What is an ETF, ETF Guide, ETF ASX

Exchange-Traded Funds have exploded in popularity, with over 200 ETPs listed on the ASX, the space now represents over $124.64 Billion in Assets Under Management. ETFs have pioneered the investment fund space and now represent the fastest-growing investment product. Prophet Invest’s Complete ETF Guide

What is an ETF?

ETFs or exchange-traded funds are products that bundle together a range of equity products into one easily traded security. ETF units represent partial ownership of a portfolio of assets that are assembled by the fund managers.

What is an ETF, ETF Guide, ETF ASX

Most popular ETFs are passive index funds (98% of ETFs follow index-based strategies), an example is VAS which purchases shares in the top 300 Australian companies. This achieves diversification across the ASX 300 companies. Thus your returns will be expected to be very much in line with the market. You may receive distributions which are payments where the money has arisen from trading within the fund, interest payments, and dividends from the underlying holdings.

ETFs can be broken down into three main categories:

  • Passive ETFs: Passive ETFs simply mimic the holdings of an index, and are the most popular option. For example, IVV tracks the S&P 500 index. It aims to perform exactly like the index (after accounting for fees).
  • Active ETFs: An active ETF is regularly managed by fund providers that choose specific assets to track, as they attempt to outperform an index. With these types of funds being actively managed they rely on increased input and turnover, as such we generally see higher management fees. An example is the ARKK ETF.
  • Thematic ETFs: Thematic ETFs are ETFs that select underlying holdings based on their exposure to particular investment themes or ideas. For example, ACDC tracks Battery, Tech and Lithium stocks.

As the name Exchange-traded fund suggests, ETFs are a type of fund which can be easily traded on an exchange such as the ASX. Due to this, ETFs allow investors to buy and sell a basket of assets just like they would a single stock. ETF units are traded throughout the day at prices that change based on supply and demand and are linked to the value of the underlying assets.

ETFs operate in a trust structure, where the assets of the unit trust are held by a trustee. This can also give investors peace of mind if a fund provider goes bankrupt as the investors are the beneficiary of the fund’s assets are held separately from the assets of the fund manager. It also means that any income generated by the fund must be returned to investors, hence why funds will pay distributions.

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  • What Does ETF Stand For?

    Exchange-Traded Fund

  • What Are the Benefits of an ETF?

    In a single trade, get diversified exposure to a number of equities and or assets.

  • What Happens if an ETF Provider Goes Bankrupt?

    Since an ETF is a Trust structure, investors own the underlying assets, which may be sold to another fund provider or returned directly to investors

What is the Difference Between an ETF and an ETP?

ETPs or Exchange Traded Products is a broad term that encompasses a range of security products that can be traded with ease on an exchange. An ETF is one example of an ETP. Here is ASX’s List of ETPs

Types of ETPs:

  • Exchange-traded derivative contracts
  • REITs: Real Estate Investment Tusts
  • Exchange-traded funds
  • Exchange-traded notes: unsecured derivative debt obligations issued by banks or investment firms with a repayment value linked to an index or basket of assets
  • Exchange-traded commodities: Asset-backed securities repackaging the value of commodities or currencies and listed at a stock exchange.
  • Exchange-traded instruments: Derivative securities repackaging the value of an index or even actively managed portfolio issued by financial institutions and listed at a stock exchange.

ETFs vs LICs and LITs

LICs are another popular method for achieving diversification. Some of the most popular LICs are AFIC and Argo, which have become multi-billion dollar companies listed on the ASX.

ETF

✓ Passive Cost-Effective Investment Strategy

✓ Authorized Participants ensure fund trades close to the AUM

✓ Added Liquidity from APs and Market Makers

✓ Fund Structure: The underlying assets are yours in the case of bankruptcy

LIC

✓ Dividend Smoothing

✓ The Option to retain all earnings: Minimises capital gains

✘ Company Structure: No protection in bankruptcy

✘ Can trade at large premiums/discounts

What is an LIC?

Listed Investment Companies (LICs) list on the stock exchange like any ordinary company through an IPO process. LICs utilize their funds to invest in other companies. So in effect when purchasing an LIC you gain exposure to the underlying holdings. Unlike an ETF you are not the actual owner of the underlying assets since it is operated as a company rather than a trust.

LICs will employ an active investing philosophy whereas the directors will select investments to try and grow the business. In effect, they are similar to managed funds but utilize an investment vehicle that is more accessible and easily traded.

LICs also charge a fixed rate fee to their investors which is usually slightly higher than ETFs and they may also charge performance fees (AFIC 0.14%, Argo 0.15%).

LIC Taxation

Since they are a listed company rather than a trust or fund the taxation is generally similar to any other ordinary share, although some may payout a capital gains component. This makes taxation easier than ETFs. Simply put the company pays the company tax rate of 30% like all other ordinary shares. The company can then elect to pay a dividend to its shareholders.

ETF VS LIC Structure

One of the most important differences between an ETF and an LIC is the structure. ETFs as mentioned earlier are a trust structure. That means that all earnings generated by the fund (less expenses) belong to the investors. For this reason, ETFs must return all earnings to shareholders which is done as distributions. Since they earn capital from a variety of sources (dividends, interest, capital gains) it is important to break down all these distributions in your income tax, hence the reasoning of the AMMA statement (which we will discuss later).

In comparison, LICs are a company structure, which means that they must pay the 30%
company tax. It also means that any earnings belong to the company not directly to the investors. Since the capital belongs to the company they can do as they please. So, they may decide to retain the earnings, or they may decide to pay a dividend, but are under no obligation to do so, or could use it for any reason such as paying expenses or paying executives wages.

Another key difference is that LICs are a close-ended investment which means there is a set number of shares. Unlike ETFs which are open-ended, meaning they can create and destroy shares to match the demand.

On a day-to-day basis, this isn’t a big consideration. But it does bring a key difference, that is LICs aren’t price regulated by Authorised Participants. What this means is that ETFs will always trade very closely to their NAV (Net Asset Value). However, LICs can and often do trade at a premium or discount to their NTA. This is driven solely by supply and demand. If investors prefer a certain LIC for some reason they may bid up the price to where it is more expensive than its underlying assets. On the other hand, their share price may be bid down to below their NTA.

LIC Premium Discount, What is an ETF, ETF Guide, ETF ASX
5 Year Historic LIC Premium/Discount Source

The above graph demonstrates that LICs can trade at large premiums or discounts of around 20% from the actual AUM. It is not a wise strategy to trade solely based on it being a premium or a discount, many of these funds will often remain at these levels.

Both options can be a good investment. We prefer ETFs. Mainly because of the passive cost-effective investment strategy. We believe that it is advantageous that ETFs will trade very close to their NAV. The trust structure means that we directly own the underlying assets and earnings of the fund, in the event of the fund closing, we will still be the owner of the underlying assets.

LITS

LITs, Listed Investment Trusts are another similar investment vehicle. These operate as close-ended trusts, which foregoes many of the ETF structural advantages meaning they can trade at a value other than the NAV. These are generally run as an active trading strategy; a popular example is MGG Magellan Global Trust.

ETFs VS Retail Funds

Some ETFs are also available as retail funds, which means the same instrument can be brought as a normal fund rather than an ETF. The benefits of this is mostly that brokerage isn’t paid when buying and selling and automatic investing options may be available. However these funds generally have slightly higher management fees, so it is important to weigh up the specific implications between each type.

ETFs

  • Easily Traded on an Exchange
  • $500 Minimum Buy-ins
  • Cheaper MER

Retail Funds

  • Larger Minimum Buy-ins
  • No Brokerage Fees
  • Multiple payment options, including automatic transfers

One example is the Vanguard Australian Shares Fund can also be purchased as a retail fund. This means instead of simply buying and selling the fund on an exchange like an Exchange Traded Fund (ETF), you instead buy the fund directly through Vanguard. As a result, no brokerage is paid in trading. However, the retail fund is slightly more expensive with fees of 0.16% pa.

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What is an ETF, ETF Guide, ETF ASX, ETF Vs Retail Fund

Either option can be a great investment strategy and the differences are pretty minor between the retail fund or ETF option. The difference in annual fees for $10,000 over the course of a year is $6. Depending on your frequency of buying and selling will depend on which option will be cheaper in the long run. However, the differences will be very minor, and we consider them negligible in most cases.

Here’s how they compare:

CapitalRetail ETF ETF 1 Trades paETF 2 Trades paETF 3 Trades paETF 4 Trades pa
$10k$16$10$20$30$40$50
$20k$32$20$30$40$50$60
$30k$48$30$40$50$60$70
$40k$64$40$50$60$70$80
$50k$80$50$60$70$80$90
$60k$96$60$70$80$90$100

In this chart, we have broken down the cost of owning the fund VS ETF at different prices and for how many times you plan on trading within a year. In this example, we have assumed a brokerage price of $10. I have underlined all instances in this example where the ETF is the cheaper option.

As we can see the ETF is obviously the cheaper option at higher capital amounts and with lower levels of trading. We can see the price differences are quite small.

A list of some of Australia’s largest ETF’s by Assets Under Management (AUM) can be found in the below table:

Who Are The Providers of ASX Listed ETF’s?

There are a number of key players in the Exchange Traded Fund Space in the Australian market, with several being Australian grown businesses these are:

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Vanguard: Vanguard has become a cult classic after the founder Jack Bogle pioneered the index fund. Today Vanguard provides a large range of Australian domiciled ETFs from Property, Shares, Fixed Income, Cash, Shares. Vanguard is responsible for the largest ETF in Australia: VAS.

BlackRock/iShares: Similar to Vanguard, Blackrock is an international giant within the investing scene with over $12 trillion in AUM. Blackrock's iShares products are home to the IOZ ETF.

BetaShares: Betashares is an Australian-based firm that has set out to disrupt the low-cost index fund space. The group has over $20 Billion in AUM. In the past two years, they launched the popular A200 fund, the world's lowest-cost ASX tracking fund at 0.07%, as well as DHHF, their high-growth fund which has undercut Vanguard's VDHG.

SPDR: SPDR or State Street Global Investors are also pioneers within the world of index investing, as the first group to successfully create ETFs. The group launched the first ETF which tracked the S&P 500 known as SPDR S&P 500 ETF Trust or SPY. Today the group has a broad range of Australian-domiciled ETFs including ASX tracking funds, Bond, property, world, US, and emerging markets products.

ETF Securities: ETF Securities is another company based in Australia. The ETF group is a leader in thematic ETFs and has released a number of popular sector-based funds including HGEN, SEMI, FTEC, and the popular and first GOLD ETF.

VanEck: VanEck is another global company that has been at the forefront of ETFs. The group has over 30 ASX-listed ETFs over a range of sectors, countries, and asset classes.

Each will have a different fee structure and slightly different product disclosure statements for each of their individual ETF product.

Characteristics of ETFs

ETFs have risen to popularity due to their simplicity of use. These funds can be traded on an exchange as easily as a stock. With ETFs being comprised of a broad range of securities and asset classes this can be a very effective way to add diversification to your portfolio.

ETFs represent a basket of assets. With a broad range of ETF options available, an individual can achieve diversification across sectors, regions, countries, and asset classes.

The large majority of ETFs are passive index funds. Due to the passive tracking nature of these funds, providers can release these funds with very low fees. This generally means that ETFs costs are significantly less than those funds which are ‘actively managed’, due to the lower administrative costs.

What is an ETF, ETF Guide, ETF ASX, ETF Index Fund

Over time passive index funds have also been proven to out-perform actively managed funds.

Passive Versus Active Investing

Passively managed are generally offered in a fund structure that is set up as a broadly diversified market capitalization-weighted to the constituents of an index. A great example is the ETF VAS which holds the ASX 300 companies weighted to the market capitalization. Thus, whatever the ASX 300 index does VAS follows. One of the implications of an index or passive fund is that whatever the market gets you get. Thus, you can’t outperform the market but also you can’t underperform the market (before fees and tax). Because you are the market. Since it is so easy to select the companies to make up an index fund the management fees are generally considerably lower than an active fund. VAS for example has a management fee of 0.10% per year. That’s $10 for every $10K. Compared to active funds which are typically 1% or higher.

Since index funds hold a predetermined amount of given companies it means that the companies are not rapidly brought and sold. This can be represented as portfolio turnover. VAS has a turnover rate of 1.08%. That is the underlying funds are 1.08% different than they were a year ago. Actively managed turnover rates are likely to be over 30% depending on the fund. A higher turnover rate will generally attract higher management fees and usually incurs capital gains which can have a taxation impact on the investor. This generally makes passive funds more tax efficient.

Actively managed funds have one large but attractive advantage over passively managed. They have a chance to beat the market. However, this comes with a catch. Since the market average is by definition the average of its trades it means that ultimately that for every person that outperforms there is a person that underperforms by the same degree. Simply put, for every fund that outperforms the market one underperforms the market. And this is before accounting for the large fees these funds
generally charge. After accounting for these many struggles to outperform. And seldom outperform continuously.

Passive strategies have rapidly grown in popularity due to their low-cost simple strategies which tend to deliver better returns.

Index Funds

You have a chance to keep pace with market returns because index funds try to mirror certain market segments. Source, Vanguard

Actively managed funds

Or you can try to beat market returns with investments hand-picked by professional money managers. Although historically they rarely do.

SPIVA is a study conducted by Standard and Poor’s to determine the performance of Active Versus Passive Index Funds. This report is one of our favorite pieces of research available and largely one of the reasons that we hold a large portion of capital in passive index funds, such as VAS and IVV.

This report found 75.27% of actively managed funds fail to outperform the S&P 500 index, over a five-year period.

We also see that 86.69% of funds fail to outperform the ASX 200 index in a year. In their latest report, this number is seen to reduce to 80% over a five-year period. However, in the past and for most other countries this number greatly increases to upwards of 90% over a 15-year duration.

“Actively managed funds have historically tended to underperform their benchmarks over short- and long-term periods. This has tended to hold true (with exceptions) across countries and regions. Another recurring theme is that even when a majority of actively managed funds in a category have outperformed the benchmark over one time period, they have usually failed to outperform over multiple periods.”

Source: Standard and Poors

Further Resources: Vanguard's Case for Low-Cost Index-fund Investing

How to Use an ETF in your Portfolio

ETFs sit in your brokerage account like regular stocks. However, there is a lot that can be done with what people typically think of as a boring investment.

There is pretty much an ETF product for nearly anything these days. From shorting the market to investing in a portfolio of the top tech companies and Currencies. There are also Geared funds for those looking to take additional leverage during market conditions. Here's our analysis of how people are using ETFs to create a portfolio.

Depending on your ETF choice people will mostly use an ETF as:

  • A standalone portfolio: such as VDHG, DHHF, ARKK
  • Combined with other funds to create a portfolio: such as VAS, IVV, VGS
  • A way to add diversification to a portfolio
  • Gain exposure to a booming sector or industry
  • Gain exposure to hard assets such as gold in a simple manner
  • Hedge against a market downturn or looking to profit from downturn: such as BBOZ, BBUS

Which ETF to Buy?

With so many ETF options it can be difficult to know where to begin. There are also a lot of ETF providers which all provide similar funds, this checklist can help you establish which is the best option for you. At the end of this article, we have also attached a list of all ASX-listed ETFs.

  • Does the ETF capture the exposure and companies you are hoping to achieve?
  • Consider how the index is weighted (Market-capitilsation, fundamentally weighted, equally weighted or other), does this match with your needs?
  • Are the indexes holdings clearly documented?
  • Are the fees reasonable and competitive?
  • How long has the fund existed?
  • What is the market capitalisation/assets under management of the Fund?
  • Does the funds returns mirror the returns of the Index it is tracking?
  • Are the underlying holdings representative of the index it is tracking?
  • Does the fund hold the individual companies or is it holding derivatives or synthetics? (these can add risk)
  • Is the turnover/rebalancing of the fund relatively small? Excessive rebalancing can incur further tax burdens
  • Is the bid-ask spread relatively narrow?
  • Are there any hidden additional fees?
  • Does the fund have a large amount of average daily volume?
  • Is the ETF provider well known and experienced?
  • Does the company have many resources and education products available to assist the investor where needed

How to Trade ETFs

Buying and selling ETFs works exactly the same as trading ordinary shares. Simply log on to your brokerage account and put it in an order the trade will be settled in the T+2 trading period.

The value of the ETF will usually closely track the value of the underlying assets this is due to the functionality of how ETFs work which we cover later. Due to this, we do see increased volatility in ETF prices upon the opening and closing of the market. During this time the exact value of the underlying assets is not known since the shares haven't opened for trading. There is nothing wrong with buying in these time frames, we just may see increased ETF premiums/discounts.

When looking for a brokerage service to purchase ETFs we generally prefer CHESS-sponsored brokers. Here is our list of Best Share Trading Platforms. Pearler is a CHESS-sponsored broker that has become largely popular after launching its low-cost flat-fee brokerage service. It also allows free brokerage on trading a range of ETF which we list below. For the best deal sign up to pearler here.

ETF Distibutions

Since an ETF is a trust structure all profits that the fund earns belong to its holders. As such the fund will pay out earnings to its owners in the form of a distibution, depending on the fund this may be quarterly, semi-annually, or annually.

The earnings of the ETF depend on the underlying assets. The fund will earn income from a variety of sources. In the case of an ETF that owns shares, the fund will receive income from the shares in the form of dividends, sometimes capital gains, and sometimes interest earned from cash holdings and a variety of other sources.

Since an ETF is a Trust structure the excess income will be returned to investors in the form of a distribution

This pool of money is added to the net asset value (NAV) of the fund and is used to pay the management fee of the ETF the excess capital is returned to investors in the form of a distribution.

As a distribution has arisen from a range of income types the taxation will differ from dividends, around tax time the fund provider will send AMMA statements to investors which help classify the breakdown of income.

What's the Difference between a Dividend and a Distibution?

A dividend is a payment from a company, which is often comprised of the dividend payment and franking credits applied to the dividend.

A distribution is a payment from a trust which is comprised of multiple sources of income including multiple dividends, franking credits, interest payments, and capital gains or losses.

Due to the complexity of multiple income sources paid out in distributions the taxation on ETFs differs from shares, we discuss this later.

A typical ETF distribution can be broken down into 5 main components:

  • Dividends:  ETF receives dividends from the companies it owns and will pass on each investors portion and associated franking credits 
  • Franking credits: ETFs are eligible to pass on franking credits from the dividends they receive.
  • Interest: for example bond ETFs receive interest (i.e. coupon payments) from the underlying bonds they own, since most ETF will hold cash from time to time inorder to function, interest may be earnt on this cash.
  • Realised Capital Gains or losses: from buying and selling the underlying shares (e.g. incurred during rebalancing) with any net capital gain passing on to the investor
  • Foreign income: from ETFs that own overseas shares and any associated foreign tax credits.

Dividends

Dividends

Franking Credits

Distibutions

Dividends

Franking Credits

Interest

Capital Gains/Losses

Foreign Income

Should I Buy an ETF based on its Distribution Yield?

For many investors, it may seem tempting to purchase an ETF based solely on its distribution yield. However, for many, there is very little reason to do so, and a higher distribution can actually lead to lower net returns after tax.

Just like shares, ETF investors can earn money in one of two ways: Capital gains or distributions. Remembering that an ETF is a trust structure that must pay out income in the form of distribution, this means that ETFs that have similar holdings will pay out similar distributions (think IOZ and STW, both of which track the ASX 200 and have averaged a yield of around 3.2%). However, some funds are created strictly to try and maximize yield by investing in high-yielding stocks. We also see that US index funds have lower yields due to the historically lower dividend payments of US companies.

When a company pays out a dividend, the underlying value of the stock is valued at less than the dividend being payout. We see this in practice on ex-dividend days whereas the share price will usually fall in proportion to the dividend payment. However when a good company elects to retain earnings the share price in theory should continue to rise as earnings rise, the company also has the added advantage of being able to reinvest these earnings. As such for investors there should be no gross difference in investing in two identical companies if one pays a dividend and the other doesn't. The same goes for ETFs.

The difference then arises when we talk about net returns after tax. Generally speaking, capital gains have a tax advantage over dividends/distributions since they are able to grow tax-free/deferred and are only taxed once the capital gains are realized. However, if a fund has a higher distribution yield, tax must be paid on this distribution each year.

ETF Fees

When we look at investing in ETFs there are a number of fees that can arise relating to trading and holding the fund. A fund's Product Disclosure Statement or PDS will detail the exact definitions of all its fees.

When Buying a fund an investor will incur: Brokerage, bid-ask spreads

When Holding a fund an investor will incur: Management fees, Performance fees, indirect costs, transactional costs, and recoverable expenses. The total cost can be referred to as the Management Expense Ratio (MER).

Brokerage

ASX-listed ETFs can be bought and sold on most standard online brokerage platforms. Just like all other securities, investors will incur a brokerage fee when buying and selling the ETF. This will vary depending on your broker. Pearler for example will allow free brokerage on select ETFs typically brokerage ranges from $10-30.

Bid-Ask Spread

Also when trading an ETF you will incur a bid-ask (buy-sell) spread. This is not imposed by the ETF issuer, but by the market maker. This is the difference between the prices at which you could buy and sell your ETF units vs. the actual NAV per unit. The buy-sell spread represents the compensation to the market maker for providing market-making services.

  • The narrower the spread the better, as this reduces the trading costs associated with buying and selling ETFs
  • Exchange-based spreads, as on the ASX, are set by the competitive tensions between market markers we will discuss this later
  • Larger Funds will tend to have lower bid-ask spreads, due to a larger amount of market makers
  • Bid-Ask spreads are not set but constantly change throughout the day, depending on supply and demand.

Investors can assess the fair value of an ETF by comparing the ETF’s market price with the ETF’s net asset value (NAV) per unit. The iNAV provides an indication of the fair value of the ETF in real-time. This can be found on the fund's website during trading hours. When purchasing units in the fund you can refer to the live iNAV to ensure spreads are reasonable.

Management Fees

Management Fees are the main fee associated with holding an ETF. The management fee is an annual fee that the fund provider will charge for their services.

Management fees are automatically deducted from the fund’s Net Asset Value on a daily basis. Actual payments are usually made at the end of each month. This means is you as an investor never have to directly send money to the fund provider. It is all processed by the fund as they deduct the fees from the underlying earnings/capital of the fund.

The management fee and other costs are typically reflected in the ETF’s NAV on a daily basis, so that the fund’s published returns already take them into account.

Because of this you never really notice the fees, instead, it just reduces the fund’s performance over time. When the fund sends out its annual statement at tax time you can see the full details of this.

What is an ETF, ETF Guide, ETF ASX, ETF Fees, How are ETF fees paid

The annual cost is expressed as a percentage. For example, a 0.5% annual management cost would represent $50 on a $10,000 investment each year. The fee will vary greatly from fund to fund. Large passive index funds will generally have much lower fees than thematic and active ETFs.

The management cost usually includes all relevant fees and costs associated with managing the ETF, including custodian fees, accounting fees, audit fees, and index licensing fees.

Performance Fees

Some ETFs will charge a performance fee, which is often taken as a certain fee above the returns of the benchmark index, thus is only charged when the fund outperforms its benchmark. This is very rare in passive and thematic ETFs and is usually only employed in active ETFs. You can check your ETFs PDS to see if they charge a performance fee.

Indirect Costs

Indirect costs are the costs arising from holding the underlying assets of the fund. For example, some ETFs will hold a number of ETFs as the underlying holdings. The total costs that these ETFs incur will be the indirect costs.

For many investors, no indirect costs will be charged by the ETF, as many large ETF providers will pay this fee themselves.

Recoverable Expenses

Recoverable expense is a broad term used by fund providers to describe any additional fees associated with running the fund which is not categorized as transactional costs or indirect costs.

These will usually involve the expenses normally incurred in the day-to-day operations of the fund including custodian, fund administration, unit registration, ASX, and audit costs.

The term 'recoverable' means these fees can be withdrawn from the ETF AUM if the fund provider wishes. However, many large ETF providers will pay this fee themselves and ensure the ETF has nil recoverable expenses.

Transactional Costs

In the operation of an ETF, the fund will incur transactional costs. These are additional costs that are not included in the management fee and account for brokerage fees, clearing costs, and transactional custodian fees when rebalancing within the fund.

Transactional costs reduce the fund's Net Asset Value (NAV) meaning just like the management fee investors won't notice it getting paid, as it will just reduce overall returns.

Transactional fees will obviously be lower in ETFs with lower turnover such as passive index funds compared to actively managed funds. Since the exact transactional cost is unknown, it is given as an estimate by the fund provider. The fund provider will often reimburse some or all of this fee.

Management Fee VS MER (Management Expense Ratio)

When investing in ETFs you will often see the fee quoted as MER or Management Expense Ratio. MER is a broader scope to properly demonstrate the actual fees incurred in investing in the fund over the course of a year. It will include additional fees such as licensing, compliance and trading within the fund during rebalancing. Since these costs will change varying on portfolio turnover the MER is usually an estimate only.

MER will include:

  • Ongoing management fees
  • Operating expenses (licensing, compliance, auditing, trading, etc.)
  • Indirect Fees
  • Recoverable Expenses

MER doesn’t include:

  • Performance fees
  • Buy/Sell spread
  • Brokerage and platform fees
  • What Fees Will I Pay When Buying an ETF?

    Just like when buying a share you will usually incur brokerage and a bid-ask spread.

  • What Fees Will I Pay When Holding an ETF?

    Management Fees, Indirect Fees, Recoverable Expenses, and Transactional Costs Some may charge Performance Fees. Together these can be described as the MER.

What is an ETFs NAV: The NAV or Net Asset Value is the market value of the ETFs underlying assets after management fees, liabilities, and any other expenses.

What is an ETFs iNAV: The iNAV is just like the fund's NAV, it serves as an appraisal for the funds underlying assets. The iNAV is the NAV at a particular point in time and is calculated live during the trading day. It serves as the 'fair value' of the ETF. A funds iNAV should be available for all ASX listed ETFs and can often be found on the fund's website. The methodology to calculate iNAV is the same as calculating NAV, it is just done in real-time and updated every 15 seconds. It is calculated by a third-party and not by the fund provider.

Why is the Funds NAV Important? Since the NAV represents the price of the underlying assets of the fund, using the NAV can ensure that when you buy and sell an ETF you are doing so at a 'fair price'. Through the competitive tensions and arbitrage of Authorised Participants, the market price of the ETF (The price you buy and sell at) is usually kept very close to the fund's NAV. The difference between these two values is the bid-offer spread, which is essentially the compensation received by the ETF’s market maker for providing liquidity in the ETF on the exchange.

If you are quoted an offer price that significantly exceeds the ETF’s iNAV, you could end up paying much more than what the ETF is worth.

From time to time the fund may trade at a slight premium or discount to the NAV, this is usually more announced in smaller, less established funds with fewer APs. When buying an ETF is can be advantageous to check the current offer price against the iNAV to ensure the market price is in line with the actual underlying holdings. Likewise, when selling a fund you may check the bid price against the iNAV.

How do ETFs Work?

As explored earlier ETF stands for Exchange-Traded Fund. This is the name given to a trust structure that holds a bundle of assets where the entire bundle (Fund) can be easily traded on the stock exchange like any ordinary single share, hence the name Exchange-Traded Fund. ETFs are available across a range of asset classes and each have unique goals and holdings. These products may hold assets to achieve broad exposure, sector exposure, small-cap exposure, yield exposure, property, cash, bear market, US, European, Asian, developing markets, developed markets, gold, silver, or bitcoin exposure.

Let’s look at an example of one of the most popular ETFs: VAS, or Vanguard’s Australian Shares ETF. VAS seeks to replicate the returns of the ASX 300 index before fees and taxes. So, the way the fund can do this is by owning a trust structure with the ASX 300 shares weighted by market capitalization. By buying the ETF you become a part-owner of these 300 companies by simply buying one product. As they are held in a trust structure you are the legal owner of these shares meaning if the fund provider were to stop existing you still own the underlying assets which can be easily liquidated.

Since ETFs hold a bundle of assets they are highly sought after as an efficient form of diversification. As many ETFs use a passive indexing investment strategy the management costs can be quite low. Furthermore, equity lending allows providers to further reduce the actual direct cost to investors and in recent times can even offer negative fees, that is the provider pays you to hold the fund. Although it should be carefully examined by the investor how the fund achieves this, and all product disclosure statements should be understood before investing.

ETF Creation and Redemption

The way an ETF is formed is through a creation and redemption system. Large financial institutes (think investment banks) will work with the fund providers these institutes are called Authorised Participants. The Authorized Participants can go into the market and buy the 300 shares individually and sell them to the fund manager hence creating the trust structure, similarly, they can buy units from the fund and sell them in the market. This is how units in the fund are created or destroyed.

This also allows an arbitrage opportunity for the AP which brings many benefits for the fund and the investors. By being able to constantly buy and sell means the AP will effectively regulate the price of the ETF to the actual underlying asset price, or net asset value (NAV). A fund's live NAV value can be watched throughout trading, it is referred to as iNAV. If the fund was trading at $90 but the NAV was $100 the AP could buy at $90 and turn around selling at $100. This quickly adjusts the NAV and price back to the same value. This means that many ETFs with many effective APs will always trade very close to their NAV. This system also providers liquidity to the ETF, meaning for well-managed funds there should always be a buying or selling AP.

Authorised Participants

APs work with open-ended funds to provide liquidity and facilitate the supply for units in the fund. APs are generally large investment banks with one or more being assigned to the fund at inception, more can participate over time. The average number per fund is around 30. They work with the fund to create and redeem units and keep them priced fairly. The AP facilitates two primary functions: the creation and redemption processes.

Authorized Participants don’t receive compensation from the ETF for their services, it is a mutually beneficial relationship. The AP will cover all the trading costs and fees associated with the process. AP’s are compensated for their activity through their trading activities, such as the arbitrage amounts they generate.

The creation process is the process in which the AP will create more units in the fund. In order to facilitate this the AP will go into the market and purchase all underlying shares that constitute the fund in the designated weightings. The fund will publish a list of securities each day as to the constituents of the ETF. This unit of assigned weighted shares is known as a creation unit, these are generally in blocks of 50,000 shares. The AP will then deliver the creation unit to the fund and in return will receive units in the fund. This occurs on a one-for-one basis, the AP will receive the exact value based on the net asset value (NAV) in fund units in exchange for the creation unit. The AP will then resell these ETF units on the market to investors. This process of creation of ETF units is known as an “in specie” contribution of stocks. Units can also be created via “cash creations”, which is when cash (rather than assets) are exchanged for ETF units.

An AP can initiate a creation in three ways:

  1. Deliver a “creation basket,” or a pre-specified bundle of securities representing the underlying index, to the ETF issuer
  2. Provide cash equal to the full or partial value of the creation basket (including actual trading costs of purchasing the creation basket) to the ETF issuer.
  3. Provide cash equal to the value of the ETF shares plus a trading spread (a buy/sell spread) to the issuer

The redemption process is the process in which the AP will destroy units in the fund. The AP can reduce the number of fund units by purchasing ETF units from the market and returning them to the fund in exchange for the underlying assets. The ETF provider then simply destroys the ETF units. The underlying assets are then broken up and sold on the market by the AP.

The interaction of APs within the market is mutually beneficial to the fund and the AP. AP not only facilitates liquidity to the fund but also regulates the price of the fund to the NAV. Without APs an ETF would function like a close-ended fund with a limited number of units, creating premiums and discounts to the NAV. When units in an ETF begin to trade away from the asset value there is an economic incentive for the APs to facilitate the creation and redemption process. For example, if the fund was selling units at $100, but the NAV was $90, the AP can sell the funds and buy the underlying units at $90. Or if the ETF is trading at a small discount, the AP can purchase ETF units and sell the underlying basket of securities for a profit. This arbitrage will regulate the price back towards the actual NAV. This process is illustrated below.

What is an ETF, ETF Guide, ETF ASX, ETF Authorised Participant, How ETF works, ETF Creation Redemption

In ETFs, APs facilitate further liquidity for investors. When buying and selling ETFs investors can trade with other investors, like regular shares. However, the creation and redemption process creates further liquidity meaning there are generally sufficient opportunities for investors to trade the fund, even in times of market downturns. With large funds there can be many APs, the competition between APs ensures there is increased liquidity and reduced margins of premiums or discounts in ETF pricing, it also reduces the bid/ask spread that investors buy and sell at. As such generally speaking larger ETFs with more APs have higher liquidity, reduced pricing margins, and reduced spreads.

What is an ETF, ETF Guide, ETF ASX, ETF Authorised Participant, How ETF works, ETF Creation Redemption

Market Makers

Market Makers are often confused with AP, in many cases, a single entity will be both an AP and a Market Maker. Market Makers will work to actively quote bid-ask prices of ETF and securities. Market Makers will facilitate liquidity and organize trades. A market maker displays buy and sell quotations for shares. Think when you are buying or selling, the share price is set by the market maker based on supply and demand. A market maker will buy and sell shares/ETF to facilitate a transaction for investors, in effect they will benefit from the buy-sell spread.

A market maker is a broker-dealer that regularly provides two-sided (buy and sell) quotes to clients

Market Makers will work closely with Authorised Participants to ensure the liquidity of the fund, by buying and selling units to the AP.

A market maker may engage an AP to initiate a creation if the price of an ETF share is greater than the value of the underlying holdings (at a premium) or redemption if the price of an ETF share falls below the value of the underlying holdings (at a discount).

Visible and Hidden ETF Liquidity: Why ETF have high liquidity

ETFs unlike shares will derive liquidity from several sources, as such they are highly liquid even in the event of market downturns. ETF liquidity can be summarised from three sources: Visible ETF liquidity, Hidden ETF liquidity, and Underlying Holdings Liquidity.

Visible ETF liquidity: When you purchase units in an ETF your transaction may have come from any of the three forms of liquidity. For example, if an investor was to sell units in an ETF these may be settled on the ASX and purchased by another investor. This is referred to as Visible liquidity as it is the bid-ask orders that you can see on your brokerage platform. This type of trading can be quantified in terms of the average daily volume or ADV. ADV is a measure of this trading activity, but it doesn’t indicate an ETF’s total liquidity.

The natural liquidity of ETFs trading in the secondary market is enhanced by exchange-registered traders called market makers. Market makers help maintain a fair and orderly market by selling ETF shares to potential buyers and by buying ETF shares from potential sellers. In the absence of another buyer or seller, a market maker can often match the other side of a pending order. Source, Vanguard

Hidden ETF Liquidity: ETFs can often be traded on multiple exchanges or in off-exchange transactions this can be called Hidden ETF liquidity.

Underlying Holdings Liquidity: Further ETF liquidity is derived from the trading of the funds underlying holdings. As we mentioned earlier Authorised Participants will create and redeem creation units within the primary market. By doing so the AP will facilitate liquidity to the fund. This can be done on-demand by the Authorised Participants. This can allow investors to execute large buy and sell orders for lower-volume ETFs, with little or no market impact on the ETF price.

AP can easily source liquidity on demand using the ETF creation process

What is an ETF, ETF Guide, ETF ASX, ETF Liquidity, ETF liquidity graph
ETF transactions are concentrated in the secondary market, Source

The vast majority of ETF liquidity (median 92%) is derived from secondary market trading, that is trading between investors and market makers on an exchange. Liquidity can also be created by APs.

Tracking Errors, Slippage, Premiums and Discounts

How can an ETF outperform the benchmark index?

An ETF that is designed to replicate an index may from time to time may actually slightly outperform (premium) or underperform (discount) the index by a small degree. This is due to a combination of three reasons:

  1. Authorized Participant Inefficiencies
  2. Representative Sampling
  3. ETF Fees

Authorized participants are organizations that create and redeem shares of an ETF and regulate the price to the Net Asset Value (NAV), from time to time there will be random discrepancies between the ETF price and NAV. This is reduced in large efficient funds.

Historically premiums/discounts can become more pronounced during market open and close and also for international funds in time zone differences. In equilibrium, an ETF will be available at a slight premium which accounts for various transactional costs faced by market makers. In the below graph we see the premiums/discounts of IVV which peak around the COVID market crash with a premium and discount of over 40 basis points (0.40%)

What is an ETF, ETF Guide, ETF ASX, ETF slippage, ETF Premium Discount

The second explanation and larger factor is most ETF use a representative sampling indexing strategy to manage the Fund. Representative sampling is an indexing strategy that involves investing in a representative sample of securities that collectively has an investment profile similar to that of an applicable underlying index. The ETF may or may not hold all of the securities in the Underlying Index.

ETF Overlap and Diversification

The main risks from equities can be broken down into two factors: Systematic risk and unsystematic risk.

Systematic risk is the risk of losing capital as a result of factors that affect the overall financial market. An example of a systematic risk factor is a recession, political changes, or interest rate changes. This type of risk cannot be eliminated through equity diversification as the entirety of the market losses values in such events. However, it is possible to reduce the personal impact of such events by investing in a variety of asset classes that will act differently in such events.

Unsystematic risk is the risk associated with a particular company or a particular sector of equities. Such examples include a company declaring bankruptcy, particular reform to an industry, or scandalous activity from a particular company. In these cases, it is possible to reduce risk by diversifying across a range of equities, but it is also important to consider that diversification can also reduce the impacts that a positive event from a particular company or sector will have on returns. 

ETF Risk, What is an ETF, ETF Guide, ETF ASX, Systematic Risk, Unsystematic Risk

One way to manage risk is through diversification. Having your capital spread across a range of investments and asset classes will ensure that your returns won’t behave the same, meaning that in the event of a downturn some of your holdings will maintain their value. 

There is no set rule for diversification. For example, if you hold two companies this probably isn’t diversified. However, if you own your house, and you have a term deposit and those companies are actually holding companies (such as Berkshire Hathaway, which holds many companies) then this may be sufficiently diversified. Additionally, ETFs are a great way to achieve diversification, however, if all your money is in a highly speculative thematic ETF then this probably isn’t diversified.

ETF Correlation and Overlap

The term used to describe how related two securities are to each other is correlation. Portfolio risk is dependent on the correlation of the shares within it. Shares that are highly correlated will mirror each other’s trends. The website: ASXCorrelations provides a tool for assessing the correlation of many ASX listed companies and ETFs.

Correlation isn’t necessarily about finding opposing shares it is about taking into consideration the effects it can have on your portfolio and it can be used as a tool to consider what areas and sectors you are concentrated to. 

There is no need to combine ETFs with near-identical holdings and correlation, however slight overlap between ETFs may be employed as an investment technique. For example, DHHF and VDHG have a large allocation to US holdings of around 30%, if an investor wanted to increase their exposure further they may consider adding IVV to their portfolio.

International Exposure and Home Bias

Most investors across the entire world are heavily biased to their domestic assets. International equities can have great diversification properties for investors. Through investing internationally we can add significant diversification to our portfolios. Not only do we gain access to international equities but also, we can gain indirect diversification to offshore currencies.

Considering that for the majority of us our jobs, cash, homes and most of our assets are based in Australia, picking up some foreign exposure can reduce any impacts a slump to the Australian economy can have on our returns. Considering that Australia is only around 2% of the global economy it makes sense to expand internationally. 

From this graph, we can see that Australian investors have a large degree of home bias. Despite Australian investors' large allocation to Australian securities, our markets only represent 2.4% of the world index capitalization.

Rolling your Own Fund or Using a Standalone Fund?

High-Growth diversified ETFs such as Vanguards VDHG, and Betashares DHHF have risen to popularity recently as an option for a standalone portfolio. These ETF options offer broad diversification across international equities and asset classes (VDHG) in one passive ETF. The funds achieve this through holding numerous underlying ETFs and funds. For example, DHHF is comprised of A200, VTI, SPDW, and SPEM, all of which are ETFs that can be easily traded.

When crunching the numbers on DHHF which we explore here, it does work out to be cheaper to hold the underlying assets rather than DHHF.

Creating Your Own: 0.0925% DHHF: 0.19%

However, for some investors holding DHHF may be a better option. Through purchasing the underlying holdings investors may incur more brokerage costs. There is also an added complexity to rebalancing your holdings. Through using a diversified product such as VDHG or DHHF the fund is automatically rebalanced back to the target benchmark.

Tax Drag: Tax Drag is another small consideration. When an Australian fund (DHHF) holds a US fund that holds stocks from companies in non-US countries, you cannot claim the dividend withholding tax credits paid by the fund that you could claim if the Australian fund held them directly. 

As a result of this impact, we do see a slight reduction in net returns. Although this is very small and nothing to be concerned about, it does effectively increase the 'fee' of the fund. 

Since DHHF contains some US-domiciled funds which contain non-US assets; i.e. SPDW and SPEM, these funds will incur a tax drag for the overall performance of DHHF (based on the previous twelve months the tax drag was 0.09%), which otherwise could have been avoided if you had direct ownership of these funds.

Will I Get Doubled Charged on Holdings? One of the main questions that come to mind, is do these funds pass on the underlying ETF fees to investors? Going back to the fund fee structure the underlying management fees are classed as 'Indirect Costs', for most providers any non-trivial management costs borne by the relevant Fund through its investment in underlying ETFs are reimbursed to the Fund by the Responsible Entity from its own resources.

In simpler terms, the fees for the underlying ETFs are not charged on top of the ETFs management fees. This may change per provider so remember to always check the PDS.

ETF Rebalancing

Rebalancing your holdings is the practice of reallocating capital to one of your underweighted holdings to re-meet a target allocation. Over time as your portfolio naturally shifts away from your target allocation, this can skew risks away from your desired levels, rebalancing will bring risk back to your targets.

The first step in rebalancing is to first identify your baseline target portfolio. After selecting your holdings you should break down a determined allocation to each fund dependent on asset type, sector, and country allocations, in-line with your risk preference.

There are two ways we can rebalance a portfolio: Rebalancing with Inflows or selling down holdings to rebalance

Rebalancing with Inflows is the practice of purchasing the most underweighted holdings of your portfolio. This is simple and can be done with your scheduled periodic investments if you are continuously investing.

Selling down holdings to rebalance is more complicated as this can become excessive and realize capital gains. When doing this you should consider:

  1. Selling to rebalance realises capital gains.
  2. The market tends to run on momentum in the short term, so rebalancing too often can be futile and skew results.

When to Rebalance:

  1. By time. Generally, once every year or two is best, and more frequently than once a year has shown not to help or become detrimental.
  2. By Percentage. Most people seem to accept a 5% margin either way before rebalancing. You can consider your own risk tolerance and goals to dictate your margin.

Currency Hedging: To Hedge or Not to Hedge?

Hedging refers to if the fund has reduced the impact of foreign currency fluctuations using hedging techniques. Consider how a currency changes when you order something from another country, in investing this can alter your returns, for better or for worse.

Many funds will have a hedged and unhedged version of the same fund, generally speaking, the hedged version will have slightly higher fees to account for the costs involved in hedging a currency.

What is an ETF, ETF Guide, ETF ASX, ETF hedging
Over most currencies and periods Hedging results in lower volatility, Source Vanguard

Short-term vs Long-term: Whether to hedge is for each investor to consider. Generally speaking, those investing for a shorter time frame or those with a lower risk tolerance may choose a hedged option to remove the currency uncertainty. For those investing over a longer-term and for buy and hold investors an unhedged option may be a better choice. As it will attract lower fees (generally speaking), it can also add for an additional level of diversification, and currency fluctuations tend to average out over the long term.

Choosing an unhedged option can provide additional exposure to international economies and currencies.

Unhedged Funds can add diversity: Expanding on the additional level of diversification point, by choosing an unhedged option not only are we betting on this foreign company but also gaining exposure to their currency and the overall economy. If the AUD goes down relative to this foreign currency our investment will be worth more in AUD, and consequently, if the AUD rises against the foreign currency our investment will be worth less in AUD.

Hence considering a situation where the Australian economy experiences a recession, not only will our international investments perform strongly relative to our domestic holdings but also a fall in the AUD will cause a further boost to our returns.

Hedging and Large Distributions:  Hedging currencies required a lot of buying and selling with the income then passed onto shareholders. The high distribution can actually be seen as a downside to the fund as this creates a large tax liability for investors which can reduce the overall net performance of the fund.

High distribution can actually be seen as a negative; they create large tax liabilities, which can reduce net returns

Non-hedged Funds which pay out very low distributions can be very attractive for net returns, due to their lower tax liabilities.

For more information on Hedging, Here’s a link to Vanguard’s To Hedge or Not to Hedge Research.

ETF Taxation and AMIT Statements

ETF taxation is a little more involved than generic dividends as ETFs are a trust structure and generate income from a variety of sources (such as dividends, capital gains, currency changes, interest, domestically and internationally). Also, being a trust these earnings are considered generated over a period and not just when they are paid out hence this is a slight subtly for when then the income is considered as generated.

First, let’s break down the AMIT/AMMA statement. The Attribution managed investment trust (AMIT) member annual tax statement (AMMA) is an important document that each investment trust is required to give to its members. This statement records and details the members determined income components for that income year, it will include all attribution, distribution, and cost-based adjustment information required for the member to fulfill their income tax obligations. The AMMA statement will not contain information pertaining to capital gains or losses that have resulted from the investor disposing of funds in the trust. Investors must calculate these individually in a similar process as you would for single shares. 

Below I have created a generic AMMA statement that will closely resemble those of the major fund providers. I have broken down each component and detailed how to account for it in your tax obligations. This is general information only, talk to your personal tax agent for personal advice and obligations. 

What is an ETF, ETF Guide, ETF ASX, ETF AMMA Statement

These statements are quite thorough as you can see. In the above diagrams, I have created an example AMMA statement, following I have broken down each component in a series of diagrams.

Part A of the AMMA statement is the most used and probably the more important section. It is a summary of all the tax implications from that period. It takes the attributions (amounts attributed to you) and breaks them down into their individual taxation sections. This makes filling out your tax quite easy. Under the ‘Managed Funds Distributions’ of ATO mytax simply enter the amounts shown into each corresponding section described by the tax return code. For example, ‘the shares of net income from trusts, less net capital gains, foreign income and franked distributions’ section will be entered into section 13U on mytax.

Within your tax return, the below segments are allocated to Section 13:

What is an ETF, ETF Guide, ETF ASX, ETF TAX, ETF Amma Statement
  • 13U: All income generated that isn't from capital gains, foreign, or from franked distributions. Hence is treated like averaged income.
  • 13C: Is the proportion of the distributions that are franked.
  • 13Q: Is the total franking credit amount that has been obtained
  • 13R: Is the amount (usually none for most retail investors) that has been withheld for tax.

Capital Gains, Section 18:

What is an ETF, ETF Guide, ETF ASX, ETF TAX, ETF Amma Statement
  • 18A: The total net capital gains attributed to the investor, these are created by the turning over of the shares within the fund. Net means that capital losses have been accounted for and CGT discounts have been applied. This amount will need to account for other CGT events.
  • 18H: The sum of all capital gains from the turnover of the underlying assets, without applying CGT discounts.

Foreign Source Income and Foreign Assets or Property Section 20:

What is an ETF, ETF Guide, ETF ASX, ETF TAX, ETF Amma Statement
  • 20E: The total assessable income derived from foreign sources.
  • 20M: This is the 20E amount less any foreign deductible expenses. If there are none the amount will be the same.
  • 20O: The total foreign income tax that can be used to offset domestic tax obligations.

Part B further breaks down all the components of Part A and features three columns: Cash Distribution, Tax paid/offsets and Attribution. Cash distribution is the amount that you actually received. The attribution section shows the gross amounts of the distribution that are attributed to the investor for taxation purposes, these amounts may and often do differ. To account for these differences the cost base of your holdings can be adjusted. This is detailed in the section ‘AMIT cost base net amount- excess/shortfall’. These are to be taken into consideration when selling units in the fund. 

What is an ETF, ETF Guide, ETF ASX, ETF TAX, ETF Amma Statement

For more information refer to:

  • Your Tax Professional
  • ATO: Personal investors guide to capital gains tax 2019, Part C: Distributions from managed funds
  • Australian Individual Tax Return Guide: Guide to your AMIT member Annual Statement
  • IOOF: Guide to your AMIT Member Annual (AMMA) statement

Why are ETFs Considered Tax Efficient?

ETFs are often considered tax-efficient as relative to other investment vehicles they create less taxable events. These can be summarised by the following:

Low Turnover: The large majority of ETFs are passive index funds. As these funds will rarely involve actively buying and selling shares this will reduce the turnover of the fund. For example, a passive index fund will usually average a turnover rate of 1-5%, compared to around 30% or more for an active fund. Because Index ETFs generally have low turnover, capital gain distributions are minimized. 

ETF Open-Ended Structure: The open ended-structure of an ETF differs from close-ended funds. In a managed fund the underlying assets are pooled together. In these funds when an investor chooses to sell down their holdings the fund must actively reduce their asset pool and sell down assets, as a result, this realizes capital gains within the fund for all investors. In an ETF when an investor sells their units they will either sell directly to a buyer, or an AP will create a redemption process. In the first option, the underlying funds are not impacted. In the second option, the AP allows the fund to reduce its number of units without realizing a capital gain event. When market makers redeem ETF units any capital gains that are generated from this redemption are distributed directly to the market maker and do not impact ETF investors

List of ASX ETFs

Further Reading:

ETF Book, What is an ETF, ETF Guide, ETF ASX
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