Exchange Traded Funds (ETFs)
The ETF industry is growing, both locally and overseas, and there are many benefits, risks and considerations to keep in mind when trading an Exchange Traded Fund
What are ETFs?
An exchange-traded fund (ETF) is an open-ended investment fund that is listed on an exchange. They are one of the fastest growing categories of investment products because they can simply be traded like a share and are a quick and cost-effective alternative to implementing investment strategies.
ETFs are available for a broad range of assets including equities (Australian and global), fixed income, currencies and commodities. There are also multi-asset solutions that offer exposures based on risk profile.
Most ETFs closely track the performance of an index or asset class and are referred to as passive ETFs. There are also active ETFs (or exchange traded managed funds) that seek to outperform an index and deliver a return that exceeds a specified benchmark.
ETFs can also be classified into ‘physical’ and ‘synthetic’. A physical ETF will hold all, or a sample of, the underlying securities of an index, whereas synthetic ETFs will often use derivatives (e.g. options, swaps, futures) to replicate the performance of a particular asset or index.
Nuts & Bolts of ETFs
Discover the world of Exchange Traded Funds
The Australian ETF market has accelerated in recent years as investors have shifted toward an asset allocation focus, with total assets under management rising to almost $100 billion since 2004. The Australian ETF market, when compared with US, Europe and Asia, is still relatively small. Like its global counterparts however, most products are equity-focused, while fixed income, commodity and currency ETFs account for a relatively smaller share (figure 2). Currently, there are more than 200 exchange-traded funds and exchange-traded managed funds.
ETFs can be bought and sold on an exchange during market hours like ordinary shares. Unlike shares, however, they do not list on the exchange via an initial public offering. Rather, ETFs rely on a creation/redemption mechanism. Understanding how this mechanism works is the key to understanding the benefits and potential risks of ETFs.
The ETF market has three primary participants including:
- ETF issuers: Fund manager which manages the ETF and its underlying securities such as Vanguard, State Street, iShares, etc.
- Authorised participants (AP): Generally institutions that have been authorised to create and redeem units in ETFs.
- Market makers: Providers of liquidity by facilitating trades on the secondary market.
To trade an ETF, a buy order can be placed into the market through a broker. This buy order can be executed by matching it against a sell order. Typically, these trades will be facilitated by market makers who are required to provide quotes throughout the day.
At this point, the ETF issuer is not involved in the transaction at all. The ETF issuer does not know that you have bought the units, nor does it receive any funds to invest. Units simply transfer in the secondary market from one investor (the seller) to another (the buyer) and go through a securities exchange two-day settlement process.
However, a scenario may arise where there is no ready seller in the secondary market, and demand exceeds what is currently available to trade. In this situation, market makers can request the creation of new units by authorised participants. To create new units, an AP enters the market and buys the underlying securities in the creation basket at the percentages according to the underlying benchmark. The AP then delivers this basket of securities to the ETF issuer in exchange for an equivalent value of units in the ETF. The market maker then acquires these ETF units from the AP, and then proceeds to offer them on the market.
The same process is reversed for redemptions. That is, if the AP has a block of ETF shares to sell, they will receive a basket of underlying securities, from the ETF issuer to sell, and the funds raised are used to redeem the ETF. This ability to create and redeem units when there are demand and supply imbalances ensures the fund trades close to its fair value and not driven by demand and supply imbalances.
Several factors influence an ETF’s price, including the movements of the underlying securities, currency movements and investors’ demand for the ETF. The ETF issuer calculates and publishes the ETF’s net asset value (NAV) daily, while some funds provide “indicated NAVs or iNAVs which are intraday fair value estimates of an ETF. The published NAV is based on the underlying securities’ closing market prices, minus the ETF’s fees.
Occasionally, mispricing in the market may occur. For example, if there are many more buyers than sellers, the price of the ETF can go up by more than the value of the underlying securities. This could create an arbitrage opportunity for market makers and APs, as they can purchase the underlying securities and create new shares of the ETF at fair value while selling them to investors at a price above this. Therefore, market makers play a crucial role in the functioning of ETF markets helping to keep the market price of the ETF remains anchored to its NAV.
Australian investors have been enthusiastic adopters of ETFs, with a number of benefits:
- Lower cost: Management fees can be significantly lower than other forms of professionally managed investments or buying the underlying assets directly.
- Intraday liquidity: Liquidity of an ETF on the secondary market is typically a function of the underlying securities. The existence of market markers and APs ensures there is an additional layer of liquidity in the primary market via the creation/redemption process. Unlike managed funds, the provision of intraday liquidity means you can trade throughout the day.
- Diversification: Cost-effective way to diversify portfolios across asset classes by allowing an investor to buy a basket of securities in a single trade. ETFs have broadened the spectrum of available asset classes and offers access to more difficult to access market such as bonds and commodities.
- Flexibility: Can be traded during market hours and settled two business days after you execute a trade.
- Transparency: ETFs publish the NAV daily on the ASX, allowing investors to see where the ETF’s market price is trading relative to its estimated fair value. Information regarding the fees, holdings, and returns can be accessed anytime via the fund manager’s website.
- Tax: ETFs are relatively more tax-effective than actively managed funds as they tend to have lower portfolio turnover which often minimises the capital gains generated on the portfolio.
It is important to understand that ETFs do not provide guaranteed returns and different risks apply to each fund. Investors should always read the associated product disclosure statement carefully to ensure they understand how the relevant product operates. Investors must to be aware of risks such as:
- Tracking error: This is how closely an ETF replicates the performance of the underlying benchmark. Fees, taxes, and transaction costs can cause a divergence between the performance of the ETF’s unit price (or NAV) and the underlying index.
- Liquidity: Most ETFs demonstrate healthy levels of liquidity, although periods of market stress could see liquidity evaporate as market makers may not be willing to provide pricing if they cannot reasonably estimate the value of the underlying holdings due to market volatility. Typically bid-ask spreads widen to reflect the market maker’s increased uncertainty and the higher risks associated with creating and redeeming units.
- Counterparty risk: This arises with synthetic replication strategies when the manager uses over-the-counter derivatives. To obtain the swap, the synthetic ETF issuer enters a swap agreement with a counterparty, which is often an investment bank. If the counterparty is unable to meet their obligations under the arrangement, this poses a risk to the value of your investment.
- Complexity: Some products may include complex features such as derivatives and leverage to enhance losses, but may exacerbate losses.
- Tax: It is important for investors to understand a fund’s tax treatment, especially if it’s exposed to commodity and currency markets. These funds are usually taxed differently than others.
- Timing: It is best to trade ETFs when the market of the underlying assets is also open. This is to ensure the market price or NAV is priced as closely to the underlying securities as possible. When the underlying market is closed, market makers may use futures contracts to estimate the fair value.
- International ETFs: ETFs that are domiciled overseas and made available for trading in Australia, may require completion of a W-8BEN form.
- Currency risk: Unless specified otherwise, most ETF products are unhedged which means investors are exposed to changes in currency moves.
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Exchange-traded instruments also known as Interest Rate Securities
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