Have you started to think about investing in Exchange Traded Funds (ETFs), or have you already gotten started? Despite being a fantastic tool for both new and well-versed investors to gain diversified exposure to specific indexes, there are some intricacies that specifically apply to ETFs, which are good to be familiar with. This article assumes some basic knowledge of ETFs, so if you’re just getting started, learn about what ETFs are here, and have a look at the resources below.

“In Australia, ETFs are quoted under the ASX Listing Rules or the AQUA rules. The AQUA rules were introduced in 2008 to facilitate the admission to trading on ASX of ETF securities, other open-ended managed fund products and structured products that track underlying instruments.”

Source: ASIC Regulation of ETFs

Underneath the glamour, how do ETFs actually work?

A physical ETF is an open-ended fund that owns the underlying assets relative to the index it’s tracking and divides ownership of the assets into shares, that investors can purchase through the Australian Stock Exchange (ASX) by going directly through their broker. The investor’s units then represent their share of ownership in the fund.

The ETF provider (e.g. Vanguard, BetaShares) will create the fund and generally employ a third-party to be the market maker for the fund. Market makers provide liquidity in the fund and ensure that the ‘ETF’s unit prices continue to track the value of the ETF’s NAV per unit, subject to a relatively narrow spread between the bid and offer’ (ASIC).

This is done by creating and redeeming units in the fund to ensure the price tracks the NAV, and buying and selling the underlying securities in the fund to facilitate the order. As the fund is open-ended, market makers can continue issuing and redeeming units at price based on the NAV, on an ongoing basis, and generally, make money from the bid/ask spread (which should be reasonable in relation to the transaction costs).

This educational guide published by ETF Securities goes into quite some depth on exactly how every single thing works when it comes to ETFs, and if you’re ready for some light reading… check out the ASIC ETF Regulatory Guidelines.

Source: ETF Securities

“A good measure of ETF liquidity is the liquidity of the underlying stocks in the index the ETF tracks. Unlike shares, an ETF’s liquidity should not be determined by trading volume, even a relatively small ETF will be liquid if there is good liquidity in the securities that make up the ETF units”.

Source: Vanguard

What does the ETF provider get out of running an ETF?

Now we well and truly know that there’s no free lunch, and the companies running the ETFs need to keep the lights on and feed their employees. The main way ETF providers benefit from running the ETF is through their management fee, which can vary widely depending on the provider. The management fee is taken out of the NAV (luckily for you – they don’t send you a bill) and this goes to cover all relevant costs involved with managing the ETF. This money goes to pay for things like custodian fees, accounting fees, audit fees and ASIC licencing fees, along with salaries, marketing and office space.

Companies like Vanguard are client owned, which means it’s in their benefit to keep management fees low, but other firms like BlackRock are listed companies, which means they need to keep reporting profits to shareholders on a regular basis. This is good to keep in mind when looking at the management fees and incentives for the firm in running an ETF, as there is a massive case for keeping your management fees as low as possible.

What happens if the ETF provider falls over?

ASIC requires ETF providers to hold each of their fund’s assets in separate trusts, so each individual fund should be protected from creditors if the provider fails. The provider is also required to appoint an independent custodian for each fund, who holds the assets in the fund for the benefit of the unitholders. This structure mitigates risk by separating the funds’ assets and the ETF providers assets and aims to prevent internal misuse of investor funds. BetaShares have published informative articles on the key players in an ETF, who holds the assets in an ETF and how safe are my ETF assets, which are all worth a read.

“A business failure at the level of the ETF issuer won’t have any impact on the security of the assets, ultimately the investors’ funds held in the MIS. If this were to occur, a new manager would be appointed and the MIS would continue to operate. Alternatively, if the MIS were to be wound up, the liquidator would sell the assets of the MIS, and the net proceeds would be paid to the MIS unitholders in proportion to the number of units they held.”

Source: BetaShares

What happens if the ETF itself closes down?

As with any fund, sometimes the ETF provider may decide to close the ETF. This could happen because the ETF provider isn’t making enough money to reasonably cover the cost of running the ETF. The ETF provider will issue a notice to the ASX explaining their decision to terminate the fund and advise the date of termination. If investors don’t sell their units in the ETF through their brokerage account prior to the termination date, they will receive a cash distribution equivalent to the NAV on the termination date to their nominated bank account.

To view a recent example of an Australian ETF closure notice, click here.

“When an ETF delists without liquidating its portfolio, investors who fail to sell their shares before the last trading date will be forced to trade over the counter—a significantly less liquid, more cumbersome and generally more expensive process than trading on an exchange”.

Source: ETF.com

The following factors may indicate your ETF is at risk of closing down:

  • Low Assets Under Management
  • Unprofitable ETF Provider
  • Unpopular ETF in a Saturated Market
  • Poor Performance Compared to Industry Benchmark and Peers

You can spend days diving into ETFs, but I think it’s important to have a broad overview of how ETFs work, so you are comfortable with the operation and risks of the product. Feel free to get stuck into some of the helpful resources I found scouring the web below. As always feel free to drop me an email at howtomoneyaus@gmail.com if you have any questions or comments!

Kate — HTM Editor & Host

Resources

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Kate Campbell is the founder of How To Money. Kate created HTM from a passion to help young Australians start talking about money, and share the resources she finds along her financial education journey. This led Kate to start her own journey to financial independence a few years back and she now works in the Australian financial services industry.

Want to learn more about money and personal finance? Check out our article archive, the How To Money Podcast and the Australian Finance Podcast. Catch us on Twitter @HowToMoneyAUS and Instagram on @HowToMoneyAUS.

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