Find the missing pieces of your portfolio

Two trades and you could add most of the Australian sharemarket as well.

Three trades and you're ... well, being greedy.

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Anyway an exchange-traded fund (ETF) lets you buy a portfolio of stocks off the rack. You can even choose your own design. By industry, for example. Or maybe you'd rather a whole country.

Think of it as a share that invests in shares though there are also ETFs for currencies, commodities and even cash. All that's missing is one for dodging tax though somebody's bound to be working on it.

ETFs are the new black for investors, especially DIY super funds. They're a managed fund trading on the ASX and usually follow an index like the All Ordinaries, owning all the shares in it in the same proportion and are not to be confused with listed investment companies, which have been around for yonks. These invest in much fewer stocks and in the proportions they want. As active managers they do something for their pay.

But even this distinction is becoming blurred. Some ETFs invent their own indexes and so for all practical purposes are actively managed, getting around the problem that a broad Australian shares index gives you CBA and BHP Billiton with not much else because they dominate it.

UBS, for example, sells the grandiloquent-sounding IQ Research Preferred Australian Share Fund which invests in its analysts' best guesses. Since it's professionally managed it comes with a 0.7 per cent annual fee where the ETF norm is more like 0.1 per cent.

Still, that's only $7 for every $1000 invested.

Market Vectors' MVW holds stocks in equal amounts so none dominate while the holdings in BetaShares' QOZ are determined by a company's "economic footprint".

Anyway, the beauty of an ETF is that it can't trade at a different price to the value of its investments, though there's no accounting for what they might be worth.

Investment companies spend most of their time trading above or, it seems more often below, the value of their investments.

There's a reason for the difference.

It's profitable for so-called market makers appointed by the fund as a condition of listing to get the price back in line. Since the fund must finish the day in line with the market they know they can exploit any kinks in the price and be rewarded by the issuer.

Relying on market middlemen might sound like the weak link in the chain, but the GFC proved that it isn't.

Trading through crisis

In September 2008 US credit markets froze as banks refused to deal with each other so for several days it was impossible to buy or sell corporate bonds. But a bond ETF traded right through the panic, albeit at depressed prices. It provided the only liquidity in the market.

The same happened in the sharemarket. You couldn't sell some smaller stocks for love or money but ETFs holding them had no problem attracting buyers and sellers.

Mind you, like anything to do with the sharemarket they have their risks. If the sharemarket falls, so do they. And you need to trust the issuer – some very small ETFs have folded. Although investors were paid out, the forced timing probably caught them short.

Managed funds have a critical mass before they're profitable for the issuer to run. For ETFs it's at least $10 million judging by the size of those wound up, and probably more like $50 million.

Incidentally their structure is the same as an unlisted managed fund so there's a trustee responsible for looking after your interests. If the issuer goes under, the trustee must find a new manager or wind up the fund and return the money to investors.

But what's given ETFs street cred was the world's most successful investor Warren Buffett telling his shareholders in Berkshire Hathaway – yes, there's also an ETF for it – that the executor of his estate should hold 10 per cent cash and 90 per cent "in a very low-cost S&P 500 index fund" for his wife's benefit. He suggested Vanguard. It's not available here although its VTS has a fee of only 0.05 per cent and invests in an even broader Wall Street index than the S&P 500.

The black box

Investing offshore is where ETFs come into their own by saving on research, tax hassles and brokerage from buying stocks separately.

The S&P 500 stock index is the black box of global sharemarkets and undeniably the tail that wags the ASX.

You read about the Dow all the time, but it represents only 30 stocks.

In fact, the first and biggest ETF is the SPDR S&P 500 Fund which, it so happens, has just started trading in Australia as SPY. It's annual fee is just under 0.10 per cent though rival iShares' IVV is cheaper at 0.07 per cent.

The S&P 500 gives you such stocks as Apple, Colgate, Exxon Mobil, Facebook, GE, Google, McDonald's, Microsoft, Pfizer and Visa.

ETFs are a fast way of getting stocks from almost anywhere but you can mix and match them too – from emerging to developed countries, small or large stocks, one industry or another.

"They're the financial version of containerisation," as iShares director Jon Howie says.

For example, in just two trades you could have the leading stocks in Australia (IOZ) and the US (IVV).  With half in each the average annual management fee would be 0.21 per cent.

Or how about the entire world? Easy, put half of what you're investing in each of IVV for Wall Street and IVE for every other developed market.  Throw in IEM (emerging markets) and you'd have the world - all in three trades.

There'd be a bonus if the dollar drops.

Then again, if the currency continues to defy economists' predictions of its demise then there's a global ETF that hedges the currency (WXHG) in which it can do anything it likes as, no doubt, it will.

ACTION PLAN

ETFs - what are they, and how can I get them:

• ETFs are managed funds that trade like shares and can be bought or sold through a stockbroker.
• They are cheaper than a listed investment company because they just imitate a market index such as the All Ordinaries.
• Register with an online broker for the cheapest brokerage.
• When choosing a fund check the annual management fee.
• Use an ETF to build a portfolio and diversify investments.
• Having a global as well as an Australian ETF can increase returns and reduce risk over time.

'I don't have to worry about the performance of a company'

As Australia moves from the resources investment boom to whatever might be next, Michael Mullane is one step ahead, investing in Chinese and Japanese stocks.

But he's using iShares which are exchange-traded funds (ETFs), copying what's in a market index.

Having previously bought shares, Michael, who even completed a diploma in financial planning just so he'd understand investing better, has gravitated toward an Australian ETF instead, the iShares IOZ.

"I don't have to worry about the performance of a company because the ETF tracks an index. It's safer, though you still have market fluctuations. You can't avoid that," he says.

"It's things like the exchange rate, interest rates and the macro economy rather than what the directors do. It's safer."

Michael is also moving into international healthcare stocks through IXJ which will complement the upcoming Medibank Private float he will take up.

But you need to "lift the lid and see what's inside" the ETF so as not to double up – a fund covering Wall Street's S&P 500, for example, will already have healthcare stocks such as Johnson & Johnson or Pfizer.

Michael is sitting on "a pot of money" only half of which is invested.

"I'm going to sit and wait. But when I invest the other half it'll be in the Medibank float and say 90 per cent in ETFs."

One of them will probably be Market Vectors' equal weighting ETF (MVW), which invests equal amounts in the top 60 Australian stocks.

"That reduces the weighting of resources and bank stocks making it less volatile though you don't get the benefit of a big market upswing," Michael says.

 'It started as a hobby and it's one of my interests keeping me busy'

It may not be your idea of a hobby but newly retired Brian Long gets a kick out of his three exchange-traded funds (ETFs).

Especially as they've bought the world to him, with interests in foreign property and multinational shares.

Before retiring he worked for local government so has a good super scheme but Brian has set aside $35,000 "play money" for shares.

He began dabbling about 15 years ago thanks to the NRMA demutualisation which gave him shares in IAG, but only discovered ETFs two years ago.

"It started as a hobby and it's one of my interests keeping me busy," Brian says.

"I look at my portfolio every day but I don't trade because I have a five to seven-year outlook. I don't want to get a nervous breakdown over it and my ETFs have stopped that."

In fact his little hobby returned 19.7 per cent last year. He's invested in the Australian dividend paying SYI (its ASX ticker) and a few weeks ago bought units in the global dividend (WDIV) and global property (DJRE) funds. All are issued by State Street Global Advisors.

"They seem to mirror what I was trying to do: a broad range of sectors covered with the prospect of a reasonable capital gain and paying a dividend," Brian says.

And he likes getting some international flavour without all the hassles.

"I could do it without all the rigmarole of a broker and foreign bank accounts. I looked at international investing 10 years ago with CommSec and it seemed so complicated with a lot of mucking around. And this way gives me international property as well.

"I've got a bit of international [holdings] but set up in Australia, subject to Australian regulations."