What are ETFs

An ETF "shadows" or replicates, the performance of a particular market, index, or sector. They enable you to buy or sell a portfolio of securities in a single purchase.

What are ETFs?
Unlike investment  funds you can trade ETFs just as you would an individual stock. You can buy and sell them at intraday prices.

The ETF offers investors a diversified way to play economic sectors, global financial trends, market events and other so-called "special situations."

Exchange Traded Funds (ETFs) are a derivative instrument that trades just like an ordinary share.  They are listed along with ordinary shares on the Australian Securities Exchange. The objective of an ETF is to track and duplicate the performance of a selected index as closely as possible.

An investment fund uses a fund manger to select individual stocks they believe will outperform the market. The result depends on the skill of the fund manager. 

The ETF uses a variety of strategies to buy and sell the underlying shares in the index so the value of the ETF is always very close to the value of index. The objective is to match index performance.

The ETF is issued by a third party such as the iShares group. In Australia, Citigroup and Susquehanna have been appointed as Market Makers in the iShares listed on ASX.

The Market Makers are required to make two-sided markets in the iShares within the maximum spread and the minimum quantity specified by the exchange. Additionally, a list of the stocks held in each ETF is published daily on the iShares website.

ETFs cover market indexes, combinations of regional indexes  and  sector indexes. Specialist ETFs cover selected segments of the market, such as the luxury ETF that includes brands such as Louis Vitton and DKNY. Others are reverse ETFs that ‘short’ the market and benefit in a  falling market.

ETFs are bought and sold just like ordinary shares through your broker. Unlike a unit trust, there are no entry and exit fees and the ETF is actively traded during trading hours.

Why use ETFs?

1) Index tracking
The ETF is an easy and effective way to participate in  broad market behaviour. The single ETF combines all the activity of each of the stocks in the top 200 that make up the Australian XJO Index. Investors buying an ETF automatically collect all the benefits from every share in the Index.

2) Reduces individual stock risk
A bad earnings report is not good for the Westpac price. This is individual stock risk. The fall in Westpac price  does not have a large impact on the XJO index or the ETF because the other 199 stocks have a variety of different performances.

The ETF reduces the impact of individual stock risk so the investors can capture the market trend. It is easier to use the ETF than it is to select the best performing stock in the index.

3) Dividends
The ETF aggregates all the dividends from the Index stocks and pays these twice a year. When the ETF goes ex-dividend there is usually a  very small impact on the ETF price because the trend direction is set by the market, not the individual stock. 

4) Global diversification
It is difficult to trade stocks in other countries. When the DOW goes up it is also difficult to decide which DOW stocks to buy.

The ETF solves this problem because it tracks the foreign Index. Some ETFs combine the activity of several regional indexes so investors can easily benefit from growth in Asia, or Latin America, or Europe. The ETF is a one-stop solution for obtaining the benefit of international market growth.

5) Risk reward profile
If you want to succeed as an investor  then it’s important to understand that it’s not the stock that you buy, but the sector that you play that is important. While the resources sector has enjoyed a bull run, there are many individual resource stocks that have either underperformed the sector, or moved opposite to the sector rise.

More than 50% of any gain an investor realises in an individual stock is due to the sector it's in, not the stock itself. A well focused ETF allow you to play the sector, theme, or global trend that will generate most of your gain.

The ETF is  a type of "fund," and offers risk diversification that individual stocks could never offer. If you identify a great global trend to play for a profit, but pick the wrong stock you could actually incur major losses, despite having chosen a winning trend.

The individual stocks may be subject to an earnings disappointment, a liability lawsuit or a financial crisis. The sector is immune from these individual problems.

Daryl Guppy, well-known international financial technical analysis expert.  He is an equity and derivatives trader and author of books including Share Trading, Trend Trading and The 36 Strategies of The Chinese For Financial Traders. His weekly analysis newsletters are followed in Asia and Australia.

Information provided is in the nature of general comment only and neither purports nor intends to be, specific trading advice.