The Australian exchange-traded fund (ETF) industry turns 20 this month, and what an eventful two decades it has had.

From the birth of the first ASX-100 tracking ETF in 2001 to the now 220-odd product range, the ETF industry has certainly amassed some significant milestones.

This year in particular, the Australian industry surpassed $110 billion in AUM after experiencing an impressive growth spurt of 75 per cent over the last 12 months, all the while battling a rather persistent virus.

Part of this momentum can be attributed to the rise in retail investor interest. Traditionally popular with financial advisers, ETFs are now bookmarked on the desktops of individual investors who are increasingly realising the many benefits that ETFs have to offer.

So as the ETF industry continues to grow, its 20th anniversary offers a timely opportunity to go back to basics and revisit the fundamentals of an investment product that has now become a market staple, starting with: what exactly is an ETF?

Hundreds of securities in one trade

An ETF is a managed fund that is traded on the stock exchange and provides investors access to hundreds – sometimes thousands – of securities in a single market trade.

ETFs can offer exposure to a range of asset classes including equities, fixed income, property and more, and seek to track the returns of a broad market index.

For example, the largest ETF on the market is the Vanguard Australian Shares Index ETF (VAS), which tracks the return of the S&P/ASX300. As the index rises and falls in value, VAS will rise and fall accordingly.

Investing in VAS is akin to investing in the top 300 companies listed on the ASX, but instead of purchasing individual shares from each of the 300 companies, VAS combines them all into the one fund according to their market size.

ETFs, like regular shares, can be bought and sold through brokerage accounts at any time during exchange hours (10am – 4pm).

Low-cost, diversified and easily accessible

The key benefits of most ETFs are that they're low-cost, accessible and provide diversification benefits in just one trade.

The management fees for index-based ETFs are usually significantly less than what it would cost you to buy the same portfolio of individual securities. ETFs are also lower cost than actively managed funds, which typically charge higher fees to cover research, transaction, and performance costs.

ETFs tracking broad market indexes also provide investors with exposure to entire markets (both domestic and international), asset classes and multi-asset class investments – essentially offering an all-in-one investment solution.

And as ETFs pool together investors' money they can offer access to a wider range of investments that may otherwise have too high an investment minimum or be too costly to access by an individual investor.

Aside from the above, ETFs are also highly transparent, liquid due to their ability to be traded, and relatively tax-efficient when compared to other investments.

Tax is naturally a concern for many investors as it can potentially take a large chunk out of investment returns. The low turnover of an index ETF however minimises the capital gains distribution impact, which improves after-tax performance and tax efficiency over the longer term.

Who suits an ETF?

ETFs may be suited to a wide range of investors, from those just starting their investment journey with smaller investment amounts, to more seasoned investors with established portfolios, to SMSFs who are looking for lower-risk products with international diversification and the potential to return both income and growth.

Different ETFs will suit different investors depending on their investment objective, time frame and risk tolerance.

For example, equity ETFs will be suited to longer-term investors with higher risk tolerances as equity markets may experience higher volatility in the short term when compared to other asset classes like bonds.

Bond ETFs on the other hand are more suitable for investors with a shorter time horizon and a goal of protecting assets rather than generating higher returns.

As index ETFs seek to track the returns of an index, they may be less suited to investors who are looking to significantly outperform the market or have very short investment time frames.

Be wary of trading the trends

With the increasing number of different ETFs now available, it's worth noting that not all ETFs were created equal.

Lately, there has been a rise in thematic ETFs that provide exposure to niche market sectors, investment themes or current trends, such as video gaming, robotics and potentially even cryptocurrency in the future.

While thematic ETFs offer investors access to specialised industries, and perhaps the opportunity to outperform the broader market, they do tend to lose out on the diversification benefits that a broad-based ETF can offer.

Additionally, trends today may not be trends tomorrow, so the question of timing becomes an issue. Sectors turbo-charged by the pandemic for example might have out-performed this year and last, but will they continue to do so next year?

What makes a good index to track, and by extension a good ETF, is those that are broadly diversified, transparent, and time-tested in various market conditions to prove liquidity. ETFs built on a narrow universe of securities may have a role to play in your portfolio but perhaps more as a satellite holding rather than the core.

Looking ahead

As new investors enter the market and as ETFs continue to gain popularity, it's likely that investors by the next decade milestone will have an even greater variety to choose from, particularly in the thematic space.

What will not change however is that investors should begin their investing journey with a strategy in mind, and then choose products that are suitable for achieving their long-term goals regardless of what trends are in vogue.

Vanguard Australia