You’re not alone if you’re wondering how to invest in ETFs. The user-friendly investment instruments first became available in 1990, and despite rapidly growing to become a crucial sector of the investment industry, which is more than $10tn in size, they are still a relatively new proposition.
There are good reasons for the popularity of ETFs, not least that they are easy to understand and cost-effective, and at the same time, can generate impressive returns. These are the ways to use ETFs to help you achieve your investment goals.
How do ETFs work?
Exchange Traded Funds (ETFs) are investments that hold a basket of different assets such as stocks, bonds, and commodities. Those assets can be grouped by various factors so that with one click you buy a fund product with a common theme. The link between the assets in an ETF can include the sector in which they operate. Mining and energy stocks are examples.
Some ETFs focus on the characteristics of a type of instrument, for example, income stocks. Other ETFs, such as the one shown in the price chart below, might be determined by size, with the iShares Core S&P/ASX200 ETF being made up of large-cap stocks that form the ASX200 index.
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iShares Core S&P/ASX200 ETF 2017 – 2023
Source: IG
Each ETF is created and managed by a regulated investment company that is confident it will be able to sell it to retail investors who might be interested in a particular basket of assets. That manager will buy and sell individual assets in the market and bundle them into one product, an ETF, which investors can buy and sell.
Investment managers often benefit from favourable trading terms, which means trading costs associated with ETF products are relatively low compared to some other types of funds. Reporting is also transparent, and you can establish if an ETF is suitable for you by considering the term sheet of the fund that will outline its investment objective. The Blackrock website states:
The fund aims to provide investors with the performance of the S&P/ASX 200 Accumulation Index, before fees and expenses. The index is designed to measure the performance of the 200 largest Australian securities listed on the ASX.
The more aggressive Vanguard Diversified High Growth Index ETF has a different investment objective, stated below:
The [Vanguard Diversified High Growth Index] ETF provides low-cost access to a range of sector funds, offering broad diversification across multiple asset classes. The High Growth ETF invests mainly in growth assets and is designed for investors with a high tolerance for risk who are seeking long-term capital growth. The ETF targets a 10% allocation to income asset classes and a 90% allocation to growth asset classes.
ETFs are similar to ‘traditional’ mutual funds, but ETFs have the advantage that they can be traded in real-time. There is no need to wait for a month-end dealing day to decide if you want to increase or reduce the size of your investment. That makes the buying and selling process very similar to buying other assets such as stocks, bonds, or gold futures. Another way ETFs differ from mutual funds is that the profit and loss (P&L) on your ETF position will also update in real-time as the prices of its constituent parts fluctuate according to market forces.
Understanding how ETFs work is possibly best achieved by considering an example where you create your own. If you wanted to gain exposure to the largest 200 stocks listed on the Australian Stock Exchange, you could access the names of the firms and book 200 trades. If you wanted to go further and have your investment track the returns of the ASX index, you would weight your capital allocation according to the size of the stocks involved, with firms with larger market capitalisations receiving a more significant amount of your capital.
The alternative would be to buy an ASX200 ETF such as the iShares Core S&P/ASX200 ETF. With just one click of a mouse or tap of a screen, you’ll achieve your aim of investing in a product that tracks the index with just one trade. In that case, your broker will effectively book the individual trades for you. That can be more convenient and also more cost-effective. The expense ratio of the iShares Core S&P/ASX200 ETF is 0.05% per annum, which means that if you invest $10,000 AUD in the product, you will pay $5 AUD in annual management fees.
The cost-effective nature of ETFs is due to the investment process being ‘passive’. There is no intervention by an investment manager. No one intervenes to adjust the weighting given to positions, even if they think one instrument is likely to generate a better return than another. The fund manager will follow the stated terms of the ETF investment mandate, which can be easily accessed and analysed before investing in the fund.
The Pros and Cons of ETFs
With ETFs being such a promising investment proposition, there is some value in carrying out due diligence and checking the pros and cons of the instruments. The weighting given to these will vary from individual to individual; however, if you’re an investment beginner looking to buy ETFs, these are some of the commonly observed features of the instruments.
Pros
Diversification – ETFs allow you to gain exposure to a wide range of instruments with just one trade. The fact that diversification is an integral part of the process helps you diversify risk, minimise losses if one company’s share price collapses, and smooth out your trading returns.
Choice – The expansion of the market has resulted in an incredible range of ETFs being made available. You can invest in one sector, such as AI, bonds, commodities, small firms, large firms, and specific countries or regions.
Cost – ETF management fees and commissions are lower than ‘traditional’ funds. The average expense ratio of an equity ETF is 0.16% per annum, compared to 0.47% for stock mutual funds.
Liquidity – You can trade in and out of your ETF any time the markets are open for the instruments it contains. Should your circumstances or view of the macro outlook change, you can adjust your holdings and even liquidate your entire portfolio instantly.
Cons
Market risk – the price of any investment can go down as well as up. As the value of the ETF is determined by the value of its constituent parts, if those assets fall in value, so will the value of the ETF.
Passive management – ETFs track the market rather than try to beat it. If you want to engage the skills of experienced investors and have them guide your wealth, you will need to consider signing up to an actively managed fund.
How to Invest in ETFs
ETFs can be bought directly from the big financial institutions that manage them or via an online brokerage account. The latter option has the benefit of allowing ETFs from a variety of managers to be offered in the same place. That’s more convenient and can help you find the best pricing terms and conditions and reduce counterparty risk.
The similarities between ETF and stock trading extend to how trades are executed. If you’re using your brokerage account to buy ETFs, you’ll already know how the trading platform works. To purchase an ETF, simply navigate to the ETF section of the dashboard or look up ETFs using the search function, click on the ETF in which you want to invest, and when you go to the monitor relating to that instrument, book a ‘buy’ trade on the execution monitor. The act of selling ETFs is similarly straightforward, with the only difference being that before you click on the ‘sell’ button, you’ll have to visit the portfolio section of the platform where open positions are reported.
The low management fees associated with ETFs have already been mentioned, and some brokers also offer commission-free ETF trading. In that situation, the broker makes their revenue from the difference between the bid and offer prices they offer to the market.
The Best Australian ETF Brokers
Once you’ve decided to invest in ETFs, the next task is finding a reputable broker that fits your trading style. All the firms below have embraced the ETF revolution and offer trading in a broad range of instruments from a wide range of fund managers. That means that you can, through one account, create a diversified portfolio of cost-effective holdings that provide you with exposure to the markets in which you want to invest.
How are ETFs taxed in Australia?
When considering taxation of ETF proceeds, it is helpful to break the subject down into income and capital gains terms and to remember there is a difference between the fund’s tax liability and the investors. Regarding income distributions, most Australian-listed ETFs don’t pay tax – they just pass any dividend income on to investors, and the investors pay tax according to their personal situation. Franking credits are also passed through; they are not taxed when held in the fund, but individuals may have a tax liability when those franking credits are paid at distribution time.
If you’re holding a position in an ASX200 ETF and the mining and banking stocks it is comprised of pay fully franked and healthy dividends, investors who have held that position at each distribution point during the tax year ended will likely receive franking credits in their tax return.
The fact that financial and resource sector stocks dominate the domestic stock market might leave you considering buying overseas stocks to gain exposure to different sectors such as tech or pharmaceuticals. The trading income of domestic and overseas firms is taxed at source, and in almost every jurisdiction, a company has to pay a corporate tax rate on any income earned.
After that point, there is a divergence between Australian and non-Australian companies regarding how profits converted into dividend payments to investors are treated. Overseas investments are not included under the dividend imputation scheme, so Australian investors don’t receive franking credits on those positions. Any corporate tax paid cannot be offset or recouped.
The view taken by the Australian Tax Office that any investment income you earn in or out of the country must be taxed is matched by tax authorities in other jurisdictions with the same policy. That can result in double taxation. In the US, for example, dividends are subject to a 15% withholding tax. It might be possible to use your foreign tax offset allowance in a case where withholding tax is applied in the company’s country of origin, with that tax credit being able to be offset against the Australian tax payable on foreign income.
Some countries, such as the UK, don’t impose a withholding tax, which simplifies the situation and highlights how carrying out additional research specific to your circumstances can improve your investment returns. You might also establish that there are some potential tax advantages of the ETF system which apply to you. One example is that if Australian company taxes are already paid by them within an ETF, investors don’t need to pay those taxes again at the personal level.
When the time comes to sell your ETF position, you could be liable for capital gains tax on any profits. Regarding CGT, there is no difference between how returns are treated on international and Australian investments. Your CGT discount, which applies to investments held for more than 12 months, still applies. Once again, more research might be needed, especially if the overseas country you have invested in has applied a form of CGT on your investment, as you may be eligible for an offset.
Final Thoughts
There are justifiable reasons why the total amount of cash invested in ETFs has grown almost ten-fold in ten years. You still need to pick the right instrument, but the cost-effective and convenient nature of the instruments means there is a place for ETFs in most portfolios.
