ETF: An Easy Guide to the Exchange Traded Fund

The Exchange Traded Fund (ETF) is one of the easiest products for any new investors to get started in the market.

They help new and experienced investors get exposure to the market, and can become the core of anyone’s portfolio.

Of course, if you’re a new investor there’s a small learning curve that needs to be taken first.

The Exchange Traded Fund

The Exchange Traded Fund received it’s name because it’s a fund that trades on the stock exchange.

Well that’s easy enough.

Listing of Vanguard Australia’s ETF VAS on the ASX wesbite

The structure of the fund makes it a little different from a normal managed fund or shares of a company however.

The Open-end Fund Structure

ETFs are an open-ended fund.

This open-end structure means any ETF’s or fund that’s open-ended will continue to issue units when investors want to buy, and cancel/take units off the stock exchange as investors sell back to the market.

The process is completed by a market maker who does all this in the background without you even knowing.

Because of this structure, the ETF always trades close to it’s underlying Net Asset Value (NAV) as it fluctuates with supply and demand of the market.

Enter the Net Asset value (NAV)

I’ll start this with letting you know you won’t ever need to work out what the NAV for an ETF. The ETF providers will have this on their website and is updated daily.

The short of it is, NAV is basically the value of all securities in the fund added together then spread out across all the shares currently in circulation. This gives you the Net Asset Value per share.

Looks confusing at first.

It’s reading the Net Asset Value (NAV) of the ETF is currently $68.33 per share. At the closing bell on April 29 2020, that was the true value of 1 share.

Premium and Discounts to NAV

Because ETF’s are bought and sold on the stock exchange just like the share of a company they can be exposed to supply and demand pushing their prices above or below NAV.

If it does trade above the NAV it’s called a premium to Net Asset Value (NAV) and when it trades below it’s called a discount to NAV.

Let’s assume the Net Asset Value (NAV) is $1 per share, it’s currently trading for $1.10 on the market, that would be a premium to NAV. If it was trading for 90 cents, that would be a discount to the NAV.

The current price is at a small premium to Net Asset Value (NAV).

Can the price of each share become wildly overvalued?

The short answer is no.

There is a market maker that creates and redeems units of the ETF depending on supply and demand. It’s known as the creation and redemption process.

This process allows the price to always trade close to its underlying Net Asset Value (NAV).

The simplest way to describe it is, whenever investors want to buy units of the ETF the market maker will create them, whenever investors want to sell their units the market maker will redeem them and cancel them.

I’ve tried to keep this short and easy because it can take awhile to get your head around.

You can search around if you want to find out more, the key thing to remember is the share price is always trading close to it’s true value!

The Unit Trust

In Australia, ETF’s operate as a unit trust. So all the assets in the fund are held by a trustee. The trust structure also means all the profits it makes must be distributed back to unit holders.

They can’t retain any earnings like a fund in a company structure can.

I recommend the book, The Australian ETF Guide by David Bassanese for an in depth read on ETFs

All this boring stuff aside, what makes ETFs so great then?

Low Fees

Because ETFs usually have passive strategies, they can charge extremely low fees.

Here are two main reasons why fees can be so low.

  1. There isn’t an active fund manager that needs paying. (Active fund managers can charge a performance fee plus assets under management fee… fees on top of fees it makes your head spin.)
  2. A computer will usually do the portfolio re balancing

Active funds are more expensive in fees because you’re meant to be paying for their performance to outperform the market. Which they usually can’t.

The funds now have two major costs out the window that it doesn’t have to pay.

These low fees are a key reason why experienced investors promote index funds over managed funds.

Why fees matter.

Knowing active managers regularly under perform the market after fees, this can have a huge difference in long term returns.

Here is why.

Assuming $10,000 invested over 20 years with returns of 10% annually (around the average returns of the stock market). After the 20 years you’d have ended up with $67,275.

That same $10,000 over the 20 year period with returns of 10% less a 1.2% management fee (meaning a return of 8.8%) you’d have ended up with $54,023.

I know these numbers won’t make any of us wealthy but it’s to illustrate a point.

These figures only get more extreme with more money invested. Using the same example, $100,00 invested and you’ll have lost $132,000.

Now we know the lower the fees the better… but how low?

As a side note, it’s worth remembering though when you’re buying an ETF you’re paying for a service.

You most likely couldn’t go out and buy all the stocks that make up the index. So, the ETF provider is doing it for you.

These funds have bills to pay too, keep the lights on and employ staff to monitor the portfolio etc.

This is where passive funds, ones that invest in indexes can charge much lower fees then a fund that’s actively managed.

For me when I’m looking at an index tracking ETF anything over 0.5 or half of 1% is way too high.

The fees are known as Management Expense Ratio (MER). Some ETF providers will just call it a management fee.

What the fees are saying

The below screenshot is the management fee for VAS.

A 0.10% fee will cost you $1 for every $1000.

Read the fine print

I would always read the Product Disclosure Statement (PDS) and check for any little extra cost’s that might put in there. Such as, indirect costs or performance fees.

This ETF provider promotes a 0.35% management fee on their website but when you read the PDS this is what it really says.

You could be charged as high as 1% some years. However, that might be okay if you’re happy with the strategy they’re using.

Remember it’s a personal preference, however all the studies do point to higher fees being a negative for overall long term returns

Investment styles

The typical investment style of an ETF is passive in nature by tracking an index, like the ASX200.

There’re many other types of ETF’s that invest in different assets and asset classes or they’ll use active strategies, like selecting individual stocks because they think they can outperform the market.

It’s worth remembering most active manager don’t outperform the market after fees. This is why so many investors have gone the index investing route.

Indexing

When an ETF tracks the index, they’re aren’t trying to outperform the market. They’re only trying to match the market returns minus any of those small fees that come with the passive strategy.

There’re a variety of indexes around now, such as an index that only tracks dividend paying stocks, or an index where the stocks must meet certain rules to be in there.

When people talk about indexing though they usually mean just buying the whole market like the ASX200 or S&P500.

I’m sure you’ve heard of those before.

How they track the index.

Vanguard Australia has an ETF that tracks the ASX300 called VAS or Vanguard Australian Shares Index.

We’ll use this as an example.

The ASX300 index is the top 300 publicly listed companies in Australia. The fund will buy all the shares that are in the ASX300 index and weight them so the ETF (VAS) will move in lockstep with the index. When the index re-balances so will the ETF.

This allows it to always be trying to track the indexes returns.

It’s also what makes them passive investment they just follow the index, there’s no real active management involved besides some portfolio rebalancing when the index rebalances.

One more example.

State Street Global Advisors SPDR S&P500 ETF (ASX: SPY) tracks the returns of the S&P500 index. It does this by buying all the stocks that make up the S&P500 index and weights them so the ETF should move in lockstep with the index.

You can see the holdings of the fund and the holdings of the index are indenctial.

Index investing is the same no matter the index or country.

The survival of the fittest

The broader market indexes are a game of survival of the fittest.

There are always other companies waiting to be included in the index when the weaker companies drop out.

Here’s what I mean.

For a company to be in the index they must be a certain size, if company 300 in the ASX300 index starts to falter and they go down in value then they will be replaced in the index with another company.

It’s a revolving door of companies. The companies performing poorly are dropped out of the index, and the companies performing well take their place.

It goes around and around.

Diversification

There’s the old saying “don’t put all your eggs in one basket”

Which I’m sure most people have heard this before, how do we not put all the eggs in one basket then?

By diversifying.

It’s a key reason ETF’s and indexing is so attractive, it’s their instant diversification.

You can buy one asset on the stock market like VAS and be exposed to 300 companies.

One buy, and your instantly diversified.

The long term returns of the stock market

Another major component of investing in an ETF that tracks the whole stock market is the long-term returns that market has to offer.

This is pretty much the bedrock of the index investing strategy.

In Australia the average yearly historical return is around   10% to 11%, you may or may not get that, but I’m happy receiving anything 7% and up while I consistently add more to my investments.

The price of the Australian All Ordinaries Index since 1963

The table below is by https://www.marketindex.com.au/ it’s the yearly returns of the Australian stock market since 1900. Plenty more positive years then negative, I like the probability of that continuing.

You see, the stock markets overall trajectory is up. Sure, there’s a few crashes and bumps along the way but the natural progression is for it trend up over time.

Those ETFs or index funds are the investment vehicles that allow you to participate in the long-term returns of the stock market.

 

Why does the stock market trend up over time you ask?

Stock prices generally rise over the long term in line with their company earnings. If companies’ earnings are growing and the stock prices are rising then the broader market (index) will rise with it.

Companies are able to increase their prices for goods and services as inflation rises, and pass this onto customers. This allows for their earnings to keep rising and not just stagnate as inflation rises.

Main Points

These are the main areas I struggled to understand at first so I’ve tried to simplify it so it’s easier to understand. There can be so much more to learn about ETF’s and you can go down a rabbit hole.

These are key things I think are important to remember.

  • Index: Is a way to track the performance of the entire market, so if you hear The All Ordinaries was up 1.5% that means all the stocks in that index moved high enough to push the price of the index up by 1.5%.
  • Fees: There’s no right or wrong answer here it all depends on what your style is. If you think an active manager is worth paying the extra money then go for it. If you’re just going passive anything over 0.5% is too high.
  • Survival of the fittest: The broader market indexes (ASX200, ASX300 etc) always have company’s revolving in and out. If the bottom companies are no longer performing there’s always a new one ready to take its place.
  • Diversification: Owning 100’s of companies by buying 1 asset.
  • Tracking the index: The fund buys all the same shares that make up an index and weights them the exact same, this allows them to move in lock step with the index and generate the same returns.
  • Stock market trends up long term: The stock market trends up over long periods of time thanks to rising company earnings. Buying a fund that tracks the stock market allows you to participate in those long-term returns.

 

Summing it up

It can seem like a lot to take in at first but the key is to keep reading and learning and everything will start to become easier.

This is an easy summary guide for anyone trying to get started or not knowing where to start.

Hopefully this has cleared up confusion for some people and made it easier to understand.

Is there anything that seems hard to understand or have I gotten anything wrong? Let me know in the comments below.

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