ETFs explained: A Path to Market Exposure and Long-Term Wealth

September 19, 2024

Editor(s): Michael Chen

Writer(s): Yitong (Tina) Ma, Sammi Lam, Nathan Ang

Investing and navigating through financial markets isn’t easy as the complexities and nuances are ever-changing. Developing a resilient and dynamic investment strategy becomes increasingly challenging as trends and sentiment shift. Despite these challenges, financial innovations in the form of ETF products have allowed investors an easy and cost-effective method of investing into the market. The demand for ETFs has ballooned rapidly, stemming from the advantages of diversification as well as the ability to stay invested for longer—allowing for the power of compounding to take place.

How ETFs work

ETFs are a blend of a stock and an index mutual fund, able to track an index and provide diversification like mutual funds, but traded on an exchange at real-time market prices. The majority of ETFs are structured like an open-ended fund. Open-ended funds do not have a limit on the number of investors. The number of units on issue are created and redeemed by issuers to meet investor demand, so there is no fixed amount of units in the fund. This helps the market price trade close to the net asset value of the ETF. 

ETFs are known for their high accessibility and ability to cater to the increasing demand of investors. There are countless variations of ETFs available, covering almost all asset classes and individual assets. The large variety available comes from the high demand and easy access from technological improvements, which allow ETFs to be easily traded at a low cost. The choices may seem overwhelming with the many options, but understanding the underlying features that define each fund will help you decide which one suits your investing needs. 

Features of ETFs

Passively managed funds

Passively managed funds have a focus on tracking the movement of a market and don’t attempt to outperform the market. These funds aim to match the returns of a market or index. Investors benefit from passively managed funds as it allows diversification within assets. However, passively managed funds rely on the asset tracked, so a fall in the market would translate to a fall in your own investment.

Active managed funds

Actively managed funds aim to outperform the market or index through active tracking. There are buy and sell decisions involved to pursue returns above the market. However high returns come at a higher risk, so there is no guarantee that the actively managed fund will outperform the market. Actively managed funds also have high costs due to the large fees associated with them. 

Physically backed

Physical assets are held for ETFs to track through physical replication or representative sampling. While this option offers high accuracy due to the same or similar match, there is a higher monetary cost and it may be difficult to achieve illiquid assets.

Synthetically backed

Synthetically backed funds hold some underlying assets and enter swap agreements using derivatives to replicate movement. There are the benefits of easier implementation, lower tracking error, and access into difficult markets with synthetically backed ETFs, but investors must be aware of the additional risk associated if the derivative fails or the swap agreement is unfulfilled. 

Market Popularity

In Australia, the popularity of ETFs is skyrocketing in the market and are becoming an attractive investment option.  The ETF market share of the Australian funds market has grown massively since its introduction with the Australian ETF market having grown 37.3% compared to the past year. The Australian ETF industry has exceeded $200 billion AUD in assets in the last financial year and the market capitalization was at an all time high across both the ASX and CBOE.

With the landscape of ETFs expanding towards cryptocurrencies, ETFs are expected to grow even further. More crypto options are becoming available, receiving increased approval and adoption from countries’ regulators. Despite being a newcomer, Bitcoin and Ethereum ETFs held the spot for best performing ETFs as of June 2024, a signal of their regard.

           Graph of ETF market share of Australian funds market over time

Diversification

Diversification has become one of the most important aspects of developing a successful investment strategy. Spreading out your risk across multiple different investments, is an excellent way to navigate the complexities of financial markets. Through the development of ETFs, investors have been able to harness the benefits of diversification in developing their own investment strategies.

Access to Broad Range of Investment Opportunities

The ability to access a broad range of different assets is one of the most significant advantages ETFs hold. Investors are able to access a multitude of investments across different geographies—whether that may be in the form of equities, bonds, commodities or even crypto currencies. In addition to this, the reach of ETFs now extends to factor investing and thematics. This opens up a whole myriad of opportunities for everyday investors, allowing them to invest with different strategies and diverse ideologies. For example, investors seeking to reap the benefits of the growing demand in automation may opt to invest in an ETF with a robotics theme in their portfolio. Alternatively, investors seeking protection and growth in tough market conditions will find that a quality factor ETF may be suitable for them.

In addition to offering a diverse range of investment opportunities, ETFs provide a method of doing so in an efficient and cheap way. Without ETF products, investors looking to invest into an index would have to purchase all the various constituents. Not only does this require an extremely large amount of capital to afford each individual stock and its brokerage, but would also require ample time and effort to maintain the portfolio. Investment management firms such as Vanguard or Blackrock, bear the brokerage costs and offer investors an affordable way to buy into the market. Furthermore, these firms will do all the rebalancing and maintenance of the portfolio, saving precious time and energy.

Risk-Reduction Potential

Diversification proves to be an incredibly effective strategy in mitigating risk whilst still providing returns. Harry Markowitz’s Modern Portfolio Theory (MPT) addresses how by utilising correlation, one can optimise a portfolio’s return based on their risk appetite. It’s a simple yet effective concept, so in the event that an investment fails to perform—a multitude still exists that may be able to offset the losses.

 Total returns (%) for the major asset classes for financial years ending between 1995 and 2024

By diversifying, investors are also able to capitalise on the gains from various different investments. Vanguard depicts the benefit of diversification in the chart above. The nature of asset class performance is rather dynamic—the worst performer one year could be the best in the next, vice versa. By essentially investing in everything, investors increase the likelihood of capturing growth opportunities across the market.

ETF Historical Returns

The Vanguard Australian Shares Index ETF (VAS) seeks to track the return of the S&P/ASX 300 Index, providing a broadly diversified exposure to Australian companies and property trusts listed on the ASX. 

VAS Top 10 Holdings:

The top 10 holdings of VAS represent 47.5% of the ETF’s value

5-Year Performance

The value of an investment today if $10,000 of VAS was bought 5 years ago

The Power of Compounding

Albert Einstein is famously attributed to the saying, “Compound interest is the eighth wonder of
the world.” This simple yet profound concept refers to the process where the returns on an investment begin to generate their own returns over time, leading to exponential growth in wealth. Unlike money left idle under a mattress, investments that leverage the power of compounding can experience significant growth over the long term.

                                             Growth of Warren Buffet’s net worth over time

Warren Buffett, one of the most successful investors in history, is a prime example of the impact of compounding. Starting with a net worth of $1 million (USD) at age 30, Buffett’s investments swelled to $1 billion (USD) by age 56. 

Today, Buffett’s fortune exceeds $142 billion. The exponential growth in his wealth, especially in the past few decades, is largely attributed to the compounding effect of his investments.

Investing regularly

Investing small amounts on a regular basis can significantly enhance your returns in the long-term due to compounding. The more frequently one adds to their investment, the greater the potential for growth, especially when reinvesting any returns from dividends or capital gains. This disciplined approach to investing that is ideally emotionally indifferent to market fluctuations, can be a powerful strategy for long-term wealth accumulation. 

Consider an investor who made a $5,000 initial investment in VAS on 1 July 2014. By 30 June 2024, here’s how the investment would have grown based on different monthly contribution strategies:

Investment growth based on varying amounts of monthly contributions

• No Additional Investments: With no further contributions, the initial $5,000 investment would have grown to $10,720.52 by 30 June 2024, more than doubling over the 10-year period.
• Investing $100 per Month: By adding $100 each month, the investment would have grown to $29,195.82. After accounting for the $12,000 in additional contributions, the investor would have gained over $17,000 due to compound growth. 
• Investing $200 per Month: With $200 added monthly, the investment balance would have reached $47,671.12. Even after subtracting the $24,000 in total contributions, the gain would still exceed $23,000.
• Investing $500 per Month: An investor contributing $500 monthly would have accumulated $103,097.01 by 30 June 2024. After accounting for the $60,000 invested over the period, the gain would be over $43,000, reflecting a total return of nearly 1,962%.

ETFs have proved to be an effective investment opportunity. Through diversification, investors are able to add resilience and risk-reducing properties to their investment strategy. Ultimately, the greatest benefit that ETFs provide is the ability to remain invested in the market over the long-term. This allows investors to harness the power of compounding to magnify their returns over the long term.

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