Exchange Traded Funds.. an index listed on the market

From a portfolio construction perspective having Core portfolio exposure into a market sector which is not actively managed can be a good way to position your portfolio to take advantage of market movements.  You can then make strategic positions into specific companies or sectors of the market using more actively managed investments.  One way to achieve the core exposure is through an index fund and there are now exchange traded funds which provide access to market segments here in Australia and overseas.

Exchange traded funds or ETF’s as they are often called have opened up a new investment opportunity for investors worldwide.

The first fund that can be described as an ETF was launched in the US in 1993. Steady growth ensued and by 1997 total assets under management in ETFs approached US$8.2 billion.

Since then, the ETF market has taken off. The message of cost-effective, diversified investing has hit home, making ETFs an ideal vehicle for modern investment strategies. Globally ETF assets hit US$933 bn at the end of September 2009.

Check out www.ishares.com.au for more information.

Structure of ETF’s

ETFs are like open-ended managed funds which are listed and traded on major stock exchanges around the world. Similar to an index tracking pooled fund, an ETF seeks to reflect the performance of the chosen index. This is achieved through holding a diversified underlying basket of securities as represented by a particular index with, for example, a domestic or international focus.

The performance of an ETF generally corresponds to the price and yield performance, before fees and expenses, of a particular index sponsored by an independent index provider.

A distinct advantage ETF’s have over managed funds is that they trade like any other listed share. They can be bought and sold on the ASX, and can employ the same trading and investment strategies used with listed shares such as market, limit and stop orders, short sales and margin lending.

The Advantages

ETF’s are liquid. High or low demand for a fund is unlikely to affect its market price. If the demand for a fund rises, new baskets of securities can be created in the US. This process works in reverse if the demand should “fall”. This ensures the fund value and price only represent the prices of the shares it holds.

ETF’s are transparent aim to reflect the performance of an index, so you know what you are investing in. ETF’s disclose their holdings regularly so you can see exactly what you hold in your portfolio. Actively managed equity funds usually disclose holdings much less regularly.

ETF’s give you diversification. Rather than the higher risk strategy of concentrating your investment on a few individual companies, index investing gives you broader exposure to entire markets. This means you can still make targeted investments in your chosen areas – but with more risk control.

ETF’s are cost-effective. The cost of investing in ETF’s is generally less than in most actively managed equity funds and even some equity index funds. They are also more cost-effective than holding the same exposure via individual shares. To achieve the level of diversification a fund offers, you would normally have to buy a large number of individual shares, taking on the trading costs for each transaction.

ETF’s are flexible. They can be bought or sold just like shares, traded through investment adviser, brokerage or internet trading accounts. Because iShares are so flexible, institutional and individual investors are using them in a whole range of investment strategies.

The Limitations

Investment risk. As with all investment products there are the associated market, political, policy and investment risks that you need to be comfortable with before investing your money.

The same market risks exist for other investment opportunities so it is important to review your complete investment strategy to ensure you are taking risks you are comfortable with. If you want to review your strategy give Money Mechanics a call today.

Scott Malcolm (scott@money-mechanics.com.au) is Director of Money Mechanics (ph: 6257 5557) a fee for service advice firm who are authorised to provide financial advice through PATRON Financial Advice AFSL 307379.

 

The information provided on this article is of a general nature only. It has been prepared without taking into account your objectives, financial situation or needs.  Before acting on this information you should consider its appropriateness having regard to your own objectives, financial situation and needs.