy at Costco.
It is “exchange-traded”, because it can be publicly bought and sold on stock exchanges (unlike hedge funds and private equity funds).
Are ETFs good for beginners?
Maybe you aren’t sure which stocks to buy or where to start. Buying ETFs allows you to invest in the market without having to put more time or effort into learning about individual stocks.
For example, if you invest in technology ETFs in Australia, you are investing in the growth of the top companies in the Australian technology sector without having to research or buy each company’s stock individually.
ETFs are popular amongst beginners and seasoned investors alike because they are a quick, easy and cheap way to diversify your portfolio.
This sounds like a great deal, right? Or also like a ready-made frozen meal from Coles.
At this point, you might be thinking of googling “how to invest in ETFs”. For beginners, it’s tempting to want to jump headfirst into the blossoming world of ETFs.
But even if you are an investing newbie, I want to give you the whole story first. Especially if you care about your shareholder voting rights or want to avoid investing in specific companies or industries (e.g. coal mining).
And you know, ETFs aren’t risk-free either. As with any investable asset often the risk stems more from an investor’s lack of knowledge rather than the asset itself! Fancy that.
Just how popular are ETFs?
The aggregate value of all goods and services produced in Australia during 2021 was US$1.37 trillion. That’s surely a mind-boggling number (or should I say mind-bogling?)
But by the end of 2021, the value of assets under management in all global ETFs topped US$10 trillion.
Again to put this into perspective, consider that the total value by market capitalisation of all the companies on all the world’s stock exchanges was measured at roughly US$95 trillion in November 2020 according to CNBC.
What about the number of ETFs?
Back in 2003, Statista reported that there used to be just 276 ETF that existed globally. Since then, the number has mushroomed to a staggering 8,552 ETFs in 2021!
That’s like having 8,552 different types of gift hampers for you to choose from. It would give even the keenest shopaholic decision paralysis.
So it’s safe to say that the growth in ETFs has been staggering considering they’ve really only been popularised in the last 20 years.
Damn, who invented ETFs?
The ingenious concept of ETFs was brought to light by Vanguard founder and mutual fund manager, John “Jack” Bogle, back in the 1970s.
By lowering the costs to index investing, he essentially democratised access to diversified share investments for the masses. He’s that friend who organises a group shopping trip to Costco. Thanks Jack for making investing so much cheaper and more accessible!
And the first ETF ever created tracked the S&P 500 index.
Who makes ETFs?
You may have heard of Vanguard, BlackRock (iShares), BetaShares or ETF Securities, VanEck, Fidelity, Magellan, or Russell Investment.
They like to put their names at the front of the ETF name. They are some of the most popular ETF providers in Australia and for some of them, globally as well.
The ‘Big Three’ asset management firms are BlackRock, Vanguard and State Street. Collectively, they manage the assets of more than 80% of the American ETF market alone. That’s a whopper!
Others include Schwab, Fidelity, Invesco, VanEck and more.
Should you buy the Vanguard ETF or the BetaShares one?
I hear this question a lot from family and friends. Like, which fund issuer is better?
Instead of focussing only on the fund issuer, most of them are massive global companies in their own right, you’d do better comparing the various facts about the ETFs themselves.
Hopefully, you shop for clothes in the same way.
Don’t look at the brand label, assessing the quality of the garment is what counts.
Four fascinating facts you should know about ETFs
1. ETFs are structured as unit trusts
When you invest in ETFs, you don’t own the underlying investments. You own units in the ETF. The ETF issuer (e.g. Vanguard) holds and manages the assets in the trust on your behalf.
You can buy shares in a company. You can buy units in a trust.
If you buy an ETF this makes you a unitholder, not a shareholder.
Why are the semantics important? Because your voting rights and power as a unitholder are not the same as if you were a shareholder.
2. ETFs are commonly weighted by market capitalisation
This means that the largest company will have a heavier impact on the performance and net asset value (NAV) of the ETF than the smallest indexed company.
The market capitalisation of a company is the market price of its shares multiplied by the number of shares held by all investors (often called shares outstanding).
3. ETFs can be active or passive. Which will you buy?
As long as you know the difference, mate 🙂 By active or passive, we’re talking about the investing strategy of the ETF.
- Passive means the ETF aims to track the performance of a benchmark or index of securities.
- Active means the ETF provider or asset manager is intentionally trying to beat the market average returns.
Index ETFs usually have lower management fees and historically have outperformed active fund managers, because passive investing is a kind of “buy and hold” strategy.
When people say “ETF”, they are often referring specifically to passive ETFs that track an index. But not all ETFs are passive or physically-backed.
4. ETFs can be physically-backed or synthetic
- Physically-backed ETFs hold all (or a subset) of the shares that are on the index in the ETF trust itself.
- Synthetic ETFs are ETFs that have undergone plastic surgery to look like the real thing. They hold some of the underlying assets of the index/class in the trust, then use swaps to replicate the rest. Swaps are a type of financial contract that allow the ETF provider to mimic the movements of an index or asset class without having to buy the actual investments (as they would for a physically-backed ETF).
You’ll be able to tell whether an ETF is synthetic, because it will have the word ‘synthetic’ in its name.
Synthetic ETFs have one important risk you should be aware of: the counterparty in the swap agreement can fail (counterparty default risk). So most people just stick to physically-backed ETFs, which should be most of the ETFs out there anyway.
My brain does this weird association thing, where I can’t help but visualise prosthetic legs every time I see the words “synthetic ETF”. Does anyone else have this problem?
Why are so many people investing in ETFs?
- Historically higher returns compared to an active strategy: It is common knowledge that most active fund managers (e.g. hedge funds, active ETFs) underperform the market in the long-run. Slow and steady wins the race.
- Diversification: This is one of the key benefits to investing in ETFs. It relieves the stress of picking a winner. Why bet on one horse when you can buy the whole house?
- Automatic balancing: “set-and-forget” since the proportions of the components are kept in check by the ETF issuer.
- Easily bought: it is easy to access via stock exchanges, and minimum investment amounts are very low compared to exclusive hedge funds, etc.
- Cheap management fees: ETF management expense ratios can be anywhere from 0-1% per annum, whereas the average US mutual fund charges around 1.42% plus performance dependent fees.
- Transparent: Compared with mutual funds or index funds, you’ll always be able to know what the underlying value of all the assets are in the ETF, because you can look up its net asset value at any time of the day.
- Efficient brokerage costs: ETFs buy and sell stocks in bulk quantities. You pay brokerage fees on one ETF trade instead of on hundreds of stocks if you were to buy them yourself.
- Access to more markets: ETFs also enable you to access companies or assets in overseas markets or that would otherwise be tricky or expensive to invest in if you tried buying each share individually.
- Greater liquidity: Statista estimates the value of assets globally in ETFs totalled roughly USD 7.74 trillion in 2020.
What are the downsides of investing in ETFs?
- Still exposed to broad risks: It won’t diversify away all your risk. You may still be exposed to sector, market, country, currency or interest rate risk depending on the type of ETF.
- Less control over company directives: If you want a say in some of the business decisions a company makes, you won’t be able to exercise the voting rights you would normally have if you were a direct shareholder in the company, because you own the ETF itself and not the underlying stock holdings.
- Less control over tax consequences: Automatic trades done to match an index or rebalance the ETF’s overall holdings will trigger capital gains on the sale of the underlying assets. This is separate to the capital gains tax you have to pay when you sell your ETF shares.
If you hold the individual shares in your own name, you control when you buy and when you sell. This is advantageous if making full use of the 50% capital gains discount is part of your long-term strategy.
- Beware of double-ups: Investing simultaneously in an S&P500 ETF and an Information Technology ETF will duplicate your exposure to companies or sub-industries that are present in both funds
- Watch out for tracking errors: Circumstantial factors such as low asset liquidity, fees or taxes can cause ‘slippage’ in the price of an ETF where it diverges from the value of the underlying index or assets. You could end up overpaying for what you are actually getting in the trust.
What are the risks of investing in ETFs?
While all investments carry risk, risks specific to ETFs are tied to the nature of the assets held in the ETF and the structure of the ETF. Here are a few of them (but not all):
Market risk is when movements in the value of securities and assets make the ETF price also go up and down – like a little boat bobbing in the ocean.
Although an ETF may hold many assets in its basket, a significant proportion of its holdings may be concentrated in certain industries, sectors or geographies. People often forget this.
Risks or adverse events that only affect a certain sector or industry are called sector risk or industry risk.
For example, you own an ETF holding 500 stocks in horse cart companies and then the automobile gets invented.
How about some realistic examples?
Take some of the most popular indices:
- The 200 largest companies by market capitalisation listed on the ASX (ASX200)
- The 100 largest companies by market capitalisation listed on the Nasdaq exchange (NDX)
- The 500 largest companies by market capitalisation listed on stock exchanges across the US (S&P 500)
These breakdowns are very revealing.
We can now see more than half of the companies on Nasdaq-100 index are in the technology industry alone! It is heavily skewed towards only a handful of industries when compared with the more diverse S&P 500 index.
That’s why people say the Nasdaq is a tech-heavy index.
Similarly, this pie chart shows us that if you bought an ETF tracking the ASX200 index, half of your funds would go towards buying financials and materials companies.
So this would include the Big Four banks (ANZ, CBA, NAB and Westpac), as well as the large mining companies (BHP, Rio Tinto, Fortescue Metals, etc.).
An Australian market-based index such as the ASX200 generally reflects the make-up of the sectors that power Australia’s economy.
In other words, by investing in an ASX200 index ETF, you are buying into the future growth of the Australian economy.
What other types of concentration risk are there?
When it comes to geographic concentration for example, an emerging markets bond ETF will be exposed to interest rate risk via movements in the interest rates of thechoose countries that the bonds were issued.
Concentration risk can also happen at your portfolio level.
You might buy multiple ETFs with overlapping holdings. And this could overexpose you to certain types of securities beyond your comfort level.
If you owned an NDX index ETF and a global technology sector ETF in your portfolio, I’m certain they would both own Apple, Amazon, Google, Netflix, Nvidia and Facebook shares.
Currency risk will affect your ETF if it follows an index or group of assets with international securities in it and your ETF is unhedged.
This is because international stocks are often traded in the currency that the business operates in or the currency of the country in which it’s listed on a stock exchange.
On the other hand, a hedged ETF allows you to invest in international assets without the currency risk.
This means the ETF asset manager also spends some time trading promises with other entities that have the desired currency to “lock in” the exchange rate so that the value of your ETF investment in Australian dollars is unaffected by currency movements.
When we’re talking about ETFs, shareholder risk is where the ETF provider does not vote in line with what you would have voted for if you had bought the shares in your own name instead.
This is because when you are a shareholder in a company, you get:
- A claim over the company’s future profits in proportion to your share of ownership
- A say in how the company is run. Certain managerial decisions are voted on by shareholders (e.g. executive compensation packages or how the company intends to manage climate and ESG risks)
In an ETF, your would-be voting rights are managed by the ETF provider via voting proxies.
And this is exactly why I laughed when Charlie Munger says that we are turning BlackRock CEO Larry Fink into the pope.
If there are only a few buyers and sellers in the market for a particular ETF, it will be hard for brokers to pair up buy orders with sell orders. This could result in large discrepancies in the bid/ask spread (more on this below).
This is when the price of the ETF diverges from the aggregate price of its underlying components. This could be explained by the management and rebalancing fees, hedging costs or taxes paid on dividends. It results in a difference between the ETF’s performance and the index’s performance.
Types of ETFs
Fixed income ETFs
Fixed income investments provide a regular income stream and usually offer capital stability. By fixed income securities, we are usually talking about bonds.
Bonds are “fixed income” assets, because every three to six months they pay you a set dollar amount (called a ‘coupon’).
Older people especially like them, because the regular income stream is handy in retirement. Also the relatively stable nature of good quality bonds helps ensure there are no heart attacks, um I mean wild swings in the value of the large honey pot you have spent your working life accumulating.
When you hold an ETF of bonds, you can still only call yourself an ETF unitholder. You are not a bondholder. A bond portfolio ETF won’t have a maturity date or a quoted face value compared to if you bought a bond directly.
Bond ETFs can be handy because bond performance tends to be negatively correlated with equities. So the price fluctuations of a bond versus a share are less likely to move in lockstep than a share versus another share.
The risk-return profile of a bond or a bond ETF depends on who originally issued the bonds (in exchange for borrowing your money). The issuer could be a government, a semi-government organisation or a company that has issued bonds.
The price of a bond ETF is determined by everything that affects the price of the underlying bonds. This includes things like the creditworthiness of the bond issuers, what people think interest rates will be in the future and how frequently the bonds pay out coupons.
These are ETFs that hold a bunch of stocks in a particular sector of the economy. Think technology, healthcare, infrastructure, or natural resources. People buy sector ETFs if they think it will perform better than the broader economy.
International ETFs only hold shares in international companies.
Just like what we talked about with currency risk, international ETFs can be currency hedged or unhedged.
Exchange rate fluctuations on an unhedged ETF will either boost or depress your returns/losses depending on which direction the FX winds are blowing at the points in time when you buy and sell.
If you have a mixed ETF bag of stocks from different countries, then the FX risk will equate to a basket of currencies in which underlying ETF assets are listed.
As an Australian investor, you won’t be able to reinvest dividends automatically on international shares or ETFs holding international equities that are not domiciled in Australia (even if they are listed on the ASX).
Instead, you’ll have to manually purchase additional shares with the cash dividends and pay brokerage fees each time, so not the most efficient.
But you obviously won’t face this problem if you are buying international shares or ETFs that don’t pay out their earnings to shareholders in dividends.
That said, any distributions you do receive are taxed as foreign sourced income.
Keep all your documentation for your international holdings in a place you won’t forget, because you can often claim a withholding tax offset in your tax return. This is because the tax authorities around the world have worked out intergovernmental agreements to prevent your money from being taxed twice as it makes its way to you.
For example, when you buy US shares or US-based ETFs, your stock broker should prompt you to fill out a W-8BEN form to tell the US government that you aren’t a US resident.
Then you’ll be able to get your US withholding tax rate reduced from the usual 30% to 15%. It’s basically a deal that the ATO has negotiated with the US tax office on your behalf.
These are raw products like wheat, barley, sugar, coffee, Iron ore, copper or gold. Since most global commodities are traded in USD, you will often be exposed to FX risk on commodity-based ETFs.
You can of course mitigate this by picking a hedged ETF, but you’ll pay in the form of higher management fees.
Diversified portfolio ETFs
These are a combo set of different asset classes in one fund. The McHappy Meal of ETFs.
They function as a portfolio in themselves, so they are as ready made as they come.
It’s like going for those 350g meal packs instead of a mixed veggie bag in the frozen section of the supermarket.
Just as there are different packs for butter chicken, singapore noodles or cottage pie, diversified portfolio ETFs differ in their objectives and investment make-up.
Some come with the standard inclusion of carbs and protein (i.e. equities and bonds).
A.K.A. trendy ETFs.
Thematic ETFs effectively allow you to make economic bets on a certain trend or industry you think will perform well in the future.
Hot topics in today’s ETF magazines include ESG plays, electric vehicles, artificial intelligence, biotechnology, Chinese internet companies, clean energy, robotics, batteries and many more.
Many of these play to three ETF megatrends spruiked by global asset managers that you definitely should try not to get hyped up about as an investor.
Bear in mind that thematic ETFs are usually narrow in scope. Many people add them to their portfolio as a satellite holding, but you can be heavily exposed to sector risk.
How does one fit different types of ETFs into a portfolio?
There are many ways to structure your share portfolio. To give some examples:
- You could have a super simple portfolio of only one ETF. These are called diversified portfolio ETFs.
- You could go with a three ETF mix – one for Australian shares, one for international shares and one for bonds (e.g. an ASX200 ETF, an ETF of the World MSCI index and a global bond ETF).
- Or if you want to have a core/satellite portfolio, you could have a modest handful of ETFs as your core holdings, and a small percentage of shares in individual companies you strongly believe in or align with your investing values.
How to choose the best ETF
For beginners, important factors to look for in an ETF include the top holdings, assets under management, management expense ratio, bid/ask spread, investment theme, geographic and sector composition, as well as an Environmental, Social, and Governance (ESG) rating.
Each fund issuer will have a fact sheet or a Product Disclosure Statement (PDS) with these details for each ETF on their website.
There is no such thing as the best ETF unless you have a crystal ball.
Here’s what you’ll need to know to evaluate an ETF:
- Top holdings: The holdings or top constituents section will tell you which and how much of each kind of securities the fund owns.
- Assets under management (AUM): Solid ETFs have a large value of assets under management and a long history. This means the fund has greater liquidity in terms of daily trading volumes and generally a smaller spread between bid and ask prices.
- Management expense ratio (MER): This is the percentage of the fund’s assets that are deducted as a fee each year. It is already factored into the ETF price, so it doesn’t feel like you pay this out of pocket. It’s like shipping costs that are already factored into the price of your frozen veggie mix.
If you are picking between three ETFs that all track the top 200 companies listed on the ASX, then all other costs equal, a cheaper MER is better. The MER on passive ETFs will range from 0.1% to 1%, but is generally around 0.3% per annum.
You probably know that you have to pay brokerage fees and the MER if you want to buy an ETF. But the bid/ask spread is an additional hidden cost most people don’t realise they end up paying, because it’s baked into the market price of the ETF.
These spread costs usually aren’t a big problem if you’re buying an ETF that is popular and that has a high AUM figure. That’s because there are hundreds and thousands of buyers and sellers for the ETF that create a liquid and efficient market for it.
- Geography: How diversified or concentrated are the top constituent holdings in a given country or region?
- Sector: How diversified or concentrated are the top constituent holdings in a given industry or sector?
- ESG rating: A score of the Environmental, Social and Governance characteristics of a fund’s underlying holdings that enables you to make investment decisions based on your personal values. Comparing between ETF providers is notoriously difficult, because they all have different ESG scoring methodologies.
Where can I find a list of ETFs in Australia?
MarketIndex has a neat list of ASX-listed ETFs grouped by ETF type.
How to invest in ETFs in Australia?
In Australia (or anywhere in the world), the process is the same as buying regular shares.
Here’s how it works.
You’ll need to open a brokerage account with an Australian stock broker, transfer funds into your new account once it is set up, then enter the ETF ticker into the search bar. Like a vending machine!
Then enter the amount of units you want to buy or the dollar value you want to invest and decide how you want your broker to execute the order (e.g. market order, limit order, etc.).
Afterwards, you’ll get some emails that say “order placed” and later, “trade confirmed” once your order has been matched with a buyer/seller on the other side.
You can also buy ETFs via full-service brokers or robo advisers. It’s less effort on your part, but also less control.
Here’s a good tip.
If you want to buy international ETFs from Australia (say, you’re looking at ETFs that are only traded on overseas stock markets), make sure you pick a broker that gives you access to the markets you want to invest in.
And remember, as an Australian investor, you won’t be able to participate in dividend reinvestment programs (DRIPs or DRPs) on international shares or ETFs that are domiciled overseas.
You might also be exposed to fluctuations in foreign exchange rates if the ETF trades in a foreign currency (e.g. USD) and it isn’t hedged.
Here’s another juicy tip.
If you arrive too early to a farmer’s market, you’ll find the stalls are still busy setting up. If you rock up too late, you’ll find there won’t be much goods left to pick from.
The same principles apply to ETFs or any types of stocks, bonds or tradable assets. Finance people call this “market liquidity”. So when you want to buy or sell an ETF at market prices, try aiming for the middle chunk of the trading day to minimise the bid/ask spread you pay.
What are the best ETFs in Australia?
There is no such thing as the “best ETF” for everyone.
It depends on your portfolio strategy, which in turn should be designed around the long-term objectives you are setting out to achieve by investing. It also comes down to how well you understand the nature of the underlying companies/products that the ETF is investing in.
|Ticker||ETF name||What’s in it||AUM (AUD)||MER (p.a.)||5-year returns||10-year returns||Returns since inception|
|VAS||Vanguard Australian Shares Index ETF||300 largest stocks on ASX||$11.05 bn||0.10%||8.95%||10.24%||9.21%|
|VDHG||Vanguard Diversified High Growth Index ETF||~90% mixed shares, ~10% fixed income (e.g. bonds)||$6.53 bn||0.27%||N/A||N/A||7.95%|
|VGS||Vanguard MSCI Index International Shares ETF||Tracks MSCI World ex-Australia index in AUD||$4.57 bn||0.18%||11.50%||N/A||11.59%|
|IVV||iShares S&P 500 ETF||500 largest US stocks on S&P 500 index in AUD||$4.60 bn||0.04%||13.95%||17.72%||5.70%|
|VTS||Vanguard U.S. Total Market Shares Index ETF||Tracks CRSP US Total Market Index in USD||$2.87 bn||0.03%||13.52%||17.43%||14.95%|
|A200||BetaShares Australia 200 ETF||200 largest stocks on ASX||$2.07 bn||0.07%||N/A||N/A||8.55%|
|NDQ||Betashares Nasdaq 100 ETF||100 largest non-financial companies on Nasdaq exchange in USD||US$2.17 bn||0.48%||18.15%||N/A||17.68%|
|VEU||Vanguard All-World ex-U.S. Shares Index ETF||Tracks FTSE All-World ex US Index in USD||US$36.8 bn||0.07%||5.47%||9.98%||7.18%|
|VHY||Vanguard Australian Shares High Yield ETF||Tracks FTSE Australia High Dividend Yield Index||$2.34 bn||0.25%||8.36%||9.95%||9.05%|
|DHHF||BetaShares Diversified All Growth ETF||It owns a bunch of other index ETFs on the ASX and global exchanges, totalling around 8,000 equities.||$154 mn||0.19%||N/A||N/A||7.92%|
What is the Vanguard Australian Shares index fund?
It’s clear when we compare the assets under management (AUM) in the table that the Vanguard Australian Shares index fund (VAS) is one of the most popular Australian ETFs on the ASX. It has relatively low management fees and has had respectable performance over various periods.
It’s top five holdings are mining giant BHP, biotech company CSL and basically three of the Big Four Australian banks. Together, these five holdings comprise over a third of the ETF.
But don’t just go for an ETF because it’s popular with everyone else. That would make you a lemming.
Do your own research and choose it on your own terms. Don’t be a lemming.
And remember folks, just like the turkeys that get fed every day in the lead-up to Christmas and don’t suspect a thing come 25th December, past performance is not an indication of future returns.
So the top three facts about ETFs have been revealed…
ETFs are probably the cheapest way to diversify your investment portfolio. They have the potential to put you in cruise mode and lower risk compared to picking individual stocks, so long as you’ve done your homework and don’t trade using your animal brain.
But now you also know that:
- As an ETF investor, you don’t own the shares in the ETF
- Buying an ETF doesn’t always put your portfolio diversification on autopilot
- VAS, VDHG and VGS are three of the most popular ETFs that Aussie investors are buying
Featured image credits: Olya Kobruseva