As an easy way of investing, exchange traded funds would be hard to beat for the couch potatoes among us. All right, so I like them.
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The thing is ETFs are like an unlisted, low-cost index fund which imitates an entire market and so give instant diversification while being simple to get in and out of.
That's why I tell anyone who's starting out in the sharemarket or wants to know what's a hot stock – really, they should know better than to ask me – that an ETF is the first step. I'd never leave home without one, frankly.
ETFs are growing like topsy. Heck, they could even gobble up the whole market one day except there are stocks out there that not even an ETF would touch.
Originally they copied an index such as the ASX200 stock for stock and in exactly the same proportions, giving you 200 stocks in one hit. This for a fee way under anything charged by a managed fund or, for that matter, a listed investment company.
The going rate is only a fraction of a cent for every $100 invested, cheaper even than we're told is the cost of running the ABC These days ETFs come in all shapes and sizes – local, global, ethical, bonds, commodities, exchange rates, you name it – and are becoming actively managed.
Magellan, with the ASX code of MGE, has listed an exact copy of its global fund, including the 1.35 per cent annual fee. There's also a 10 per cent performance bonus – for the fund manager, not you.
This, incidentally, fudges the distinction with listed investment companies which have been around for yonks.
But there's a critical difference, at the moment working in favour of ETFs which are open-ended and so can receive or redeem funds all the time. Listed investment companies can't accept new funds unless there's a special rights issue, or return money without a special dividend.
Either way it's not something they can make a habit of so they're almost perpetually out of whack from the value of the stocks they hold. As we speak their sum is greater than the parts, but they also go through long periods the other way round.
The leading ones are trading 20 per cent higher than the value of their investments. So you could buy the same stocks they hold for 20 per cent less, though you'd want to watch the brokerage.
The promoters claim ETFs trade at or close to their underlying value. This is usually but not always correct.
They appoint market makers to provide quotes around their true or "net asset" value whose role is to iron out kinks in the market. In other words, an ETF may not be near its underlying value when you happen to be buying or selling units. Indeed their trade with you – selling for more than its worth or buying for less – could be how they nudge the price toward the true value.
Mostly this shouldn't matter much since the published net asset value is only a day old. Anyway you have to accept shares bounce around.
But in a fast-moving market it can make a difference with some of the less liquid ETFs, such as those covering small stocks or a specific sector.
Just before property trusts found favour again three years ago, one ETF following them recorded a 22 per cent price swing in 24 hours when the index it's supposed to copy climbed about 2.5 per cent.
True, the real test was the global financial crisis when often ETFs following bonds were for a while more liquid than the real thing.
Still, you have to trust the market makers, which are big broking houses and merchant banks, will do their thing and don't run into liquidity problems themselves.
But I'd say an ETF following a broad index, making it naturally diversified, will be a better bet than buying a stock you heard about at the pub.
