What are ETFs?

An Exchange Traded Fund (ETF) is a diversified portfolio of securities constructed using an index approach that can be readily traded on the Australian Securities Exchange (ASX).

Investors in Vanguard ETFs own a share of a portfolio of listed securities, indexed by Vanguard. As an index manager Vanguard's aim is to deliver the index return, before fees, by building investment portfolios using similar assets and weightings as the benchmark index - we don't try to pick winners from losers. This means an ETF's returns, before costs, should closely match the index it tracks, just like a traditional index managed fund.

Vanguard ETFs deliver two sets of benefits to investors - the trading speed and flexibility of shares merged with the low-cost*, diversification of index funds. This has made ETFs one of the fastest growing investment solutions in the world today, with hundreds of billions of dollars now invested globally using ETFs.

Australian investors currently have access to both domestic and cross-listed ETFs. Domestic ETFS are funds that have their primary listing on the local exchange (relative to the investor) such as the ASX for Australian investors. Cross-listed ETFs are ETFs that have a listing on a different exchange than their primary or original listing.

ETF tracking

* Investors may also incur brokerage and a bid ask spread when acquiring ETFs on the ASX.

How do ETFs work?

Vanguard ETFs are constructed using an indexing approach, so their value moves in line with the index they track. For example, a 2% rise or fall in the index would result in approximately a 2% rise or fall for an ETF which tracked that index (all other things being equal).

Buying an ETF is an easy, fast and low cost way for investors to own a slice of that underlying portfolio, and benefit from changes in its value. You can buy or sell Vanguard ETFs at any time on the ASX throughout the ASX trading day.

ETF markets

ASX Aqua Market

The ASX AQUA market is a service for quoting managed funds, ETFs and structured products on the ASX. It is aimed at domestic and international product issuers that

provide investment products for both retail and institutional investors who have not traditionally been provided with a dedicated operating framework within the exchange-traded environment. Investors purchase ETF securities on the AQUA market in exactly the same way they would any other security for example BHP or ANZ.

Market liquidity for ETFs is maintained by ‘market-makers’ who ensure that buy and sell prices are quoted continuously on the ASX. The structure of ETFs ensures this investment generally trades close to the Net Asset Value (NAV). The NAV is the underlying total value of net assets divided by the number of units on issue.

As ETFs are quoted investments, a ‘share registry’ manages the administration for investors such as confirming settlement, providing distribution and tax information. Vanguard works with Computershare as their nominated share registry.

Benefits of Vanguard ETFs

Low cost

ETF fees are usually significantly less than actively managed funds. ETFs are also more cost efficient than investing in the same exposure of individually purchased shares.

Diversification

Vanguard ETFs provide investors with a highly diversified

investment with broad exposure to entire markets within an index. This also includes shares that investors may not be able to access directly on the ASX such as international shares.

Tax efficiency

The traditional low turnover of investments provided by an indexing approach minimises the capital gains distribution impact. This improves performance and tax efficiency over the longer term.

Liquidity

Vanguard's ability to create and redeem ETF units on a daily basis ensures the primary underlying depth of liquidity. Secondary sources of liquidity exist in the volume of trading of the ETF itself and the investment environment it is trading in.

Transparency

Vanguard provides regular information to the market including the daily fund Net Asset Value (NAV) making ETFs highly transparent investments

ETF fees and costs

Index based ETFs are generally a low cost investment, and substantially lower in cost than investing in the same exposure of individually purchased shares. Because the funds are managed using an index approach the cost to manage is generally less than actively managed funds.

Management fees

A management fee applies to ETFs as with any other managed fund. This is a fee charged by the fund issuer, generally included in the unit price, covering all relevant fees and costs involved in managing the ETF. These fees and costs include things like custodian fees, accounting fees, audit fees and index licence fees.

Brokerage fees

Brokerage fees are fees charged by the broker each time you purchase (or trade) an ETF. These fees vary, starting from around $20 per transaction.

Exchange Traded fact - Bid/Ask Spread

The amount by which the ask price exceeds the bid price. This is essentially the difference in price between the highest price that a buyer is willing to pay for a security and the lowest price for which a seller is willing to sell it.

ETF myths and misconceptions

Myth 1: All ETFs are the same

Some view ETFs (and index funds in general) as commodity-like products with no material differences. However, even ETFs supposedly tracking the same market segment can deliver very different results because of factors such as the construction methodology of their target indexes and their day-to-day portfolio management.

Vanguard ETFs are a diversified portfolio of securities constructed using an index approach which invests in all or a representative sample of the index they track. Using this approach enables the portfolio performance to be broadly in line with the returns of the underlying asset class or market over the long-term.

Myth 2: ETFs are illiquid

There are two levels of liquidity to think about with ETFs. The first, like listed shares, is shown in the quotes in the market as the number of shares available for purchase or sale at a particular price during the trading day. This liquidity is affected by the number of firms trading each ETF, the number of orders from other investors and the investment environment on that day. The second source of liquidity comes from an ETF’s capability to issue or redeem units to meet excess demand or supply for purchases or sales above the liquidity shown in the market. This source of liquidity is defined by the composition of the ETF itself and the trading volume of the individual securities in the underlying fund. In effect, Vanguard’s creation and redemption process ensures an ongoing underlying depth of liquidity on a regular basis for Vanguard ETFs making them a flexible investment solution.

Myth 3: ETFs are complex

Vanguard ETFs are very simple to understand. Just like Vanguard’s range of managed funds, Vanguard ETFs provide exposure to broad market indices. There is no leverage or derivative structure involved with these products.

Put simply, Vanguard ETFs combine the low cost, diversification benefits of index funds with the trading flexibility of shares.

Myth 4: ETFs are tax inefficient

Vanguard ETFs offer investors potential tax efficiencies due to their buy and hold approach and are potentially more tax-efficient than traditional managed funds. As index portfolios, Vanguard ETFs tend to realise fewer capital gains than actively managed funds. This is due to a low turnover in the underlying securities in the fund.

Myth 5: ETFs are only for market-timers

Some believe that ETFs are only appropriate for speculators, market-timers, or other investors with short time horizons. However, ETFs may benefit long-term investors even more so as the ETFs’ low expense ratios can more than offset commissions and spreads over time.

Myth 6: ETFs are derivatives

Vanguard ETFs are not derivatives.* Like any managed fund, the value of an ETF depends on the net asset value of the fund underlying the ETF. Vanguard ETFs are invested directly in the securities in the benchmark index.

* Note: Synthetic ETFs may use derivatives in their investment strategy. Vanguard currently does not offer synthetic ETFs.

Choosing between ETFs and traditional index funds

Vanguard's ETFs are one of two ways to invest with us, you can also use our traditional index managed funds. Vanguard has been managing investments for more than 10 years for Australians. Our ETFs and their equivalent managed index funds own the same underlying assets. So for investors, it comes down to which method best suits your particular circumstances.

When deciding between and ETF or traditional fund, you should consider:

  • If you have, or are prepared to open, an account with a sharemarket broker. You will need a brokerage account to buy and sell ETFs. If you invest using a financial planner, they can access either index managed funds or ETFs via administration platforms such as master trusts and wrap access.
  • How often you invest. Brokerage fees apply when buying ETFs on the sharemarket, however contributions to a traditional (managed) index fund do not attract any fees (other than the applicable entry and exit spreads). So ETFs may not suit investors who make ongoing, small contributions.
  • The importance of trading to you. Trading flexibility is a key benefit of ETFs, but if this flexibility is not important to you the added brokerage costs of investing in ETFs may not be worthwhile for you.

Choosing between an ETF or Managed Index Fund?

Exchange Traded Funds are suited to investors who:

  • Have an ASX broker account.
  • make large or irregular investments.
  • require trading flexibility.

Managed index funds are suited to investors who:

  • do not have an ASX broker account.
  • make ongoing, small contributions.
  • do not require trading flexibility.

Liquidity in ETFs

One of the primary advantages of ETFs is that there are two sources of liquidity. There is liquidity on the market as defined by the securities on issue and the depth of trading on-market. There is also liquidity that sits with the issuer and the ability to create or redeem ETF securities to meet investor demand - this liquidity reflects the open-ended nature of ETFs and the liquidity of the securities held by the ETF.

Where is liquidity found?

ETFs are open ended: for example, if liquidity in the market was $5 million and an investor wanted to purchase $10 million of Vanguard ETF units, they could contact an Authorised Participant (AP), who has the option to create a further $5 million worth of ETF units with Vanguard and then sell directly to the investor. The securities required to deliver in the creation process are readily available (for example ASX / S&P 300 securities) which supports the liquidity of the products to meet demands from buyers and sellers. Conversely, if an investor wanted to sell $10 million worth of Vanguard ETF units, the AP would provide a purchase price for the securities with the investor then redeem the $10 million worth of ETF units with Vanguard. It is the ability to create and redeem ETF units with the issuer that makes ETF's such an innovative and flexible investment vehicle.

How can an ETF's liquidity be measured?

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.

What motivates APs and market makers to maintain liquidity?

AP's operate at arms-length from ETF issuers. They are remunerated by their own market activities. Market makers in Australia are offered an incentive to maintain spreads and liquidity on market via a financial incentive offered by the ASX. APs and market makers are active market participants and earn revenue through the bid/ask spread and volumes that they trade. APs earn revenue by acquiring ETFs in the primary market at the ETF's NAV and then selling in the secondary market at a margin above the NAV. Similarly they can acquire ETF securities in the secondary market below the NAV and redeem in the primary market. Competition between the APs quoting each ETF security helps to ensure that bid/ask quotes for the ETF securities are consistent with the NAV. APs that quote wide spreads will be undercut by other APs and as a result will not have competitive trades available for the market.

How does Vanguard select market makers?

In selecting market makers for Vanguard ETFs, Vanguard focuses on companies trading ETFs in Australian and international financial markets. The companies selected by Vanguard currently operate as market makers in existing Australian ETF securities quoted on the ASX and have agreements with the ASX to operate in this capacity. Internationally, the market makers selected will also have experience in the respective ETF markets, such as the New York Stock Exchange.

ETF market participants

The ETF market is made up of a primary and secondary market.

Primary market

The primary ETF market is made up of three participants:

  • Issuers of ETFs.
  • Authorised participants.
  • Market makers.

Secondary market

The secondary market is made up of buyers and sellers of ETF securities on a securities exchange. Different parties include:

  • Securities exchange (for example the ASX).
  • Financial advisers and brokers.
  • Investors.
  • Share registrars.

The issuer of an ETF is the fund manager who manages the ETF and its underlying securities (for example Vanguard is the issuer of Vanguard ETFs). The issuer publishes a basket of securities for delivery each trading day to authorised participants and swaps this basket when delivered for ETF units.

Authorised participants or APs are authorised trading participants with the ASX that have an agreement in place with the issuer to create and redeem units in an ETF.

An AP applies to the issuer for wholesale lots of units - called creation units, typically 20,000 securities or more. To settle this application the AP delivers a basket of securities rather than cash in exchange for an equal value of units in ETFs. The required basket for delivery is published every day by the issuer and reflects the investments and value of the underlying fund. Redemptions occur via a similar process, where the redemption is settled with the AP in exchange for a basket of securities of equal value to the ETF securities being redeemed.

A market maker's role is slightly different. They provide liquidity to the market by quoting buy and sell prices throughout the trading day.

Market makers seek to provide continuous liquidity to the market. The process begins with the issuer distributing the current fund composition to the market every morning, allowing market makers to price the basket of securities underlying the ETF. Market makers place a buy/sell spread around the true value of the ETF and send these prices to the stock exchange as orders. These orders are published to market, and investors can either 'hit' orders to trade with the market maker or send their own orders to the exchange and wait for someone else to 'hit' them.

Market maker orders are updated continuously throughout the day to reflect price changes in the underlying securities. Often, participants in the market can fulfil both the market making and authorised participant roles.

ETF - Fact or fiction?

An ETF can collapse in the event of a large redemption - FICTION

  1. An AP can only redeem with settled ETF securities, meaning they must have the ETF securities in their possession. This also requires those securities to be released from any stock lending agreement.
  2. No one AP can enter an order to redeem the entire amount of ETF securities outstanding.

The security exchange's primary role is to provide buyers and sellers a platform (or marketplace) to trade ETF securities. The ASX conducts a formal review process of each ETF issuer and product before new ETFs can be quoted on the exchange. Having products that trade on the ASX also means that ETF issuers are subject to ASX market supervision rules.

In Australia, ETFs are quoted for trading on the ASX AQUA platform. This dedicated market service was launched in 2007 to provide managed funds, ETFs, and structured products with a tailored trading platform and access to a back-office clearing and settlement service offered by the ASX.

Financial advisers and brokers can trade ETFs on behalf of their clients through two types of brokerage services: non- advisory brokers - which include direct orders through an administration platform or online broker, and, full service brokers who can offer advice and guide an investor or their adviser through the ETF transaction process.

Investors can trade ETF securities directly via their financial adviser or broker. As ETFs are quoted investments, a share registrar manages the administration for investors such as paying distributions, providing distribution and tax information and allowing investors to elect and change their tax file number status and distribution reinvestment plan elections. Computershare is the share registrar for Vanguard ETFs.

As ETFs are quoted investments, a share registrar manages the administration for investors such as paying distributions, providing distribution and tax information and allowing investors to elect and change their tax file number status and distribution reinvestment plan elections. Computershare is the share registrar for Vanguard ETFs.

The creation and redemption process

To create new ETF units, the AP applies for new ETF securities to be created in multiples of creation units (typically one creation unit is 20,000 securities). Only APs can create or redeem ETF units with the issuer.

In return they deliver the basket of securities specified by the issuer. On settlement, the AP then has an inventory of ETF securities that can be sold on the ASX (the "secondary trading market"). The redemption process works in the opposite way: the AP applies to redeem securities in multiples of creation units and in return receives a basket of securities. This creation and redemption process is referred to as an in-specie or in-kind transaction.

Throughout the trading day, market makers continuously provide on-screen quotes for both buy and sell orders. They can also mediate for investors wanting to buy or sell large parcels of ETF securities, effectively providing an additional layer of liquidity beyond that shown on-market.

ETF spreads

The spread is the difference between the bid price and offer price. A market maker's role is to provide liquidity in trading volume and quote within agreed spreads.

Market makers earn their revenue from trading and have a strong motivation to maintain tight ETF bid-offer spreads.

Better spreads and liquid markets are more attractive to investors, increasing the demand for securities which in turn creates higher trading volumes. In addition, the ASX provides incentives via ASX fee rebates if market makers maintain certain spread levels.

Where spreads are not attractive the market maker may be able to earn a larger margin on each trade. However, this can stifle long-term investor interest and demand and may result in lower amounts of business in the longer term. Globally there has been rapid growth in ETFs issued and traded.

Spreads can also be affected by market uncertainty. In the case where there is a very high degree of uncertainty in the sharemarket, spreads on all trading securities in that market may be affected, including ETF securities. However, unlike shares, an ETF has a well-defined underlying value - the NAV. The NAV of the underlying Vanguard index fund is published daily on the Vanguard website. This provides both investors and market participants with daily information on the ETF's value.