An exchange traded fund (ETF) is a managed investment fund that can be bought or sold on a stock exchange. In many ways, ETF combines favourable elements of a managed fund with favourable elements of the listed investment company. But an ETF is not the same as either a managed fund or a listed investment company. Many people argue that an ETF combines the best of both of these forms of investment.

An ETF typically holds a series of underlying investments. The purpose of the ETF is to provide a convenient and efficient way for an individual investor to gain access to a broad range of underlying investments.

In Australia, the majority of ETF’s are passive in nature. This means that they track some form of index and that their portfolios are constructed in concert with such an index. Traditionally, index fund investors have been attracted by low transaction costs and low holding fees – two particular features of an ETF that have undoubtedly helped explain the increasing popularity of this type of investment.

The indices tracked can be broad-based or relatively narrow. For example, an ETF might track only a particular sector of the Australian market, such as the banking sector. Or it might track a broad-based market index such as the ASX 200..

Open-end

ETFs are ‘open-end’ investment funds. This means that the fund manager can issue or redeem units at any time in response to investor demand. There is no upper or lower limit to the size of the fund, and an investor can transact directly with the fund manager rather than with another potential shareholder.

In contrast, most listed investment companies are closed- end. This means that the number of investment units on offer is closed. An investor wishing to purchase shares in a listed investment company must buy those shares from an existing shareholder. The underlying assets of the company are not affected by the transaction. Similarly, an investor wishing to sell shares in a listed investment company must find a willing buyer of those shares.

With an exchange traded fund, a purchaser or seller may transact directly with another purchaser or seller. Or, they may transact directly with the fund manager. This usually means that there will be someone with whom to trade units in an ETF.

Buying and selling

Units in an ETF are bought and sold on the ASX in exactly the same way as shares in companies listed on the ASX are bought and sold. In practice, this means that most people who purchase or sell units in an ETF do so via an online brokerage service. As with all shares bought and sold in this manner, the transaction typically occurs immediately, with settlement for the trade taking place within the next three days.

This ability to access ETF’s through the ASX is one of the key advantages of this kind of investment. When making an investment into an unlisted managed fund, there can be a substantial delay between the time at which the order to buy or sell units is made and the time at which the transaction actually takes place.

Low fees

One of the defining features of ETF’s is that they typically impose a much lower fee on unit holders. For example, the fee for Vanguard Australian index share ETF is just 0.14% per annum. The fee or the Vanguard Australian index share managed fund can be as high as .75% per annum. Given that these two investment vehicles hold the same underlying assets, the ETF is a much more efficient way of accessing what will be the same before fee return.

Diversification

Diversification is, of course, the main rationale behind any form of managed investment. If a managed investment was going to invest in one asset only, then the investor should simply avoid the investment manager and purchase the asset themselves.

For this reason, most ETF’s hold a substantial range of investments. Much of the rise of ETF’s has been an index tracking funds. This makes sense, given that the whole rationale of indexing is to achieve the average returns to be expected from a diversified portfolio with minimal transaction and holding costs. The substantial cost advantage enjoyed by ETF’s makes ETF’s very attractive to passive investors.

Transparency

As outlined above, ETF’s are subject to the same listing rules as all other listed securities. One of these requirements is that of continuous disclosure. As its name suggests, continuous disclosure requires the listed entity to keep the market informed of all material information that might affect its share price. Obviously, this will include basic information about the fund such as its investment philosophy and underlying investment holdings.