A Beginner’s Guide to Exchange-Traded Funds

Author: Martin Kovacs  

Exchange-traded funds (ETFs) can provide a simple and effective means to diversify your investment portfolio, offering streamlined access to different industry sectors and asset classes. However, before making any type of investment, it’s important to weigh up what’s on offer and what is right for you.

First introduced in the early 1990s, ETFs have experienced strong growth in markets around the world in recent years. In New Zealand, investors have access to ETFs with both a domestic and global focus.

In this guide we’ll look at ETFs, what to keep in mind when investing in one, their pros and cons, and the options currently available at a local level.

What are exchange-traded funds?

An exchange-traded fund is mix of different investments that are bundled together. They can be a mix of different stocks and bonds, or just focus on one particular industry, or just bonds, for example. As an investor, you own a portion of the bundle, not just one particular share or bond.

A key characteristic of ETFs (and a fundamental difference between ETFs and managed funds) is that they trade on a stock exchange, and can be bought and sold like shares.

The Financial Markets Authority (FMA), which describes ETFs as being “made up of a ‘basket’ of investments, usually shares, bonds, commodities or currencies”, advises that most ETFs offered in New Zealand are “passive” investments that track a market index.

For instance, an ETF may track an index containing a number of the largest stocks listed on a stock exchange, such as the S&P/NZX 50 Index, with the value of its units rising and falling in line with the index.

This provides for diversification, meaning that the risk is spread out (as opposed to investing in just one company) across the individual investments that make up the ETF.

Less common are “active” ETFs, which the FMA notes are overseen by investment managers, who assess market conditions, and buy and sell in line with the investment objectives of the fund.

Before investing: what to look for?

Before investing in an ETF, it helps to gain an understanding of how they work and how a certain ETF may potentially complement your portfolio and line up with your financial objectives.

In this respect, it’s important to thoroughly research the ETFs you are interested in, to be aware of the risks involved and to clearly set out your goals.

In seeking to reduce risks, the FMA advises that investors focus on:

• ETF specifics – what exactly does the ETF invest in? Research the products, geographical areas and sectors included in an ETF.
• Areas of focus – is an ETF geared to heavily invest in a specific area? Risk can potentially be spread out by investing in a more diversely focused ETF, and exposure spread out across multiple ETFs.
• Volatility – providers are required by law to use a risk indicator showing a fund volatility, which can be found in the product disclosure statement and fund updates.
• Costs and fees – while costs are generally less than other managed funds, it is important to compare like-for-like funds (such as comparing passive funds with other passive funds), and to be aware of the range of costs that may be incurred.

It’s also important to keep in mind potential liquidity risks, which can impact the capacity to buy and sell when required, and to research any other particular financial risks that may be associated with a specific ETF.

Of course, in addition to undertaking your own research, it may also be worthwhile seeking out advice from an investment adviser or financial professional.

Exchange-traded funds pros and cons

When weighing up the pros and cons of ETFs, it’s important to consider your approach to investing. Do you want to play an active role in your investment, and have you compared ETFs to other investment opportunities?

Some potential ETF pros include:

• Diversification – a single ETF unit can provide immediate investment diversification. For instance, an ETF that tracks the S&P/NZX 50 Index will provide access to the index’s range of stocks in one go, rather than having to make individual investments.
• Cost – given that many ETFs are passive investments, they are generally cheaper than actively managed funds, however, as mentioned above, it’s important to compare like-for-like funds.
• Convenience – just like stocks, investors can buy and sell ETF units at their discretion during exchange trading hours, with public pricing information allowing for ongoing monitoring of investments.

Some potential cons include:

• Capacity to outperform – with most ETFs being passive investments, their value will go up and down in line with the index or asset they are tracking, rather than actively seeking to outperform the market like some other types of funds.
• Tracking error – an ETF’s performance may be different than the index or asset it is tracking due to a range of factors related to expenses associated with the ETF. This can result in a variance between the ETF’s net asset value and market price.
• Market risk – as with any investment, there are degrees of risk involved, with different ETFs carrying different levels of risks. A range of factors can influence performance.

What’s available in New Zealand?

For investors seeking to buy and sell ETFs on the NZX, there are a number of options available, with both a local and global focus.

NZX-owned Smartshares, New Zealand’s only issuer of listed ETFs, currently offers 31 ETFs, which invest across New Zealand, Australia and a number of global stock exchanges.

Smartshares advises that its ETF categories comprise:

• SmartLARGE – 10 funds focusing on some of the biggest companies listed in NZ and offshore.
• SmartMEDIUM – three funds focusing on a selection of medium-sized companies listed in NZ, Australia and the United States.
• SmartSMALL – one fund focusing on a selection of smaller companies listed in the United States.
• SmartINCOME – three funds that are actively managed and made up of interest-bearing assets, bonds and other fixed-interest assets across NZ and a range of global markets.
• SmartDIVIDEND – two funds made up of some of the highest dividend-paying companies listed in NZ and Australia.
• SmartSECTOR – four funds made up of some of the largest companies in the property, financial or resources sectors listed in NZ and Australia.
• New ETFs – eight funds allowing for investment in environmentally and socially responsible global equities, megatrends and passive global bonds.

Investors can invest online directly via Smartshares, via an NZX participant, or via an authorised financial adviser. In addition, NZX-owned financial services company SuperLife allows investors to include Smartshares’ ETFs as an investment option in their KiwiSaver scheme.

If you are thinking about investing in ETFs as part of KiwiSaver, it’s worth considering the many other KiwiSaver funds on the market to see if they better match your investor profile. To help you with your research, Canstar rates KiwiSaver providers for value and has a free comparison tool. To check out our KiwiSaver Star Ratings, click here … and for our comparison tool, just click on the big button below.

Compare KiwiSaver providers for free with Canstar!