Course #: Title

Course 2

What are ETFs?

Topic 1: ETF features ................................................................................................................. 3 Index tracking ......................................................................................................................... 3 Trades at NAV ........................................................................................................................ 4 Open-ended............................................................................................................................ 4 Exchange traded..................................................................................................................... 4 Topic 2: How ETFs are created .................................................................................................. 5 Primary and secondary market ............................................................................................... 5 How are ETFs created? .......................................................................................................... 5 What happens to the underlying securities?............................................................................ 5 ETF redemption process......................................................................................................... 5 ETFs are open-ended ............................................................................................................. 6 Topic 3: Understanding Net Asset Value (NAV).......................................................................... 7 Market price vs. NAV .............................................................................................................. 7 How is the NAV calculated? .................................................................................................... 7 Where can I find the NAV?...................................................................................................... 7 What keeps the market price in line with the NAV? ................................................................. 7 Arbitrage ................................................................................................................................. 8 Market price vs. index level ..................................................................................................... 8 Topic 4: ETFs - cost and tax efficient........................................................................................ 10 Low management costs ........................................................................................................ 10 Tax efficient .......................................................................................................................... 10 Topic 5: ETF strategies ............................................................................................................ 12 Instant diversification ............................................................................................................ 12 Core plus satellite ................................................................................................................. 12 Geared exposure .................................................................................................................. 13 Adjust asset allocation .......................................................................................................... 13 Summary .................................................................................................................................. 15

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officers and contractors shall not be liable for any loss or damage arising in any way (including by way of negligence) from or in connection with any information provided or omitted or from any one acting or refraining to act in reliance on this information. ASX does not give any warranty or representation as to the accuracy. AllOrds®. reliability or completeness of the information. You should obtain independent advice from an Australian financial services licensee before making any financial decisions. ASX and its employees. Although ASX Limited ABN 98 008 624 691 and its related bodies corporate (“ASX”) has made every effort to ensure the accuracy of the information as at the date of publication. To the extent permitted by law. S&P™ is a trademark of Standard and Poor’s. ASX20™. © Copyright 2011 ASX Limited ABN 98 008 624 691. ASX®. ASX50™. ITS® are registered trademarks of ASX Operations Pty Limited ABN 42 004 523 782 ("ASXO"). ASX200™. Version 1 March 2011 2 . ASX100®. All Ords®. ASX300™ are trade marks of ASXO. CHESS®.Course 2: What are ETFs? Information provided is for educational purposes and does not constitute financial product advice. All Ordinaries®. a division of The McGraw-Hill Companies Inc. All rights reserved 2011.

Version 1 March 2011 3 .S. It could be a sector index such as the S&P/ASX 200 Resource Index. Underlying indices ETFs are available over Australian sharemarket indices and international indices. Index tracking ETFs are index funds. The underlying index could be a broad market index such as the S&P/ASX 200 index in Australia. Let's look at each of these features. The ETF manager's job is to ensure the fund's holdings generally match the composition of the index. Accurate price tracking An ETF's price tracks the underlying index. ETFs: • • • • track a sharemarket index trade at or very close to the underlying net asset value are open-ended are bought and sold on ASX. which reflects the performance of listed resource companies. Exchange traded commodities (ETCs).Course 2: What are ETFs? Topic 1: ETF features An Exchange Traded Fund (ETF) is a diversified portfolio of securities that is traded on ASX. Or it could be an index created with a specific aim such as achieving a certain income yield. ETFs are 'passively managed'. Their aim is to replicate the performance of the specified sharemarket index. or the S&P500 index in the U. Their price moves in line with the index they track. give you exposure to precious metals such as gold. which are a variation of ETFs.

Settlement of the trade takes place three business days after the transaction (T+3). Open-ended ETFs are open-ended. The fund manager constructs a portfolio that varies from the composition of the index in an attempt to achieve outperformance. Version 1 March 2011 4 . The open-ended structure is one reason why ETFs track the NAV. The number of units in the fund is not fixed. The ETF issuer can create or buy back (redeem) units in response to demand from investors. You receive a holding statement. just as you buy and sell ordinary shares. Trades at NAV The price of an ETF should be at or very close to its net asset value (NAV).) In contrast the number of units on issue in a closed-ended fund is fixed. You buy and sell through your stockbroker at any time during ASX trading hours. actively managed funds aim to outperform a specified benchmark.Course 2: What are ETFs? In contrast. Exchange traded ETFs are traded on ASX. (This is discussed further in Topic 3. You cannot buy ETFs directly from the issuer. just as you do when you buy shares. The NAV reflects the market value of the underlying portfolio of shares. adjusted for the fund's fees and expenses and expressed on a per unit basis. Investor demand can result in the unit price trading at a significant premium or discount to NAV.

Course 2: What are ETFs? Topic 2: How ETFs are created Primary and secondary market You cannot apply for ETFs in a float. You can only buy ETFs on the secondary market (ASX). Version 1 March 2011 5 . ETFs are issued on the primary market to authorised participants. The redemption process works in opposite way to the creation process. The basket of securities to be delivered reflects the composition of the index underlying the ETF. but is independent from the issuer. Instead of paying cash for these units. What happens to the underlying securities? When ETFs are created. How are ETFs created? The authorised participant applies to the issuer for units in the ETF. who is responsible for holding them. which in return delivers a basket of the underlying securities to the authorised participant. the underlying securities are transferred to a custodian. These participants can create and redeem units in an ETF. the authorised participant is able to sell them to buyers on ASX. the The authorised participant transfers ETFs to the issuer. the authorised participant delivers a basket of securities equal to the value of the ETFs. The issuer then cancels the ETFs. The custodian is appointed by the issuer of the ETF. ETF redemption process Authorised participants can also apply to the issuer to redeem ETFs. Once the issuer creates the new units.

and then sell those units on ASX. or very close to the NAV.Course 2: What are ETFs? The process of creating and redeeming ETFs in exchange for the underlying securities is called an 'in-specie' or 'in-kind' process. meaning the number of units on issue can be increased or decreased in response to demand from investors. This is explained fully in Topic 3. authorised participants can redeem units. If the existing supply of ETFs is insufficient to meet investor demand. If the supply of ETFs is more than is needed to meet investor demand. authorised participants can apply to the issuer for new units to be created. Version 1 March 2011 6 . The open-ended structure of an ETF helps ensure that its market price stays at. reducing the number on issue. ETFs are open-ended In Topic 1 we said that ETFs are openended.

Issuers generally publish the NAV of their fund on their own website. YSTW will return the iNAV for the ETF with the code STW. The market price is the price the ETF trades at on ASX. an ETF's market price should be at or very close to the NAV. or via Company Announcements on the ASX website.Course 2: What are ETFs? Topic 3: Understanding Net Asset Value (NAV) Market price vs. divided by the number of issued units. NAV The market price of an ETF and its net asset value (NAV) are two different things. How is the NAV calculated? The NAV is the total value of the assets in the ETF (adjusted for fees and expenses). Where can I find the NAV? The NAV of most ETFs is published daily. For example. If the price of an ETF moves out of line with the NAV. What keeps the market price in line with the NAV? The price of an ETF rarely deviates much from its NAV. divided by the number of issued units. A limited range of ETFs over Australian indices provide an indicative NAV (iNAV) that is continually updated during the trading day. However. Version 1 March 2011 7 . The NAV is the total value of the assets in the ETF (adjusted for fees and expenses). You can find this on your broker's website by typing the letter 'Y' in front of the ASX code for the ETF. this presents an arbitrage opportunity to authorised participants and professional traders. This ability to closely track the NAV is a fundamental feature of ETFs.

What if the price of an ETF is significantly higher than the NAV? An authorised participant can: • • • buy the underlying securities on ASX deliver them to the issuer in exchange for new ETFs. then sell the securities on ASX. Buying the ETF will push up the price of the ETF until it is again in line with the NAV. An authorised participant can: • • • buy ETFs on ASX deliver them to the issuer in exchange for the underlying securities. The difference between the price paid for the ETFs and the amount received for selling the securities on market is the arbitrageur's profit. Selling pressure will push down the price of the ETF until it is again in line with the NAV. This is because demand has dropped relative to current supply. In this case the difference between the price paid for the securities and the amount received for selling the ETFs on market is the arbitrageur's profit. Version 1 March 2011 8 . Arbitrage Assume the price of an ETF drops below the NAV. index level It's important to understand that an ETF's price is not necessarily 'equal to' the level of the underlying index. then sell the ETFs on ASX.Course 2: What are ETFs? Arbitrage is a technique used by professional traders to take advantage of perceived mispricing and earn profits. Let's look at how this works. Market price vs.

1 points. What matters is that in percentage terms. a change in the level of the index will result in a similar percentage change in the price of the ETF.64. an ETF that tracks the S&P/ASX 200. Version 1 March 2011 9 .Course 2: What are ETFs? For example. on 14 October 2010 the S&P/ASX 200 index closed at 4699. closed at $44. The SPDR 200 ETF (ASX code: STW).

For example. and are then assessable in your hands. minimising the tax impact on investors in the fund. As a result. so their MERs tend to be low. The fund manager's sole task is to ensure the fund's holdings match the composition of the index. Fees and costs are explained in detail in Course 3. these capital gains/losses are passed on to you the ETF holder in distributions. which tracks the S&P/ASX 200 index.09% per annum. At the end of each tax year. due to the way they are structured. has an MER of around 0. which tracks the MSCI US Broad Market Index. Capital gains/losses made by the fund are separate from any capital gain or loss you make when you sell your ETFs. the SPDR S&P/ASX 200 Fund. The fund manager usually only buys or sells securities to rebalance the portfolio in line with changes to the composition of the underlying index. it may make a capital gain or loss. has an MER of around 0.cost and tax efficient ETFs offer cost and tax efficiencies. The Vanguard US Total Market Shares Index ETF.29% per annum. Version 1 March 2011 10 . This is sometimes called the Management Expense Ratio (MER). Low management costs Fund managers charge a fee to manage a fund.Course 2: What are ETFs? Topic 4: ETFs . the fund realises few capital gains or losses. ETFs are passively managed index funds. Tax efficient Low portfolio turnover When an ETF issuer buys or sells shares.

which can result in a capital gains tax liability for remaining unitholders in the fund.Course 2: What are ETFs? On-market sales do not affect remaining investors. This may crystallise capital gains. An investor disposes of their ETFs by selling on ASX. such as unlisted funds. the fund may have to sell some of the fund's underlying securities. Compare this with investments which are redeemed by the issuer. Version 1 March 2011 11 . To pay out the investor. The sale has no impact on other ETF holders.

An important consideration in this approach is that you achieve your core returns at low cost . but relies on the core to generate market returns. no matter how small your investment. Version 1 March 2011 12 .Course 2: What are ETFs? Topic 5: ETF strategies You can use ETFs in a number of ways. Core plus satellite The core plus satellite approach has two elements: • • a core portfolio that produces returns in line with the market. as it reduces the impact on your portfolio if one or two companies perform poorly. giving you instant diversification. and one or more investments the investor thinks will outperform the market (satellites). Let's take a look at these applications in detail. Instant diversification An ETF provides exposure to all the stocks in the underlying index. Having your money spread across a range of shares can decrease your overall risk.you don't want to pay high costs simply to achieve market returns. ETFs typically serve as the 'core' investment. including: • • • • instant diversification core plus satellite geared exposure adjust asset allocation. The investor looks to the satellites to boost overall returns by taking advantage of opportunities.

the way you spread your money between asset classes such as: • • • • • Australian shares international shares property bonds. and buy ETFs that track the overseas market's index. ETFs are generally on the list of 'approved products' against which margin lenders will lend you money. You can also use ETFs as satellites. Or you might have a view that an overseas market will perform strongly. producing market returns at low cost. Your asset allocation has a significant impact on your investment returns. If you think a particular sector will do well. or actively managed funds. Adjust asset allocation In Course 1 we looked at the importance of asset allocation . and cash. Geared exposure You can use ETFs as part of a geared investing strategy such as margin lending.for example changing your exposure to equities. Using borrowed funds to invest in ETFs can increase your returns if the ETF performs well. The satellites could be individual shares you think will outperform the market.Course 2: What are ETFs? For example. However. you could buy ETFs that give you exposure to that sector. From time to time you may want to adjust your asset allocation . you could buy ETFs that track the performance of the S&P/ASX 200 index as the core of your portfolio. Version 1 March 2011 13 . you will suffer increased losses if the ETF performs badly.

or a sector of it.buying ETFs to increase your exposure. selling to decrease it.Course 2: What are ETFs? ETFs enable you to easily adjust your weighting to the sharemarket. in one transaction . Version 1 March 2011 14 .

either a broad market index or a sector index. Because they are passively managed index funds. including: . ETFs are open-ended funds. and then can be traded on ASX. The issuer can create or redeem units in response to investor demand. • Version 1 March 2011 15 .to achieve instant diversification .Course 2: What are ETFs? Summary • • • ETFs track a sharemarket index.to adjust your asset allocation.as part of a 'core plus satellite' approach . An ETF generally trades at or close to the net asset value. Arbitrage activity ensures that the ETF price remains in line with the NAV. • • ETFs offer cost and tax efficiencies. which is the value of the securities underlying the ETF. due to the way they are structured. They are created by the issuer. management costs tend to be low.as part of a geared investing strategy . You can use ETFs in a number of ways.