Introduction to Exchange Traded Funds: Domestic ETFs

It's important to get a good grasp of the sharemarket index before getting into the details of domestic ETFs. Domestic ETFs ride on the back of the sharemarket index. What is a sharemarket index? A sharemarket index is a measure of the performance of a group of stocks as opposed to one stock alone. The S&P/ASX 200 and All Ordinaries indices, for example, are whole market measures while the S&P/ASX 200 Utilities index is a sector measure.

When prices of individual shares move up and down, it follows that the index level also changes. The index measures the cumulative effect of the share price movements and gives the investor a picture of how the market or sector has performed over time. A company with large market capitalisation (market cap) will make the biggest impact on the sharemarket index.

Remember that market capitalisation is number of shares outstanding multiplied by shares price. Let's assume 5% change in share price for two companies, BHP Billiton and a stock ranked 100th on the index. BHP has a significantly higher market cap (greater number of shares outstanding) so it will have greater market impact.

You will see two calculations reported for the S&P/ASX indices, represented by two lines in the index chart. The price return index accounts only for share price movements, while the total return (accumulation) index accounts for both share price and paid dividends, assuming that all dividends are reinvested. This means that the total return index will show higher values than the price return index.

Index ETFs

Index ETFs replicates or tracks the performance of the S&P/ASX 50, 200 and 300 indices. If the sharemarket performs well, the value of your index will rise. The opposite is also true.

ETFs closely follow returns of the relevant accumulations index (before fees and expenses are deducted). Most ETFs also include a distribution reinvestment plan and if you choose to participate, your distributions will automatically reinvested.

An index ETF is passively managed, which means that shares are determined by the composition of the index. What do you pay the fund manager for, then, if the ETF is passively managed? The fund manager tracks index performance and oversees the pooled funds according to the group's objectives.

The ETF price is not always the index level price, although the two can sometimes overlap. Note that a index level changes cause a similar percentage changes in the ETF price.

Let's take an ETF that tracks the S&P/ASX 200 index. Assuming dividend reinvestment, returns before income and expenses should closely match the S&P/ASX 200 accumulation index. On the chart, you will see the nearly identical ETF line and the index accumulation line.

Sector ETFs

As opposed to a whole market, sector ETFs track a sector index. A sector index measures the performance of the companies included in that particular sector. Example of sectors in the Australian market include energies, utilities, industrials, information technology, and resources.

Risks

The ETF issuer will list all the risks that come with your investment, so be sure to understand this part of the document. If the whole sharemarket falls, the value of your ETF will also fall. This is also true for a sector. If the sector index moves unfavourably, your ETF decreases in value.

A diversified portfolio most likely already includes stocks in certain sectors, for example in financials and utilities. When you invest in a financial or utilities ETF, the risk for that sector is added on top of the broad sharemarket risk. This exposure to additional risk should be considered before buying ETFs.

In Summary

• An index measures the performance of a block of shares. The index can encompass a whole market (S&P/ASX 200) or a sector (S&P/ASX 200 Mining).
• An accumulation index or a total return index assumes all dividends are reinvested. It takes into account both share price and distributions paid by those shares.
• Assuming that you reinvest all distributions in ETF units, an ETF closely follows the same returns (before fees and expenses are deducted) as the accumulation index.
• If the market performs unfavourably, there is a concomitant drop in value of your ETF. You also risk duplicating risks when investing in sector ETFs.