What is an ETF and how does it work?

If you’ve ever typed “What is an ETF” into Google, you’re not alone. 

Exchange-traded (ETF) funds have exploded in popularity among Australian investors because they make it easier to access diversified exposure in a single trade. ETFs combine features of managed funds and shares and today they cover almost every corner of the market – from Aussie banks to U.S. tech giants and even green energy themes.

This guide explains what an ETF is, how ETFs work, the different types available and the benefits and risks to consider. We’ll also highlight some of the most held ETFs on Superhero to give context on what Aussie investors are choosing.

What Is an ETF?

An Exchange Traded Fund (ETF) is a managed investment fund that trades on a stock exchange. Instead of owning just one company, ETFs pool money from investors to buy a portfolio of assets – such as shares, bonds or other securities.

For example, an ETF like VAS aims to track the S&P/ASX 300 Index, giving you exposure to 300 of the largest companies in Australia. Another ETF like IVV tracks the S&P 500, which includes around 500 major companies listed in the U.S. In one trade, you gain exposure to all of those holdings.

How Does an ETF Work?

Think of an ETF as a “basket” of investments that you can buy and sell on the stock exchange. Here’s how it works in practice:

• Buying and selling – ETFs trade on the ASX and Wall Street just like company shares. You can buy them through an investing platform or broker during market hours and sell them the same way.
• What’s inside – most ETFs are designed to copy an index (like the S&P/ASX 300 or S&P 500). This means when you buy one ETF unit, you’re getting a slice of all the companies in that index.
• Keeping prices in line – specialist traders called market makers help keep the ETF’s price close to the value of the investments inside it.
• Income payments – if the companies or bonds inside the ETF pay dividends or interest, the ETF usually passes that income on to investors through distributions.

Types of ETFs

ETFs come in many forms. Here are the main types you’ll come across:

1. Index ETFs – track well-known indexes such as the S&P/ASX 300 or the S&P 500. These are some of the most common ETFs and are usually low cost.
2. Thematic ETFs – focus on a specific trend or sector like clean energy, cybersecurity or healthcare. They can be more volatile because they’re concentrated in fewer companies.
3. Bond ETFs – invest in government or corporate bonds. These ETFs provide access to fixed income markets, which can behave differently to shares.
4. ESG ETFs – build portfolios using environmental, social and governance screens. For example, they might exclude fossil fuels or tobacco.
5. Dividend ETFs – focus on companies with higher dividend yields or dividend-focused strategies, however future distributions aren’t guaranteed.
6. Active ETFs – run by a professional manager who decides what to buy and sell. They aim to outperform an index but usually charge higher fees.
7. Passive ETFs – simply follow an index. They don’t try to beat the market, they aim to match it.

Active vs Passive ETFs

One common question with ETFs is the difference between active and passive ETFs. These refer to the way these ETFs are managed by their provider:

• Passive ETFs – these funds aim to mirror the performance of a chosen index, like the S&P/ASX 300 or the S&P 500. They don’t try to beat the market, they simply track it. Passive ETFs usually have lower fees because there’s no team of managers making investment decisions. They provide straightforward exposure and are often used as core building blocks in portfolios.
• Active ETFs – these funds are run by professional managers who make decisions about what to buy and sell. The goal is to generally outperform an index. Active ETFs often come with higher management fees because they require more hands-on oversight. Their performance depends on the skill of the manager and the strategy used.

Neither is “better” than the other – they’re simply different approaches, and the right choice depends on an investor’s objectives, risk appetite and preferences.

Benefits and Risks of ETFs

Benefits of investing in ETFs

ETFs have become popular amongst investors for several reasons:

• Diversification – one ETF can hold dozens or even hundreds of securities, so you’re not relying on a single company’s performance
• Accessibility – you can buy ETFs on the stock exchange through a broker in the same way you’d buy a share
• Cost efficiency – fees are usually lower than traditional managed funds
• Transparency – many index ETFs publish holdings daily but disclosure frequency varies by issuer and product
• Flexibility – you can choose from a wide range of ETFs to target different markets, sectors or strategies

While these are common advantages, they don’t make ETFs suitable for everyone. Each ETF has its own risks, costs and performance drivers that should be considered.

Risks of investing in ETFs

Like any investment, ETFs come with risks.

• Market risk – if the underlying assets fall, the ETF’s price falls too
• Currency risk – international ETFs can be impacted by exchange rates
• Liquidity risk – some ETFs don’t see as much trading volume as others, leading to wider gaps between buy and sell prices
• Tracking error – returns can differ from the index due to fees or imperfect tracking

ETF Costs Explained

Like all investment products, ETFs come with costs:

• Management fee – charged annually as a percentage of your investment. For example, a 0.10% fee on a $10,000 investment is $10 per year
• Brokerage – the fee charged by your broker when you buy or sell units
• Bid-ask spread – the difference between the highest price buyers are willing to pay and the lowest price sellers are willing to accept
• Currency conversion – when buying international ETFs, exchange rates can impact both purchase cost and returns

Over time even small fees can reduce returns, so it’s worth comparing ETFs on both cost and exposure.