What are ETFs and How Do They Work?

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This article is not financial advice. I am not a financial advisor. Please do your own due diligence before making decisions.

What are ETF’s?

Do ETF’s confuse you? Understanding what ETFs are can be confusing, especially to anyone new to investing, wrapping your head around what an ETF actually is can be challenging and confusing.

The internet is full of explanations, yet most of these use terminology that is not always friendly to those who are new to the world of investing.

Firstly, ETF stands for Exchange Traded Fund. An ETF is a type of investment vehicle that as it’s name implies, is exchange traded, meaning they are bought and sold on the stock exchange.

The second part of the name, ‘fund’ hints that the investment vehicle contains more than one company.

So simply put, an ETF is an investment vehicle that is bought and sold on the stock exchange, in which when you buy, you are buying little pieces of multiple companies.

ETF’s are often created with the goal of tracking particular indexes. For those who don’t know an index is just a particular group of stocks. Some common examples are the S&P500 (biggest 500 US companies) and S&P/ASX 300 (biggest 300 Australian companies)

Exchange traded funds allow investors to invest in markets as a whole, which removes the often difficult part of having to pick individual stocks. When you purchase an ETF you are often automatically getting diversification across 100’s of companies from all different sectors.

Still confused? Let’s take a look at an example. Vanguard, which is one of the worlds largest investment providers, has an ETF called VAS. VAS aims to track the returns of the ASX300 (biggest 300 Australian companies). This ETF can be purchased directly from the stock exchange. Once you own VAS, you own little bits of the top 300 Australian companies.

I hope it is starting to make a little bit more sense now. If you are still struggling to understand what an exchange traded fund is, remember these basics.

  • An ETF is not one company
  • An ETF is a basket of companies
  • When you buy an ETF you are buying little pieces of multiple companies
  • ETF’s remove the need to pick individual stocks
  • ETF’s are purchased on the stock exchange
  • ETF’s exist that track indexes, sectors & commodities. Some are also actively managed
  • Without ETF’s if you wanted to track the ASX300 you would need to individually buy all 300 companies within it
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What are the Benefits of Having ETF’s in your Portfolio?

Diversification: Owning an ETF offers a great deal of diversity as rather than owning one single stock you own little bits of multiple companies. Ever heard the famous saying ‘don’t pull all of your eggs in one basket’, well ETF’s are symbolic of this saying and ensure adequate diversification within your portfolio.

Low Costs: ETF’s are an extremely cost effective way of gaining exposure to a large number of companies. Without ETF’s if you wanted to track the performance of an index you would need to individually purchase all stocks within that index. This would cost an absolute fortune in brokerage fees. ETF’s make this possible for an extremely reasonable fee.

Simplicity: ETF’s can be simply purchased from any stock exchange as if you were buying any other type of stock.

Performance: Arguably the most important benefit, ETF’s that track major indexes such as the S&P 500 or the ASX300 aim to receive the same returns as the indexes. History has shown that index investing is the wisest choice for most, as all but a tiny majority of investors are able to consistently out perform these indexes by picking individual stocks. Most that try and outperform market returns, end up doing the exact opposite.

This post contains affiliate links. This means that if you purchase an item, I will receive a commission. Please keep in mind I only recommend high quality products and services that I have either used or thoroughly researched. These commissions allow me to keep making awesome content for you

10 ETF’s for your Portfolio

Everyones portfolio should be designed differently depending on age, risk tolerance, investment experience, investment goals and a whole lot of other factors.

Here is a list of 10 high quality ETF’s from good providers that I believe are worth considering for your portfolio.

VAS – Vanguard Australian Shares ETF

Aims to track the returns of the S&P/ASX 300 Index (Top 300 Australian Companies)

  • Expense Ratio: 0.10%
  • Number of Holdings: 306
  • Average Dividend Yield: 2.65%

VAPVanguard Australian Property ETF

Aims to track the returns of the S&P/ASX 300 A-REIT Index (Top Australian Real Estate Investment Trusts )

  • Expense Ratio: 0.23%
  • Number of Holdings: 32
  • Average Dividend Yield: 3.65%

VGS – Vanguard International Shares ETF

Aims to track the returns of the MSCI World Ex-Australia Index (Largest companies from developed countries excluding Australia)

  • Expense Ratio: 0.18%
  • Number of Holdings: 1505
  • Average Dividend Yield: 1.6%

VEQ – Vanguard FTSE Europe Shares ETF

Aims to track the returns of the FTSE Developed Europe All Cap Index (Largest companies from Europe)

  • Expense Ratio: 0.35%
  • Number of Holdings: 1322
  • Average Dividend Yield: 2.28%

VGE – Vanguard Emerging Markets ETF

Aims to track the returns of the FTSE Emerging Markets All Cap Index (Top companies from emerging markets)

  • Expense Ratio: 0.48%
  • Number of Holdings: 5225
  • Average Dividend Yield: 1.93%

VGB – Vanguard Australian Government Bonds ETF

Aims to track the returns of the Australian Government Bonds Index

  • Expense Ratio: 0.20%
  • Number of Holdings: 146
  • Average Dividend Yield: 1.06%

DJRE – SPDR Dow Jones Global Real Estate Fund ETF

Aims to track the returns of the Dow Jones Global Real Estate Index (Global REITS)

  • Expense Ratio: 0.5%
  • Number of Holdings: 257
  • Average Dividend Yield: 3.05%

IVV – iShares S&P 500 ETF

Aims to track the returns of the S&P 500 (Biggest 500 US Companies)

  • Expense Ratio: 0.04%
  • Average Dividend Yield: 1.13%

VDHG – Vanguard Diversified High Growth Index ETF

Aims to track the returns of returns of various funds in which invests

  • Expense Ratio: 0.27%
  • Number of Holdings: 7
  • Average Dividend Yield: Not displayed on website

IOO – iShares Global 100 ETF

Aims to track the Global 100 Index (Biggest 100 companies globally)

  • Expense Ratio: 0.40%
  • Number of Holdings: Not displayed on website
  • Average of Dividend: 1.39%

Summary

You should now have at the very least a basic understanding of what ETF’s are and how they work. The best way to keep learning is to keep reading. Every new article you read on ETF’s will help bolster your understanding of them and how they can be used in your portfolio.

Personally, I believe ETF’s are a top choice for anyone’s portfolio as most people are simply unable to outperform the market through individual stock selection.

Despite almost exclusively forming my stock market portfolio, I strongly encourage you do your own research on whether ETF’s are suitable for your portfolio as I myself am not a financial advisor and this is not intended to be financial advice. I have included a list of some amazing books I think can help you immensely on your stock market journey below and a little description of what each entails.

The Little Book of Common Sense Investing by John Bogle : Written by the founder of one of the worlds largest investment providers, this book discusses the “simplest and most effective way of getting stock market returns over the long term”. It is perfect for anyone who is new to the stock market and explores the powers of index fund investing.

The Intelligent Investor by Benjamin Graham: This book is recommended by the greatest ever investor Warren Buffet. It covers everything from basic investment principles to stock selection tips. This book is an absolute must for anyone who is looking to take stock market investing seriously.

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