An Exchange Traded Fund or ETF is simply a managed fund which is listed on the stock exchange.
VIDEO: ETFs Explained
Pulling Apart An ETF
A managed fund (read: ‘mutual fund’ in the USA) is a pooled sum of money that is managed by a professional funds management company.
Just imagine you and 20 friends put $5,000 into a special bank account (your accountant calls it a “trust”). That’s the ‘fund’. If you pay a professional to invest that money for you, presto, you have yourself a ‘managed’ fund!
Watch our ‘What is a Managed Fund?‘ video.
An Exchange Traded Fund or ETF is simply a managed fund that can be bought and sold on the stock exchange.
For example, imagine one of your 10 friends — let’s call him, Dave — says that he, “wants out!”.
In other words, Dave wants to exit the managed fund.
An ETF allows investors — even ex-friends like Dave — to log into their online stockbroking account, click ‘sell’, and withdraw their investment from the fund.
Are All ETFs Also Index Funds?
ETFs can use a passive or “index” investment strategy (e.g. to track the ASX 200 index) or they can use “active” investment strategies, which is when a professional money manager picks only the stocks they think will do better than the market.
Watch our ‘What is an Index Fund?‘ video.
An ETF might also invest in different asset classes — not just shares.
For example, some ETFs invest in bonds, cash accounts or commodities (e.g. gold), and can often invest internationally (e.g. US stocks). It all depends on the strategy used by the fund.
You can read more about the ETF’s strategy in its Product Disclosure Statement (PDS).
How Does An ETF work & How Can I Buy Them?
Investors buy and sell into an ETF the same way they would buy a share on the market.
After the investor clicks “buy” in their stock brokerage account, the fund manager accepts the order and uses the investor’s money to buy more investments to include in the managed fund. In exchange, the investor receives ‘units’ in the fund.
For example, Marley is a great investor in the making. If she bought into an ETF/fund which tracks Australia’s ASX 200 index, the ETF management company responsible for the ETF would issue ‘units’ to Marley (which appear in her brokerage account). Behind the scenes, the ETF manager uses her money (e.g. $500) to buy all 200 shares in the ASX 200 by pooling it with other investors’ money.
When Marley decides to sell her ETF ‘units’, the ETF/fund manager will sell the equivalent amount of shares in the ASX 200 and transfer the right amount of cash (the value of her units less fees) back to her sharebroking account.
Are ETFs Risky?
Like all investments ETFs have risks. Some of the risks will be listed in the fund’s Product Disclosure Statement (PDS), which can usually be found on the fund manager’s website.
Typically, ETFs will be susceptible to market rises and falls (known as “market risk”). There’s also the risk that something might go wrong behind the scenes (“execution risk”) and many others. The exact risks will depend on the strategy and the fund manager.
Knowing What’s Right
If you are confused about the potential benefits and risks of ETFs or investing, a trusted and licensed financial/investment adviser can help you make an informed decision. A qualified financial planner can take into account your risk profile, goals, needs and objectives.
You might also access the research of a professional investment research company to get ‘general financial advice’. Regardless, we think it’s good to read the PDS or ‘product disclosure statement’ before investing.
Video: The Difference Between Personal Financial Advice And General Financial Advice
This education originally appeared on Rask Finance. Rask’s FREE education website.