The prevalence of Exchange Traded Funds (ETFs) has grown rapidly over the last few years. ETFs are publicly listed investment vehicles, which usually aim to track the performance of a market or sector index.
There are different ETF structures, with the most widely used being a ‘physically backed’ ETF, where the fund buys and holds the underlying assets in the index it aims to follow.
ETFs allow investors to diversify their portfolio easily in a cost-effective manner and provide the ability to implement broader strategies such as focusing investment on a particular region or sector.
An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
Unlike mutual funds, an ETF trades like common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.
In the simplest terms, Exchange Traded Funds (ETFs) are funds that track indexes like the ASX 200 (Australia’s top 200 stocks weighted by size). When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its target index.
The main difference between ETFs and other types of index funds is that ETFs don't try to outperform their corresponding index, but simply replicate its performance. As ETFs are passive and not actively managed, the returns from an ETF should not differ in any significant way from the index it aims to follow, except in that returns may be slightly lower due to fees.
There are two broad classes of ETFs, physically backed and non-physically backed.
Physically backed ETFs hold the underlying shares in the index which the fund tracks, while non-physical ETFs hold contracts (options between two parties, where the ETF provider is promised the return on a market index, usually from a bank) to replicate the return of an index.
Most investors will be familiar with buying shares and focusing on individual companies, in order to create a portfolio or trade. In essence, ETFs combine the range of a diversified portfolio with the simplicity of trading a single stock. Investors also see this as a way to diversify away individual company risk. ETFs allow investors to diversify their portfolio easily and, in a cost, effective manner. ETFs also provide the ability to implement broader strategies such as focusing on a particular region or sector (For example buying US Technology Companies can be done through an iShares ETF).