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How ETFs may help diversify your portfolio and spread risk

How ETFs may help diversify your portfolio and spread risk

Exchange traded funds (ETFs) can offer a low-cost method of portfolio diversification that could help some investors spread risk.

ETFs are listed on the stock exchange and can be bought and sold like shares. They aim to replicate the performance of a share index or different group of underlying assets by investing in their component parts.

Australian ETFs are generally passive investments, which means they only try to match the performance of the underlying assets they track rather than beat it.

If the index rises, then so too should the value of units in the ETF – roughly by the same percentage. Likewise, if the index falls, so too would the value of your investment.

Investing in an ETF provides an overall, broad-market return, whereas investing in various individual companies might see some outperforming the index over the year, while some might underperform.

You can use ETFs to gain exposure to a range of different asset classes including:

  • Australian shares
  • International shares
  • Commodities
  • Currencies
  • Fixed Income and Cash

How do ETFs work?

A standard S&P/ASX 200 index ETF, for example, buys shares in the 200 companies listed on the index, so you can get exposure to all of them.

When you invest in an ETF you buy units in the fund, which are listed on the ASX, and rise and fall in value on a daily basis, in line with the shares in the fund.

Investors own units in the fund, rather than the underlying assets themselves, which are owned by the ETF provider.

What are the benefits of ETFs?

  • Diversification - you can gain exposure to lots of different companies or assets through just one trade 
  • Accessibility - you can access asset classes that might otherwise be difficult to reach
  • Low cost - ETFs generally cost less than other managed funds that are not listed on the share market
  • Visibility - ETFs are listed on the ASX so you can monitor their value on a daily basis and also see what underlying assets the fund is invested in

What else do you need to consider?

As with any investment, there is a risk that ETFs will not deliver the returns you hoped they would and you could lose money. There is also a chance the ETF won’t exactly replicate the index it tracks, due to fees, taxes and other factors.

If you’re investing in ETFs that track international shares, they will carry a currency risk if they are not hedged back to Australian dollars. There could also be more onerous tax reporting responsibilities in the case of assets held overseas.

Just as ETFs can reduce the risk in your investment portfolio through diversification, they can also limit your potential gains as they will not outperform the index they track.

Are they easy to buy and sell?

You should not overlook the liquidity — how easy it is to buy and sell in the market — of an ETF because it affects the bid-ask spread, which is the difference between the highest price a buyer is ready to pay and the lowest price a seller is willing to accept.

When buying units in an ETF, chances are you may pay a price higher than the fund’s net asset value (NAV), or the total value of the assets in the ETFs minus liabilities.

Likewise, when you sell your units, you could receive an amount less than the NAV due to supply and demand.

This bid-ask spread is one of the components that affects your total cost. The narrower the spread, the lower your cost would be.

ETFs charge an annual management fee, which is generally included in the unit price.

While the fee you pay to the manager of an ETF is often, though not necessarily, cheaper than managed funds due to a certain degree of passive management, it should be noted that the management fee is not the only cost incurred when investing in ETFs.

Since ETFs trade like shares, you invest in them through a broker or adviser and the buying process is similar to buying the stocks of a single company.

Whenever you buy or sell units in an ETF, you pay your broker on a per-trade basis. As such, whether you trade frequently, or whether you are holding an ETF investment for a longer term or shorter term, could affect your total cost.

It should also be noted that there may be other additional fees and expenses. Investors should always read the product disclosure statement of an ETF and the fine print to get a detailed cost breakdown.

This article is intended to provide general information of an educational nature only. It does not have regard to the financial situation or needs of any reader and must not be relied upon as financial product advice. Investors should consult a range of resources, and if necessary, seek professional advice, before making investment decisions in regard to their objectives, financial and taxation situations and needs because these have not been taken into account. Any securities or prices used in the examples, including but not limited to Exchange Traded Funds given are for illustrative purposes only and should not be considered as a recommendation to buy, sell or hold. Past performance is not indicative of future performance. Commonwealth Securities Limited ABN 60 067 254 399 AFSL 238814 (CommSec) is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945 and a Participant of the ASX Group and Chi-X Australia.