In our previous article, How to use ETFs in an SMSF, we looked at the how Exchange traded funds (ETFs) allow access to different markets that may be difficult to invest in directly or provide sufficient diversification, an example being international shares.
To buy or sell ETFs you will need an account with a broker like CommSec and the process is the same as with buying and selling shares. There is a wide variety of ETFs on offer and the question often becomes which ETF should I buy to fulfil my investment goals.
Many of the well-known brokers provide a screening tool. Using CommSec as our example we can find the ETF screener after logging into your CommSec account under Quotes & Research / Tools / ETF screener. Then it’s a simple matter of making the filter selection to narrow down a short list for further investigation. There are 2 filter levels – basic and advanced – with the advanced filter allowing a greater ability to use financial metrics to fine tune your selections.
Figure 1. The basic filter
Figure 2. The advanced filter
This however is just the start of the process and there are some important things to understand before you start trading ETFs.
The screener provides the short list for further research. Each ETF should be reviewed to ensure you understand the underlying components, risks and strategy of the ETF. By going to the issuer’s website the fund details are available via the product fact sheets. Do the fundamentals match your investment strategy?
ETFs are what’s called an opened ended structure. That means that units of an ETF can be created or redeemed by ‘market makers’ unlike normal shares which are fixed. Therefore unlike shares the market depth or liquidity of an ETF does not relate directly to the units quoted in the “market depth” section of your broking screen. This ability to create and redeem means ETFs are more liquid than may appear. Liquidity of an ETF is mainly determined by the holdings of the fund.
Net Asset Value (NAV)
The NAV is the estimated intra-day "fair value" of the ETF (which is the price per unit of the basket of underlying securities held by that particular ETF less any liabilities such as management fees) which updates multiple times per minute. NAVs bring pricing transparency to ETFs in contrast to unlisted managed funds which are usually determined daily at the trading day.
The NAV for ETFs can either be found on the CommSec website under Quotes & Research after typing in the relevant ASX code as seen in the screenshot below.
Bid & offer spreads
Exchange-traded funds are subject to bid and offer spreads. This is the difference between the NAV and the price at which the ETF can be bought or sold on the ASX. Unlisted managed funds are subject to similar spreads that are quoted by the fund manager.
The difference or “spread" is a market maker's compensation and will vary as they are largely dependent on the liquidity of the underlying securities. In general, the more liquid the security, the tighter the spread. Bid/offer spreads for all ETFs can be found on the CommSec trading site under Quotes & Research, watch lists or when placing a trade.
"Market orders" and "limit orders"
When placing an order through your broker, you have the option of placing your trade as a "market order," in which you are agreeing to bid on whichever price the market is willing to pay, or a "limit order" in which you determine the price you are willing to bid.
The risk with the market order is that if there are many orders placed at the same time your trade runs the risk of being filled with the next best market bid and this may be worse than the best price possible.
To avoid this risk, you may wish to place a "limit order". Although you may run the risk of your order not being filled immediately, you still avoid the risk of getting worse than your desired price for the ETF.
Best times to buy
Investors may also wish to avoid trading near the market open and close. Market makers can experience higher risk because the prices of the underlying securities tend to fluctuate more at these times and this may result in wider than normal spreads. This volatility occurs around the market close as the "matching period" approaches (all trades that take place on the close transact at a price determined by the market, regardless of what price an investor bids or offers).
In addition to being able to invest passively via an index ETF and as an alternative to actively managed Listed Investment Companies (LIC) or unlisted Managed Funds, SMSFs can invest in active ETFs. Active ETFs use various strategies to provide an active element in stock selection and are obviously not subject to all of the passive ETF arguments previously discussed. They have an advantage over unlisted managed funds of being more convenient to buy and sell because they are listed on the ASX and are in many cases cheaper.An advantage of active ETF over LICs is that they usually do not trade at a premium or discount to NAV. This is because an active ETF does not have a fixed number of shares on issue. If someone puts in an order to buy shares, more are issued and the fund manager has to buy more assets with the money. If shares are sold, the number on issue has to be reduced and the fund manager has to sell assets. The result is that they trade at or close to net asset value at all times. LICs are closed ended funds whereby the price of a set number of units is based on supply and demand as well as the underlying assets. This can lead to premium or discounts to NAV.
The Australian ETF market continues to grow solidly. ETFs can offer real benefits in terms of cost and ease of diversification but as always within an overall investment strategy. In terms of the passive funds, the real risk comes from the underlying index. For all funds you still need to do your homework to ensure you understand the underlying components.