Exchange Traded Funds (ETFs)

Exchange traded funds (ETF) are the ones that track an index but are traded like stocks on the Australian Securities Exchange (ASX). In case of ETF, the shares are bundled together in the index so that the traders can easily sell or buy them through a single transaction.

The traditional exchange traded funds track a sector, index or a geographic region. Say for example, the ETF that is tracking the S&P/ASX 200 index is the one that is tracking the developments occurring in the top 200 companies of Australia. In other words you can say that, the fund manager buys all the stocks that are available in the index and then weight them based on the market capitalisation of each and every company. Under this system, the dividends, gains or losses along with franking credits are passed to you.

When it comes to trading ETFs, it is suggested that an investor should buy that particular ETF that tracks a sector or index which is likely to perform positively over the next few years or complements with the overall portfolio of the trader.

Often you will find private client advisers buying ETFs that track the broader market as the foundation of the share portfolio of the client and afterwards they may mix it up with some resource or bank shares. However, ETF is considered as the pure diversifier. This particular strategy is known as the “core-satellite approach”.

Active and Passive ETFs

ETFs can be considered in two ways, they are either active or passive. Although you may not be able to tag one as the better one than the other, but it is important for the traders to have a clear understanding about the distinctions between them.

An ETF that tracks the performance of the S&P/ASX 200 index is the one that is considered as passive ETF. These ETFs simply attempts to imitate the performance of the index that it is following.

On the other hand, the active ETFs attempt to enhance the performance by managing the fund. The active ETFs will try to bump the returns of the fund through buying and selling the shares. In addition to this, an active ETF will also try to prevent the returns (from the fund) from sagging when the market corrections take place. Despite the fact that this type of funds may look more attractive in comparison to the passive funds, the profitability of such funds depends largely on how they are being handled by the managers.

Traders are advised to take a look at the historical data of an ETF during their investment but they also needs to keep this in mind that past performance may not provide any guarantee for the future performance of the funds.

Evaluating the performance of an ETF

An investor needs to understand that an ETF that is tracking an index or sector won’t try to exceed the numbers that the market will come up with but instead will try to gain the same sort of returns to that sector or index which it is tracking. Say for example, if the S&P/ASX 200 Index records about 10 percent of returns for a year, then the ETF which is tracking this index will also look for achieving 10 percent, not more than that. Now if that ETF provides a 5 percent return (with market return remaining at 10 percent) then that can be considered as a poor return from the investment. Always remember, as long as the ETF is generating returns similar to the market, you may consider that as a successful investment.

The active ETFs usually invest on the basis of a particular investment style such as value or growth and in many cases the performance can be credited to that approach of investing, moving in and out along with the developments in the market.