What are exchange traded funds and how do they work


Exchange traded funds ETFs can be a simple and low-cost way to get investment returns similar to a share index or another underlying asset. However, some ETFs are more complex and risky than others. Here we explain the risks and what you need to know before you invest. An ETF is a type of investment fund that can be bought and sold on a securities exchange market. They generally do not try to outperform the market and will go up or down in value in line with the index they are tracking.

If an investment is called an Active ETF then the fund manager is actively trying to outperform the market or index to achieve a different investment objective. See other exchange traded products for information on Active ETFs. What are exchange traded funds and how do they work are available for a broad range of assets including Australian shares, international shares, fixed income products, foreign currencies, precious metals and commodities.

Standard or 'physical ETFs' buy the underlying investments such as shares and other assets on the reference index that the ETF is seeking to track. Your main investment risk is the performance of the underlying shares or other assets.

Other risks are discussed below. Synthetic ETFs have a material exposure to derivatives as well as the underlying assets that the ETF is seeking to track.

Find out more about synthetic ETFs. Products labeled 'exchange traded commodities', 'exchange traded notes', 'exchange traded certificates', and 'exchange traded securities' are not ETFs. The risks of these products can be different and sometimes much higher than the risks of ETFs. See other exchange traded products for more information. The value of a physical ETF investment can rise and fall daily, usually in line with the index it is tracking.

If the offer price you are quoted by a broker is significantly above the NAV, there is a risk you might pay far more for an ETF than it's worth. If the bid price is significantly below NAV, there is a risk you could sell for less than the value of the underlying investments. This is called a tracking error. This helps create a more liquid ETF market. To receive an ETF price that is closer to the value of the underlying assets, place orders to buy or sell units at least 30 minutes after the share market opens.

This may reduce price discrepancies between the ETF and the price of the shares that it holds. While ETFs may have lower fees compared with other managed investments, management fees can vary and may be higher than the fees of an equivalent unlisted or unquoted index fund.

You will also pay brokerage fees when you buy or sell ETF units. If you want to make a small regular investment in a product that tracks an index, you might be better off using an unlisted managed investment such as an index fund where broker fees won't apply to each contribution, although other fees may apply.

The 'buy-sell spread' the difference between the prices that you can buy and sell ETF units at could be considered a cost for you when you buy or sell ETF units, although market makers usually ensure the spread remains relatively small. If you're selling you can work out the 'buy-sell spread' by subtracting the bid price from the NAV to calculate a 'dollar spread' and then dividing the 'dollar spread' by the 'bid price' to get the 'percentage spread'.

If you're buying you can calculate the 'dollar spread' by subtracting the NAV from the offer price, and then calculate 'percentage spread' by dividing the 'dollar spread' by the offer price. Some ETFs offer exposure to investments such as small companies, emerging markets or commodities that may be harder to sell in certain circumstances, or more complex and volatile than ordinary company shares.

This could increase risks for investors. If the ETF tracks overseas assets, changes in the value of the Australian dollar may also affect the value of your investment. Some funds may be 'currency hedged' to reduce this risk. When you buy units in an ETF located in what are exchange traded funds and how do they work country but also traded on an Australian market foreign taxes may apply.

Read the PDS to understand how your investment will be taxed, and if you're not sure contact the ETF provider or a tax adviser. Fixed income ETFs aim to replicate the performance of assets such as bonds and debentures. The Australian Securities Exchange ASX has restrictions on what indices or non-exchange traded bonds what are exchange traded funds and how do they work debentures can underlie an ETF, however the value of the underlying assets may rise and fall, which means the price of the ETF can also rise and fall.

The secondary market for corporate bonds may be less active than the market for ordinary shares, making it harder for the ETF issuer to sell its bond investments.

See ASIC's investing in corporate bonds for more information about fixed income investments. Before you invest in ETFs do your homework. Read the PDS and consider getting advice from a licensed financial adviser. Diversifying your investments between asset classes and product issuers can help control your risks.

What is an ETF? What are the risks? The difference between physical and synthetic ETFs ETFs are available for a broad range of assets including Australian shares, international shares, fixed income products, foreign currencies, precious metals and commodities.

How to buy and sell ETFs The value of a physical ETF investment can rise and fall daily, usually in line with the index it is tracking. Here are some tips on what to look for before you invest. What will your investment cost? Buy-sell spread The 'buy-sell spread' the difference between the prices that you can buy and sell ETF units at could be considered a cost for you when you buy or sell ETF units, although market makers usually ensure the spread remains relatively small.

Market liquidity Some ETFs offer exposure to investments such as small companies, emerging markets or commodities that may be harder to sell in certain circumstances, or more complex and volatile than ordinary company shares.

Currency risk If the ETF tracks overseas assets, changes in the value of the Australian dollar may also affect the value of your investment. International taxes When you buy what are exchange traded funds and how do they work in an ETF located in another country but also traded on an Australian market foreign taxes may apply. Liquidity - Is there an active market for the underlying investments? You may be more likely to get a fair price for your ETF units if the underlying assets are traded regularly.

Tax - How will the ETF returns be taxed? Market - What are exchange traded funds and how do they work you buying a product on an Australian market?

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