An exchange-traded fund is a collection of investments that trade just like a stock on an exchange, and is generally used to track the performance of a specific market index.

For example, if you want to invest in the overall ASX 100 Index, you can buy an ETF that will mimic its movements. You can also buy ETFs that track other benchmark indices such as the ASX 300, the S&P 500 or the NASDAQ 100, or smaller niche indices.

The Vanguard Australian Shares Index ETF (ASX: VAS) is one of the most popular Australian ETFs, as viewed by Morningstar readers. It seeks to track the returns of the 300 largest listed Australian companies by market capitalisation – known as the ASX 300. The top 10 holdings of VAS comprise around 44 per cent of the ETF's net assets.

The largest holding in the ETF is Commonwealth Bank of Australia (ASX: CBA), comprising 7.53 per cent of the portfolio. Beadell Resources Ltd is the ETF's smallest stock holding, with a 0.0002 per cent share of the total holding.

Vanguard Australian Shares Index ETF

ETF chart vanguard

 

Vanguard charges 0.14 per cent annually for VAS, making it the cheapest broad market ETF, slightly ahead of iShares S&P/ASX 200 ETF (ASX: IOZ) at 0.15 per cent. As an investor, you should also consider buy/sell spreads and brokerage when assessing fees, as these are an incremental cost of investing in these vehicles.

5 upsides of ETFs

  • Low cost
  • Diversification
  • Easy access to other markets
  • Accessibility
  • Liquidity

ETFs are known to have extremely low annual expenses, even lower on average than traditional tracker funds. They are generally cheaper than actively managed investment funds because they do not require an investment manager to be involved in picking stocks. Instead, as the process is highly automated, ETF fees are very low – less than 0.5 per cent in most cases.

They also offer investors the ultimate diversification tool: you can invest directly in an overall market instead of picking individual stocks.

In addition, there is an extremely wide range of ETFs available to investors. While traditionally it was difficult for Australian investors to access overseas markets or alternative investors, ETFs enable you to invest in things as diverse as soy beans, forestry and timber, as well as a FTSE 100 tracker or a corporate bond fund.

The fourth of these advantages is accessibility. Because ETFs have no minimum investment requirements, you can buy a single ETF, or many.

Finally, because ETFs trade like stocks, they're highly liquid, able to be bought and sold throughout the trading day, without the trading restrictions of managed funds.

3 negative features

  • Outperformance
  • Wide product variations
  • Liquidity

In general, ETFs do not give investors the opportunity to outperform the market. By contrast, other diversified investments such as managed funds are specifically designed to outperform the broader market, though sometimes they outperform while other times they underperform.

While the wide variety of ETFs is often viewed as a positive, this also means that some of them may not be suitable for individual investors. ETFs use various methods to mimic their chosen index, and some of these methods may create additional investment risk. The caveat ‘don’t buy what you don’t understand’ is always worth remembering.

Liquidity is another aspect that sits in both the pro and con lists. Since ETFs trade like stocks, it can be tempting to trade ETFs frequently, especially when markets are volatile. However, investors can rack up significant costs by frequently buying and selling ETFs, which will eat into any potential investment gains. It is important to take a disciplined approach to your ETF investments.

Which ETF should you buy?

There are more than 150 ETFs listed on the ASX. However, choice is not always a good thing, especially if you don't know where to start. Morningstar fund analysts review over 60 ETFs giving each a rating from Negative to Gold, based on five pillars: People, Process, Performance, Parent, and Price.

Here are five passively-managed ETFs which have received gold or silver Morningstar ratings:

 

 

More in this series

 

Emma Rapaport is a reporter for Morningstar Australia.

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