What are ETFs (Exchange Traded Funds)?

What is an ETF?

An ETF, or Exchange Traded Fund, is an investment fund that holds a basket of assets. That means when you invest into a single ETF, you’re actually getting exposure to many different investments all at once, not just one.

Think of an ETF Like a Box of Toys

Imagine an ETF as a big box of toys, where each toy inside represents a different company. If you buy the box (the ETF), inside you might find:

  • A car (Company 1)
  • A doll (Company 2)
  • A ball (Company 3)
  • A bear (Company 4)

If most of the toys in the box do well, the whole box becomes worth more. If most of them do badly, the box is worth less. And if one toy breaks or turns out to be a dud, you’ve still got plenty of others, or the fund can swap it out for a better one. That’s the whole point. It’s safer than betting everything on just one toy, or one company.
Over time, we know that the best performing “toys” in the box will tend to rise in value, and that’s what drives the overall growth of the ETF.

What is an Index, and Why Does It Matter?

You’ll hear the word “index” thrown around constantly when people talk about ETFs, so let’s break it down properly.

An index is simply a list of companies grouped together to measure the performance of a particular market, sector, or theme. Think of it like a scoreboard. It doesn’t hold any money itself, it just tracks how a defined group of companies is performing as a whole.

The S&P/ASX 200 is a good example. It’s an index made up of the 200 largest companies listed on the Australian Securities Exchange, and it’s used as the go to measuring stick for “how is the Australian share market doing today.”
Here’s the important part: you can’t actually buy an index directly. It’s not a product, it’s just a benchmark. This is where ETFs come in.

How Do ETFs Track an Index?

Most ETFs aim to track an index. A good example of this is VAS, which tracks the S&P/ASX 200. When you buy VAS, the fund manager behind it holds shares in all (or close to all) of the 200 companies in that index, in roughly the same proportions as the index itself.

So instead of you needing to individually buy shares in 200 different companies, one ETF does it for you in a single trade. As the index moves up or down, the value of the ETF moves with it.

We know that over time, the Australian economy, or the 200 largest companies within it, tends to grow in value. If we invest in an ETF tracking that index, we should see a healthy return over the long run, even if some individual companies inside it don’t perform well. Compare that to investing in just one company: if that company doesn’t do well, you lose money, full stop.

Pros and Cons of ETFs

Pros

  • Diversification – spreads your risk across many companies rather than betting on one
  • Low fees – generally cheaper than actively managed funds
  • Liquidity – you can buy or sell anytime the market is open
  • Transparency – you know exactly what you’re invested in

Cons

  • You get market returns, not “outperformance” – you won’t beat the market, you’ll roughly match it
  • Market volatility – the market can go up and down, and if you sell while it’s down, you lock in a loss
  • There are still risks involved – ETFs reduce risk, they don’t eliminate it

Is It Right for Me?

If you have money you want to invest into something low cost, low risk relative to picking individual shares, with strong long term returns, and you can keep it invested through market volatility (think 7 to 10+ years), then ETFs may be something you can research about.