7 Questions to Ask Before Investing in ETF Investing
Since State Street developed the first US listed ETF in 1993, ETFs have boomed to over 8,000 funds with more than US$5.2 trillion in assets1.
ETFs offer efficient, cost-effective access to the performance of most of the world’s listed investment markets, with market-wide diversification.
ETFs help bring asset allocation strategies to life with physically-backed exposures across local and global markets and sectors.
As investors increasingly look to ETFs as a foundation for their investment portfolios, we answer 7 key questions to consider when investing in ETFs.
1. What is an ETF?
An ETF (exchange traded fund) is a pooled investment vehicle with shares that can be bought or sold throughout the day on a stock exchange at the prevailing market price.
There are many types of ETFs, including those that invest in: indexes, market sector indexes, active strategies, smart beta strategies, themes, factors, physical assets (like real estate and infrastructure), among many others.
ETFs issue shares that can be traded on the stock exchanges where they are listed—each share of an ETF represents an interest in the underlying assets of the fund. Most ETFs are regulated; this provides investor protections, such as oversight by an independent board of directors, and the requirement that fund assets be held separately from the assets of the adviser, among many others.
2. What Kinds of ETFs are Available?
ETFs cover every asset class and almost every global market. With ETFs, investors can also access almost any investment strategy, such as:
index-based strategies that seek to replicate market performance
active strategies that seek to outperform market performance, long-only strategies
geared (or leveraged) strategies
real asset investing (like real estate and infrastructure)
hedged and un-hedged approaches
blended multi-market or multi-asset approaches
sector focused strategies
socially responsible screening
and many others, including combinations of the above.
However, the majority of ETFs are index-based, that is, they are designed to track the performance of a designated index.
3. What Should I Know Before Investing in an ETF?
ETFs follow a wide range of investment strategies and objectives. Understanding the basics is critical, such as: What the ETF seeks to achieve, against what benchmark, and how this will be achieved, what assets it will buy to achieve this, and what risks the ETF takes to generate performance.
What Does the ETF Seek to Achieve?
Index-based ETFs typically seek to track the performance of an index. How these indexes are constructed matters to the performance of the ETFs tracking them. For example, an index might weight its holdings equally; by market capitalisation; by dividends; or through many other mechanisms.
Actively managed ETFs seek to outperform a particular benchmark or index by making active decisions to accept and reject securities and assets, rather than invest in the overall market.
What Assets Does the ETF Buy to Achieve its Objectives?
You should also assess how the ETF seeks to achieve its investment strategy. For both index and active approaches, what assets will it buy to replicate the index performance (index), or outperform the index performance (active).
An ETF may invest in the underlying securities in the index it tracks, known as physically-backed ETFs. Alternatively, it may invest in a representative sample of securities in the index. Some ETFs may also employ derivative instruments to track an index, rather than the underlying securities or assets. The chosen approach may affect how well the ETF tracks the index (tracking difference), and its overall risks.
What Risks Are Associated with the ETF?
Like all investments, ETFs are subject to risk. The principal risks are typically those associated with the ETF’s investment objective, and the assets it acquires to meet these objectives. Risks can also include currency, interest rates, the impact of economic growth, and other factors that impact the market, and the assets.
One risk of index-based strategies is tracking error (the difference between the return of the ETF and the return of the index it tracks) —more on this in Question 6.
Another risk for all ETFs is premium/discount volatility (that is, disparity between the market price of ETF shares, and the market value of the underlying assets — net asset value or NAV). Disparity can occur because shares are traded on the exchange, and temporary sentiment and market volatility can drive prices beyond NAV. However, with most ETFs the price should usually correct again towards NAV over time. The longer the investment term generally, the less relevant these types of movements are for the investor.
4. How do Investors use ETFs?
Investors use ETFs in a wide variety of ways, such as:
to build diversified portfolios
investing for long-term compound returns
in core-satellite portfolio strategies
to add market (beta) exposures to your portfolio
to implement regular investment plans
for asset allocation
to diversify your return and risk sources
reduce portfolio concentration
5. What are the Costs Associated with Investing in an ETF?
Management fees are the cost the asset manager charges for managing the ETF, typically a percentage fee per annum, charged monthly.
Fund Operating Expenses
Like managed funds, there are additional expenses to the management fee with ETFs such as advisory services, administration, and recordkeeping, among other things. These fees are also commonly called an “expense ratio” and are expressed as a percentage of fund assets and paid annually.
Because ETFs are exchange-traded, investors must buy and sell ETFs through a broker, who typically charges a commission for this service.
When buying or selling ETF shares on the secondary market, there is typically a difference between the highest price a buyer is willing to pay for an ETF share (the “bid”), and the lowest price a seller will accept to sell an ETF share (the “ask”). Bid/ask spreads are typically lower for larger ETFs and those that are heavily traded and/or highly liquid.
The Costs of Frequent Trading
While it is easy to understand costs for buying and holding an ETF for the long term, when investors trade ETFs more regularly, they incur additional costs—trading costs. Trading costs are not actual costs and expenses in the design of ETFs, but rather, the impact from outside costs on the returns an investor achieves.
The types of costs outside of the ETF that can reduce returns include broker commissions and costs from excess trading in ETF shares, implied costs when selling at prices that are below NAV, or buying at prices above NAV, the impact of exchange rates on regular traders, costs that come from attempting to time the market by buying in and out of an ETF—investors who switch in and out investments in an attempt to time the market create compounding costs that act as a drag on overall investment returns.
6. How can an ETF Performance be Evaluated Against its Benchmark?
While past performance is not an indication of how an ETF may perform in the future, an investor may wish to evaluate an ETF’s performance against its stated objective or benchmark.
For an index-based ETF, performance is measured against its benchmark by the ETF’s tracking difference (which shows how closely it has been able to replicate the benchmark).
For an actively managed ETF, an investor might look at how the ETF has performed, based on the outperformance objective and the benchmark.
Tracking Difference or Error
Tracking difference (sometimes call tracking error) is the extent to which the ETF’s return deviates from the return of its benchmark index. Tracking difference can be influenced by a number of factors, such as how an ETF seeks to track the index (that is, whether it invests in every security in the index or in a representative sample of securities in the index), the ETF’s operating expenses, and how the manager handles index rebalancing and corporate actions.
Tracking difference is the actual difference between the performance of the ETF and its benchmark. Tracking error is this difference expressed in standard deviations.
7. How Do Investors Buy and Sell ETFs?
Most investors buy and sell ETFs on the stock market at a market-determined price, typically trading through a brokerage account, just like trading a stock.
As with buying and selling shares, there are two basic options when trading ETF shares: market orders and limit orders.
A market order is an order to buy or sell a security at the best available price, at the price that has been created on the market by the supply and demand. Generally, this type of order will be executed immediately. Although placing a market order usually ensures that a trade will be executed, the price at which the order will be executed is not guaranteed to be an optimal price. It is important for investors to remember that the last-traded price is not necessarily the price at which a market order will be executed.
A limit order is an order to buy or sell a security at a specific limit price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. A limit order is not guaranteed to execute. A limit order can only be filled if the security’s market price reaches the limit price, with the right amount of stock demand to meet your trade. While limit orders do not guarantee execution, they allow the investor to control the price at which they are willing to buy or sell.
Liquidity refers to how easily shares can be bought or sold without moving the market for those shares. Securities with high trading volumes are generally considered more liquid.
ETF liquidity should be considered with respect to both the ETF shares and the underlying securities the ETF holds. Highly liquid ETFs and ETFs that have highly liquid underlying securities (even if the ETF shares do not have high trading volumes) typically have narrower bid/ask spreads than ETFs that trade less or hold less liquid securities.
Issued by State Street Global Advisors, Australia Services Limited (AFSL Number 274900, ABN 16 108 671 441) ("SSGA, ASL"). Registered office: Level 14, 420 George Street, Sydney, NSW 2000, Australia · Telephone: 612 9240-7600 · Web: www.ssga.com.
State Street Global Advisors, Australia Services Limited (ASL) (AFSL Number 274900, ABN 16 108 671 441) is the issuer of interests and the Responsible Entity for the ETFs which are Australian registered managed investment schemes quoted on the AQUA market of the ASX or listed on the ASX. This material is general information only and does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. You should seek professional advice and consider the product disclosure document, available at www.ssga.com/au, before deciding whether to acquire or continue to hold units in an ETF. This material should not be considered a solicitation to buy or sell a security. ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETF's net asset value. ETFs typically invest by sampling an index, holding a range of securities that, in the aggregate, approximates the full index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. Investing involves risk including the risk of loss of principal. Diversification does not ensure a profit or guarantee against loss. Holdings and sectors shown are as of the date indicated and are subject to change. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future. Sector ETF products are also subject to sector risk and non-diversification risk, which generally results in greater price fluctuations than the overall market. SPDR and Standard & Poor's® S&P® indices are trademarks of Standard & Poor's Financial Services LLC and have been licensed for use by State Street Corporation. The Dow Jones Global Select Real Estate Securities Index is a product of S&P Dow Jones Indices LLC and has been licensed for use by State Street Global Advisors, ASL. MSCI indices, the property of MSCI, Inc. ("MSCI"), and ASX®, a registered trademark of ASX Operations Pty Limited, have been licensed for use by State Street Global Advisors, ASL. SPDR products are not sponsored, endorsed, sold or promoted by any of these entities and none of these entities bear any liability with respect to the ETFs or make any representation, warranty or condition regarding the advisability of buying, selling or holding units in the ETFs issued by State Street Global Advisors, ASL. State Street Global Advisors Trust Company (ARBN 619 273 817) is the trustee of, and the issuer of interests in, the SPDR® S&P 500® ETF Trust, an ETF registered with the United States Securities and Exchange Commission under the Investment Company Act of 1940 and principally listed and traded on NYSE Arca, Inc. under the symbol "SPY". State Street Global Advisors, ASL is the AQUA Product Issuer for the CHESS Depositary Interests (or "CDIs") which have been created over units in SPY and are quoted on the AQUA market of the ASX. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors, ASL's express written consent.