Article written by Thom Bentley, Head of Business Development
Smart

Exchange Traded Funds, or ETFs, have changed the way everyday investors can access investment markets.

With one investment, an ETF can give you access to hundreds of companies around the world, a particular market such as New Zealand or the US, bonds, gold, or even assets such as Bitcoin. Many ETFs do this by tracking an index. Others work differently.

So, what exactly is an ETF, what is an index, and how do the two fit together?

First, what is an ETF?

An Exchange Traded Fund, or ETF, is a managed fund that can be bought and sold on a share market, such as the NZX.

Instead of investing in just one company, an ETF can give you exposure to a group of investments through a single fund. Some ETFs invest in hundreds or even thousands of companies. Others focus on a particular country, sector or type of investment. An ETF might invest in bonds or property or can provide exposure to an asset such as gold or Bitcoin.

This makes ETFs a useful building block for investors wanting to create a diversified portfolio without investing in dozens or hundreds of individual shares.

That flexibility is one of the reasons that ETFs have become a popular way to invest.

For example, if you wanted to invest across the New Zealand share market, you could buy shares in many different companies yourself. Or you could choose an ETF that gives you exposure to a broad group of New Zealand companies through one investment.

What is an index?

An index is a way of measuring the performance of a particular group of investments.

The S&P 500 Index, for example, tracks 500 of the largest listed companies in the United States. Closer to home, the S&P/NZX 50 Index includes 50 of the largest companies listed on the NZX.

Each index has rules determining which investments are included and how much weight each one receives. Specialist index providers, such as S&P Dow Jones Indices and MSCI, set and maintain these rules.

Indices can cover broad markets, particular countries or regions, sectors such as healthcare or technology, or types of investments.

What is index investing?

You can’t invest directly in an index. But, you can invest in a fund designed to track it.

Rather than an investment manager choosing individual investments in an attempt to outperform the market, an index fund aims to broadly match the performance of its chosen index.

Take the S&P 500. Recreating it yourself would mean buying shares across 500 companies and then adjusting your investments as the index changes.

An index fund does this for you, following a rules-based approach that determines what the fund holds. This can help keep management costs down.

Index investing is often called ‘passive’ investing, but there’s plenty happening behind the scenes. Fund managers manage the portfolio as the index changes, with the aim of keeping the fund’s performance as closely aligned with its index as possible, after fees and other costs.

Many ETFs track an index, but not all do. Some ETFs are designed to provide exposure to a particular asset rather than a group of investments. The Smart Gold ETF, for example, gives investors exposure to movements in the price of gold, while the Smart Bitcoin ETF provides exposure to movements in the price of Bitcoin. This allows investors to gain exposure through an ETF without buying and holding the asset directly.

What makes an ETF different from an unlisted managed fund?

Both ETFs and unlisted managed funds pool investors’ money into a fund. The main difference is how they are bought and sold.

Neither structure is automatically better. The starting point is still your overall investment plan: what you’re investing for, how long you have, and how much investment risk you’re comfortable taking.

The bigger picture

ETFs have made a wide range of investments easier for everyday investors to access.

Instead of trying to predict which individual investments will perform best, you can invest across a broader market. ETFs have made that approach easier to access. Whether this approach is suitable depends on your individual goals, financial circumstances, and attitude to risk.

Before investing, look at what the ETF holds, how diversified it is, the risks involved and what it costs.

The basics of investing haven’t changed: understand what you own, spread your risk, keep an eye on costs and invest with your goals and timeframe in mind.

If you’d like to learn more about the Smart Funds, please refer to the Product Disclosure Statements and other disclosure material available on Smart landing page on InvestNow.

Disclaimer:

This article is for general information only and does not constitute personalised financial advice. Investing involves risk. The value of investments can go down as well as up, and returns are not guaranteed.

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