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What are ETFs?

  • Willard Lloyd
  • November 1, 2019
Reading Time: 2 minutes

Like a traditional managed fund, an exchange-traded fund (ETF) offers the opportunity to invest in a portfolio of securities, such as shares or bonds.

As with a managed fund, each ETF unit represents an undivided interest in the underlying assets. In Australia, this interest is usually in the form of a unit in a unit trust. ETFs and managed funds also both offer professional management, so you don’t have to keep track of every security your fund owns. However, ETFs are different in that they can be traded throughout the day on an exchange at a market-determined price.

Most ETFs use an indexing approach. Index ETFs are built so that their value can be expected to move in line with the indices they seek to track. For example, a 2% rise or fall in an index should result in approximately a 2% rise or fall for an ETF that tracks that index (before fees and expenses).

ETFs combine the features of managed funds with those of individual shares

Managed fund characteristics

  • Diversified
  • Professionally managed

Individual share characteristics

  • Continuously priced
  • Liquid

An ETF is a managed fund quoted for trading on a securities exchange. Generally ETFs are constructed as indexed portfolios of shares, bonds or property securities.

ETFs can be bought and sold through brokerage accounts in the same way as shares at any time during exchange hours at intraday prices, rather than end-of-day prices as with unlisted managed funds.

How ETFs work

ETFs are traded throughout the day on exchanges at sharemarket-quoted prices, just like individual shares, bonds or property securities.

In contrast, managed fund units are bought and sold directly through the fund company at the fund’s net asset value (NAV) at the end of each trading day.

Although they trade like individual securities, ETFs – like managed funds – are open-ended investments. That means new units can be created and existing units redeemed daily, based on investor demand. Closed-end funds and individual securities, on the other hand, generally issue a fixed number of units.

As ETFs are quoted investments, a ‘share registry’ manages the administration for investors by confirming settlement and providing distribution and tax information. Vanguard works with Computershare as their nominated share registry.

The ETF creation and redemption process

While any investor can purchase or redeem managed fund units directly with the fund manager or distributor, only authorised participants can interact directly with the ETF provider (for example, Vanguard) to create or redeem ETF units. Also, while managed fund investors generally exchange cash for managed fund units, the authorised participant can typically exchange the underlying securities or cash for new units of an ETF.

The ETF units that authorised participants create are then traded by investors on an exchange.

.Click here for a video explanation 

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