Sunday, May 25, 2014

What Are Exchange Traded Funds And How Do They Work?

In his 2013 annual letter to shareholders, Warren Buffett put forward some ideas on ETFs. He discussed how in his will he's left instructions for 90% of the money which is to be held in trust for his wife to be invested in (low cost) ETFs. If one of the most successful investors in history is recommending exchange traded funds, maybe the rest of us should have a closer look as well.

What Is An ETF?

It's a product which provides investors with relatively low cost exposure to a broad range of companies or other invest-able assets. They are traded on the stock market just like the shares of listed companies.

An ETF tracks an index like the ASX300 or the price of a commodity like gold.  This means that investors should receive the same return as they would if the held all of the shares which make up the index, or in the cast of something like gold, it would be similar to buying gold.

Do Exchange Traded Funds Pay Dividends?

Whether an ETF pays dividends will depend upon the underlying assets it holds. If the fund owns shares in dividend paying companies then these will usually be distributed to fundholders.

If the underlying asset does not produce any income (commodities for example) then there would be no distributions. An investor would be relying on movements in the underlying asset's price to provide capital gains in their investment.

How To Buy Exchange Traded Funds

As already discussed, ETFs trade on the stock market just like normal shares. This means they can be bought and sold through your stock broker just like normal shares. And you can view their prices in the financial pages of newspapers, in the online financial press and through your online broker's website.

How Many Exchange Traded Funds Are There?

As I write this, there are over 70 ETFs listed on the Australian Stock Exchange. They cover areas such as:
  • Various Australian share price indexes
  • Specific sectors of the Australian stock market
  • Various international markets and their sectors. This can be a cost effective way of buying international shares.
  • Particular investing strategies (eg value investing, high dividend yield, etc)
  • Various currencies
  • Cash and fixed income
  • Commodities

The complete exchange traded funds list is published on the ASX website.

Read more here.