How do exchange traded funds work?
Exchange traded funds (ETFs) can provide you with a simple and affordable way to invest in multiple companies, bonds or other investment types – all in one go. If you’re thinking of investing in an ETF, this guide may give you a better understanding of how ETFs work and help you to decide if ETFs are right for you.
What is an ETF?
An ETF is an investment fund that can combine a range of securities – like shares, bonds, commodities, or a mix of assets – all into one investment. In addition to a range of asset classes, some ETFs offer investors access to different markets. For example, you can purchase units in an ETF that’s listed on the NZX or ASX but invests in international shares.
Like managed funds, investors pool money together to invest in a fund managed by an independent manager. But unlike managed funds, ETFs trade on the share market just like shares. This means ETFs can be traded whenever the share market is open and there are buyers and sellers in the market. Settlement will generally occur two working days after the trade date.
It’s important to understand that when you invest in an ETF, you don’t own the securities the ETF invests in – you’re simply buying units in a fund.
How are ETFs managed?
Broadly speaking, there are two approaches to managing a fund: passive management and active management.
ETFs are generally passively managed, which means they track a market index (such as the NZX50, ASX200 or S&P500) with the aim of replicating the performance of that index.
Let's take the example of an ETF that tracks an index containing the 10 largest companies on a stock exchange. The ETF holds shares in each of the companies in proportion to the index, so if the price of the shares in each of the companies goes up, the value of the ETF as a whole should go up as well, and vice versa.
On the other hand, ETFs that are actively managed are picked by individuals, rather than track an index. The securities are chosen by a fund manager according to a particular strategy that generally aims to outperform the market.
Actively-managed ETFs can be more risky than passively-managed ETFs as they depend on the skills of the individual fund manager selecting securities, rather than simply tracking a market. They can also incur higher fees as more management time is required for active investing.
How is the value of an ETF determined?
Because ETFs trade on the share market, their value is determined by supply and demand, as well as factors like the economy and the performance of its underlying securities or assets. Like shares, they are bought and sold at the market-determined value, which can change throughout the day.
To gauge whether the market value is a fair price, you can look at what's called a Net Tangible Assets (NTA).
The NTA is an important calculation that provides what is considered the actual value of the underlying assets for each unit of an ETF. The NTA can be found along with other pricing information about an ETF. By looking at the NTA, an investor can generally see if the ETF is trading above the actual value (called 'trading at a premium') or below actual value (called 'trading at a discount').
How can ETFs make money for investors?
How an ETF makes money depends on the ETF, but generally, there are three ways you may be able to get returns from ETFs:
- Dividends – if the ETF invests in shares that pay dividends.
- Interest – if the ETF invests in bonds or other fixed interest securities.
- Capital gains – this is the profit you make by selling an ETF for a higher price than you paid.
Distributions, or pay-outs, from dividends and interest are usually paid quarterly, semi-annually or yearly – depending on the ETF – and any fund management fees are deducted before distributions are made. Every ETF is different so it’s important to read the ETF’s product disclosure statement for more details.
You can organise to have your ETF distributions reinvested or paid out to a bank account that you select.
What are the risks of investing in ETFs?
The risks may vary from fund to fund, but here are some of the risks ETFs could expose investors to:
- Like shares, ETFs are traded on the share markets so prices are influenced by supply and demand, as well as other factors, such as the economy, industry trends or company’s performance. This means the market value of an ETF could deviate from the actual value of the securities it is invested in (the NTA).
- If you buy an ETF that is heavily invested in one area, like one industry, your risks may not be as well spread. You need to consider how well an ETF fits with your investment strategy, spreads your investment risk and provides you with diversification. So it’s important to do your research and understand what the ETF you’re investing in holds, as well as how often the fund is rebalanced.
- A risk specific to ETFs that track an index is tracking error. This is where the ETF's returns differ from the returns of the benchmark index. A low tracking error means the ETF is closely following the index. The main reason an ETF's returns may lag behind the benchmark index is due to the management fees of an ETF, charged by the fund manager for administering the ETF.
Before you invest, always read the relevant product disclosure statement (PDS) to ensure you understand any further risks.
What are the fees of investing in ETFs?
As ETFs are a cross between managed funds and share trading, there are generally two types of fees:
- Brokerage fees to buy and sell ETFs, visit ASB Securities rates and fees page for our brokerage rates.
- Fund management/administration fees vary from ETF to ETF and these will be advised in the ETF’s PDS. Please read the PDS carefully before investing in an ETF.
It’s important to include these fees when working out your investment strategy and potential returns.
How do I invest in ETFs?
Find an ETF to buy
Whether you're interested in investing in ETFs on the NZX or ASX, we can help you get started. Find out more.
ASB Securities clients can invest right away
If you aren't already an ASB Securities client, the first step is to join ASB Securities online.
If you’re an ASB Securities client, you can invest in ETFs straight away. For ETFs listed on:
- New Zealand and Australian markets – simply place an order in Online Share Trading, just like you would for an ordinary share.
- International markets – call us on 0800 272 732 Monday to Friday, 7am to 6pm and we’ll place the order for you.
You can also view market pricing for New Zealand and Australian ETFs in Online Share Trading.
Next steps
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ASB Securities Limited is an NZX firm. When you trade on the NZX markets through ASB Securities you must comply with NZX rules as outlined in the ASB Securities Trading Conduct for Online Share trading. ASB Securities terms and conditions apply. Pricing data supplied by ASX and/or NZX. ASB Cash Management Account, ASB Foreign Currency Account, ASB Margin Lending and ASB Term Deposits are provided by ASB Bank Limited. ASB term's apply. Rates and fees may change. Refer to asb.co.nz for other fees and charges. This page does not have regard to the financial situation or needs of any reader. As individual circumstances differ, you should seek appropriate professional advice. See the ASB Securities glossary for share trading and investment terms or Morningstar for research terms.
