Before we get into the dirty details of exchange traded funds, let’s take a step back. Why do you want to invest in them? If you’re expecting a how-to on trading ETFs, throw this guide into the bin. But before you do, let me explain why it’s a bad idea. What is great about ETFs is how easy it is to buy and sell them. The downside of the ease in trading ETFs is that it can help encourage two of the main ways that investors get in trouble:

  • Problem #1: Chasing returns. If you’ve ever talked with mates about the stock market, you’ve probably felt the urge to invest in a new hot stock or sector. The problem is this: so has everyone else.
  • Problem #2: Exiting the market during downturns. When the markets get jumpy, people ask themselves, “Is the market going to fall more, and should I get out?” Unfortunately, it’s impossible to tell whether a drop in the markets will continue, or whether it will rapidly turn around. In the extreme, Morningstar research shows that if investors pulled out of the market and missed the 10 best upswing days from 1992–2012, they’d have lost 45% of their returns. 

For every dollar traded, one side is likely to come out ahead. While the economy as a whole tends to grow, driving up asset values, the growth is divvied up through a zero-sum game we call the financial markets. Some assume that an above-average level of skill can put you ahead. However, good investors tend to control a disproportionate amount of capital. Warren Buffett, for example, controls hundreds of billions of dollars and regularly makes billion-dollar trades. For Buffett to reap above-average returns, the thousands of investors opposite of his trades had to lose. Investing is like a tournament. There are a few big winners and lots of small losers. Ray Dalio, founder of the hugely successful Bridgewater Associates, has this to say about the prospect of beating the markets:

“We have 1,500 people…We spend hundreds of millions of dollars on research and so on, we’ve been doing this for 37 years, and we don’t know that we’re going to win. If you’re going to come to the poker table, you’re going to have to beat me, and you’re going to have to beat those who take money.”

Warren Buffett has long advocated passive investing for the majority of investors. He said, “If you buy equities across the board–which means an index fund—and you do it over time…that’s probably the best investment that most people can make.”

I’m not saying it’s impossible to beat the market. However, for the typical investor, using ETFs is not the best way to go about it. ETFs provide exposure to broad, liquid asset classes. Trying to earn substantial above-market returns with them is kind of like trying to score points in the NBA. A better idea is to play in the peewee leagues, where your competition is less informed. This could include less-liquid, obscure opportunities such as corporate actions in pink sheets and micro-cap stocks, LICs, and so forth–areas where the level of play is much lower.

I’d say it’s close to impossible to beat the market with ETFs through day trading. The level of play in high-frequency strategies is impossibly high. Math geniuses with supercomputers and low-latency data feeds spend their waking hours dreaming up ways to identify and exploit fleeting market arbitrages. They have nearly insurmountable advantages in resources, time, and cost efficiencies.

The highest and best use of ETFs is to obtain passive exposure to markets and reap the rewards for bearing risk. It’s about low cost, transparency, and getting your fair share of capitalism’s growth. Don’t throw that all that away on a vague, ill-founded belief in your ability to beggar thy neighbour.

The ETF structure

Exchange-traded funds, a motley bunch, share three qualities: they’re pooled investment vehicles, their shares trade on stock exchanges, and they have a daily share creation and redemption mechanism. An ETF can be thought of as a managed fund whose shares happen to trade on stock exchanges.

The biggest ETFs are passive investments, which merely try to replicate the behaviour of a market or market segment. The biggest ETF in Australia, SPDR® S&P/ASX 200 ETF (ASX: STW), tracks the ASX 200 index. In recent years, quasi active index strategies as well as full-blown active ETFs have gained traction, but they’re still small.

The ETF bears a strong resemblance to the Listed Investment Company, or LIC, which raises a fixed amount of capital in an initial public offering. LICs have a net asset value, or “fair value”: what the LIC could disburse to its investors if it liquidated all its assets and paid off all its liabilities. Because LIC shares trade on exchanges, their prices often deviate from their Net Asset Values (NAV). LICs sometimes undertake actions to close the gap between NAV and market price, but such actions must be initiated by the board of directors. ETFs, on the other hand, create and redeem shares at NAV at the end of each trading day, just like managed funds. The daily share creation/redemption mechanism makes ETFs unique.

ETFs don’t create and redeem shares for just anyone. They’ll only do it for designated institutions called authorized participants (AP), and only in big blocks, usually a multiple of 50,000 shares, called creation units.  

APs don’t do this out of charity. They get paid to do so, but the process is rather roundabout.

The AP is like an entrepreneur and the ETF a factory. The entrepreneur can buy widgets (stocks) according to a specified formula and send them to the factory (the ETF) for assembly into machines (ETF shares). Alternatively, he can buy machines and send them to the factory for disassembly into widgets. If it takes 500 widgets to make a machine, he can compute the total price of those 500 widgets and compare it to the price of a completed machine.

When there’s an imbalance between the two prices, he has an arbitrage opportunity: buy whatever’s cheaper and sell whatever’s more expensive. If the widgets are cheaper, he can buy them up, send them to the factory for assembly into machines, and sell them on for a tidy profit. If the machines are cheaper, he can buy them up, send them to the factory for disassembly, and sell the parts for a profit.

Naturally, in order for this process to work, ETFs are required to disclose all their holdings daily.

Consider the SPDR® S&P/ASX 200 ETF (ASX: STW), which owns the 200 stocks in the ASX 200 in the same proportions as the index.  When STW’s market price is at a big enough premium to NAV, an AP will purchase all the constituent stocks of the ASX 200 in the portions specified by the ETF, assemble them into a creation basket, and hand it over the ETF in exchange for newly created STW shares. The AP will then sell the shares for a profit, and in doing so drive down the fund’s premium. The creation/redemption mechanism works in reverse when the ETF trades at a big enough discount.

The process occurs in-kind, a sort of modern-day barter. For all its complexity, it has its advantages. First of all, it’s a very fair arrangement. Traditional managed funds internalize the costs that entering or exiting investors impose on the funds’ current shareholders. It’s galling that a loyal fund shareholder can end up with a huge tax bill at year-end because other investors sold out. If you’re the buy-and-hold type who doesn’t enjoy subsidizing panicky investors, ETFs are a godsend. The costs of creating or re- deeming new ETF shares are borne by entering or exiting shareholders.

The real benefit shows up at tax time. The ATO doesn’t tax in-kind transactions, so ETF share redemptions don’t sock current investors with nasty tax consequences. As a kicker, ETFs can pick the lowest-cost tax lots when fulfilling redemption requests and purge themselves of embedded capital gains. This, in addition to the low-turnover nature of passive investing, is why many ETFs rarely distribute capital gains at the end of the year.

How to trade ETFs  

Like any stock, an exchange-traded fund has two prices: a bid and an ask, the prices at which you can sell and buy shares, respectively. The difference between the two is called the bid-ask spread, or spread. It is the transaction cost of buying then immediately selling a security (a round-trip trade).  The spread compensates market-makers for the costs and risks they bear for keeping shares on hand.

In general, the narrower the spread, the more liquid an ETF is said to be. Liquidity is the ability of an asset to be traded without significantly moving the price and with minimal loss of value.

All but the most-liquid ETFs should be traded with limit orders, which specify a transaction price. Because of the in-kind creation/redemption mechanism discussed earlier, the true liquidity of an ETF is not determined by its asset size or its secondary market trading volume, but the liquidity of its underlying holdings. However, much of that liquidity may not be visible in the order book, which lists the number of shares and prices investors are willing to transact in a security at a given time. A limit order will often draw out hidden liquidity, making it cheaper to transact the ETF than the order book implies.

Horrible things can happen if you use market orders. They can “eat through” the order book of a less- liquid ETF before market-makers can react, creating big price swings. ETFs can also experience rare “flash crashes,” where their prices suddenly drop due to the withdrawal of liquidity by market-makers.

5 tips for trading ETFs

Investors can overcome these trading issues if they exercise caution when using passive ETFs in their broader portfolios.

1. Avoid trading first 30 minutes or during market volatility

Morningstar director of global exchange-traded fund research Ben Johnson recommends investors avoid trading ETFs just after the opening bell, as ETFs may take a while to "wake up" in the morning.

"For a variety of reasons, it takes some time for all of the securities in their portfolios to begin trading," he says. "Before all of an ETF's constituents are trading, market makers may demand wider spreads as compensation for price uncertainty."

Investors should wait about 30 minutes after the opening bell. For similar reasons, investors should be on high alert before trading during volatile market conditions altogether, as this is when bid/ask spreads can widen significantly.

While the impact will be felt more so by smaller and newer listed product, even large and very liquid listed products can be affected. The day of the most recent US Presidential election, 9 November 2016, provides one of the starkest examples of a volatile trading day for most international exchanges, including the ASX.

At the start of the day, the spread—or gap between the bid and ask prices—of the iShares Core S&P/ASX200 ETF (ASX: IOZ) was minimal, but this blew out completely once the election result was known. This happened to many if not all ETFs during this trading period.

iShares Core S&P/ASX200 ETF (ASX: IOZ) bid-ask spread, 9 Nov 2016 (basis points) 

iShares Core S&P/ASX200 ETF (ASX: IOZ) bid-ask spread, 9 Nov 2016 (basis points)

Source: Morningstar Direct

 

2. Check the market depth and spread before you trade

Investors should check the market depth—a list of all the buy and sell orders in the market—and the spread before trading ETFs. This way investors can ensure they can trade the volume they want and the price they want.

For global products, liquidity should be viewed before any trading as the underlying holdings may not be trading during ASX open hours.

Investors can check the depth and spread via their brokers.

3. Use limit orders wherever possible

Investors should use limit orders—opposed to a market order—when trading ETFs.

  • A limit order means you can set the maximum or minimum price you are willing to pay for an ETF. If the ETF is trading anywhere below your maximum purchase price, or above the minimum selling price, the trade will be executed.
  • A market order tells the broker to buy or sell at the best price he or she can get in the market, and the trades are usually executed immediately.

Johnson says limit orders help investors ensure that they are receiving favourable execution from a price perspective.

Market orders tend to be used when time is of the essence and price is of secondary importance. For very large and liquid ETPs, market orders can be less problematic when spreads are narrow, which usually indicates orderly trade. 

4. Trade with a longer-term mindset

ETFs with a longer-term mindset to avoid being tempted into excessive trading. 

"A short-term outlook only increases the likelihood of an unsatisfactory result," he says.

5. Consider an index fund

If you place no value on intraday liqudity and you would prefer to forgo navigating the ins and outs of ETF trading, then an index fund tracking the same benchmark may be a better choice for you, Johnson says. 

How much does that ETF really cost?

Fees deserve a good amount of thought. Most investors focus on the prospectus net expense ratio, the annual percentage fee on assets that a fund is expected to pay over the coming year. It’s a good guide. Over the long run, well-constructed ETFs lag their benchmarks at an annualized rate close to their expense ratio. This is especially true for ETFs that track liquid markets, like U.S. stocks and Treasuries. However, the expense ratio is an incomplete measure of total cost. It’s a floor, not a ceiling.

While there are several types of hidden costs, the most insidious and biggest of them is undoubtedly market impact. It can be many multiples of a fund’s stated expense ratio. Market impact is the adverse price change that arises from a trade. There is no way to detect market impact costs by comparing a fund’s performance with its benchmark.

To understand this corrosive cost, let’s begin with a basic fact: Almost all indexes periodically reconstitute their holdings. Firms go bust, new ones appear, and they all change in character over time. Indexes must publicly release any changes to their holdings in order to be investable. Most indexes have sharp cut off dates on which they add or delete holdings.

Imagine you are managing hundreds of billions of dollars. Would you be comfortable doing the same thing, announcing that on a certain day you’re going to buy or sell billions of dollars of a stock, regard- less of price? It would be a nightmare. Clever traders would jump ahead of your announced trades. 

That’s exactly what happens with the most popular index funds. According to Standard & Poor’s, an estimated $3.4 trillion of assets are dedicated to tracking the S&P 500 as of this writing. This means that whenever S&P adds or deletes a stock from the index, a portion of that huge pile of money will buy or sell the stock on the same day, near the same time. A stock worth 1% of the index getting kicked out means about $16 billion worth of the stock is sold on the same day, indifferent to the price. The process works in reverse: When a stock is added to the index, some portion of that huge pile of money is going to buy that stock on the same day, again, heedless of price.

However, because the S&P 500 mostly holds liquid, large-cap U.S. equities, the market impact is relatively modest. Historical estimates of this market-impact cost ranges from 0.03% to 0.28% annualized.There’s some uncertainty to this figure because it depends on your assumptions of when market impact shows up.

Some clever index fund managers take advantage of this phenomenon by buying stocks before the official add date, and delay selling stocks until after the official delete date. Why don’t all fund managers do this? Their mandate is to track the index. Any deviations, even if they might add value, might incur tracking error, and too much of that earns the manager a pink slip. Most index fund managers play it safe and let their investors eat market-impact costs. 

The S&P 500 is unusual among large-cap equity indexes. Most don’t incur such market-impact costs because the money tracking them is tiny in relation to the market’s liquidity. This is certainly true for Australian indexes. However, when the market becomes less liquid, it takes less money tracking an index to produce adverse market impact.

There are two ways to sidestep these costs. One is to buy total stock market funds like Vanguard MSCI Index International ETF (ASX: VGS). The other is to avoid owning funds that track the most popular indexes. It pays to be unconventional even with something as boring as index funds.

Types of ETFs

Since exchange-traded-funds (ETFs) began trading in Australia 20 years ago, there has been a proliferation of different types.

Today, more than 200 exchange-traded products trade on the Australian Securities Exchange, some tracking broad market indexes, while others offer exposure to popular trends such as cybersecurity.

This plethora of competing products is making it harder for investors to make informed decisions for not all ETFs are created equal. 

Following is a guide to the different types of ETFs so you can select the right funds for your portfolio.

Passive ETFs

ETFs that track market indices are called passive ETFs. Managers who oversee overseeing passive ETFs will take a hands-off approach, simply ensuring that their ETFs replicate their designated indices. A manager will not intervene if an index takes a turn for the worse. In other words, the manager is being passive.

Active ETFs

While the vast majority of ETFs are categorised as passive, a handful of active ETFs have now become available to investors. Active ETFs are run by a manager or a management team that attempts to outperform their designated index. But outperformance is not guaranteed; sometimes an ETF can do better than its index, but sometimes it can do worse. For example, an investor holding an active ETF that tracks the S&P 500 would experience slightly different returns from the returns of the S&P 500 index because management is actively using strategies to try to outperform the index.

Smart Beta ETFs

To manage risk in a portfolio, some investors have turned to indexing strategies that ignore market cap in favour of other factors such value, dividends, low-volatility, momentum and quality. In a sense, factor-based indexing mimics strategies that many active fund managers use. But rather than a human deciding on which stocks to buy and sell and when based on his analysis, factor-based indexing automates the process by applying a model that determines what goes in the portfolio. This makes them "smart". This eliminates the need for an active manager and thus helps reduce fees. However, factor-based funds and ETFs still tend to charge more than market cap-weighted index funds and ETFs. You might think of factor-based indexing as a hybrid approach that combines the strategic advantages of active management with the lower investment costs offered through indexing.

Asset class ETFs: Stock ETFs, Bond ETFs, Property ETFs

Stock ETFs—also known as equity or share ETFs—are the most common type of ETF you'll come across. Stock ETFs 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 about 44 per cent of the ETF's net assets.

Bear in mind that when you invest in international ETFs, you also take on currency risk. You can't buy a foreign company without also buying that company's currency and that can expose you to currency losses.

You can also buy ETFs that will give you exposure to other asset classes such as bonds and property. Like buying a traditional bond, a bond ETF will still give you interest/coupon payments.

Currency ETFs

Most currency ETFs track the performance of a currency such as the US dollar or euro. You'll make money if the Australian dollar slumps, or if the other currency soars. But in the reverse situation, you'll lose money. Currency ETPs are often used by speculators who want to bet on the macro, political, and economic events that drive currencies. They can also be used to hedge against risks such as the cost of future financial outlays or to take a longer-term investment view on currency.

Commodity ETFs

Yes, you could physically buy gold bars or barrels of oil and keep them in your garage, but is that practical? There’s insurance and storage to worry about, and some soft commodities like corn aren't going to hold up too well over the years. Exchange-traded products have now made it possible for individuals to gain direct exposure. For example, BetaShare's Crude Oil Index ETF-Currency Hedged (synthetic) (ASX: OOO) allows investors to gain exposure to the performance of the crude oil included in the S&P GSCI Crude Oil Index Excess Return without the need to invest in the futures market or take physical delivery of the commodities.

Multi-asset ETFs

Index ETFs traditionally offer exposure to a single asset class—e.g. large-cap Australian equities or Emerging Market Shares—but in 2017 Vanguard launched a series of multi-sector ETFs. In a single trade, investors can gain access to a diversified portfolio of stocks, bonds and cash. The four diversified options—Vanguard Diversified Conservative ETF (ASX: VDCO), Vanguard Diversified Balanced ETF (ASX: VDBA), Vanguard Diversified Growth ETF (ASX: VDGR) and Vanguard Diversified High Growth ETF (ASX: VDHG)—are designed to suit different investor objectives and risk profiles.

Sector ETFs: Consumer staples, technology

Sector ETFs allow investors to buy into companies in a specific sector. For example, BetaShares Technology Asia Technology Tigers ETF (ASX: ASIA) seeks to track the price movements of a portfolio containing the top 50 technology and online retail stocks, by free float market capitalisation, which have their main area of business in Asia (excluding Japan). 

Thematic ETFs

These funds seek to capitalise on the growth of popular trends  such as cybersecurity or the spending habits of millennials. They access investors’ collective fascination with a range of niche topics, offering the potential to capitalise on the growth of something popular or trendy. Examples include ETF Securities’ Global Robotics and Automation ETF (ASX: ROBO) and BetaShare's Global Cybersecurity ETF (ASX: HACK), Global Healthcare ETF (ASX: DRUG) and Global Robotics and Artificial Intelligence ETF (ASX: RBTZ).

Green/Ethical ETFs

The ethical fund industry is expanding to accommodate the growing number of investors seeking to put their money in companies they feel do the right thing. Vanguard has launched two new ESG exchange-traded funds: Vanguard Ethically Conscious International Shares Index Fund and ETF (ASX: VESG), and Vanguard Ethically Conscious Global Aggregate Bond Index Fund (ASX: VEFI). These remove companies involved in alcohol, tobacco, adult entertainment, fossil fuels, gambling, weapons and nuclear power.

How Morningstar rates ETFs

Too many investors focus on short-term performance when evaluating funds and ETFs. An overemphasis on short-term performance can cause investors to make poorly timed buy and sell decisions. The reason for this is simple. By their very nature, returns are backward-facing. Simply looking at the past performance doesn’t tell you why it occurred, and it certainly can’t predict if the same returns will continue into the future.

The Morningstar Analyst Rating is a forward-looking analysis of a fund or ETF’s likelihood to outperform. The Analyst Rating is based on the analyst's conviction in the fund or ETF's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund or ETF receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund or ETF and expect it to outperform over a full market cycle of at least five years. To determine this rating our manager research analysts evaluate funds and ETFs based on three key pillars– Process, People and Parent– which we believe indicate a likelihood for outperformance the long-term on a risk-adjusted basis. Each of the following pillars will receive a rating:

  • Process: What is the fund's strategy and does management have a competitive advantage enabling it to execute the process well and consistently over time?
  • People: What is Morningstar's assessment of the manager's talent, tenure, and resources?
  • Parent: What priorities prevail at the firm? Stewardship or salesmanship?

Each ETF that we cover will receive one of the following ratings:

  • Gold: Best-of-breed ETF that distinguishes itself across the five pillars and has garnered the analysts' highest level of conviction.
  • Silver: ETF with advantages that outweigh the disadvantages across the five pillars and with sufficient level of analyst conviction to warrant a positive rating.
  • Bronze: ETF with notable advantages across several, but perhaps not all, of the five pillars—strengths that give the analysts a high level of conviction.
  • Neutral: ETF that is unlikely to deliver standout returns but also unlikely to significantly underperform, according to the analysts.
  • Negative: ETF that has at least one flaw likely to significantly hamper future performance and that is considered by analysts an inferior offering to its peers.

How we can help you achieve your financial goals

Morningstar’s core mission is to help individual investors make better financial decisions. The following section outlines how we help investors select ETFs to achieve their financial goals.

Discover new investments

Morningstar provides a variety of ways that you can discover new ETF investments including:

  • pre-defined ETF screens that show our Gold, Silver and Bronze rated ETFs across a number of asset classes;
  • investment filters that allow users to select criteria to search our database of over 200 Australian ETFs.