A fund that tracks an index, but is traded like a stock on the Australian Securities Exchange (ASX). ETFs bundle together the shares in the index so investors buy (and sell) them in a single transaction. .

Traditional ETFs track an index, sector or geographic region. For instance an ETF that tracks the S&P/ASX 200 Index is simply tracking the performance of Australia's top 200 companies. In other words, the manager of the fund will buy all stocks contained in the index and weight them according to each company's market capitalisation. Any capital gains or losses, dividends and franking credits are passed onto you.

It's important to buy an ETF that tracks an index or sector that you believe will perform well over the coming few years - or that complements your overall portfolio.

Many private client advisers will buy an ETF that tracks the broader market as the foundation of a client's share portfolio - kind of like laying the slab of the portfolio before any real action takes place. Afterwards, they might add some bank or resource shares to the mix, but the ETF is the pure diversifier. This strategy is called the core-satellite approach.

Active or passive

ETFs can be either active or passive. Neither is good or bad - but it's important to understand the difference.

An example of a passive ETF is one that tracks the performance of the S&P/ASX 200 Index. This type of ETF simply attempts to mimic the performance of this index - nothing more complicated than that.

An active ETF, by comparison, tries to boost performance by managing the fund. It will buy and sell shares in the fund to bump up the fund's returns, as well as prevent the fund's returns from sagging during market corrections. Although this type of fund sounds more appealing than the passive variety - especially during bearish times - the success of an actively managed ETF really hinges on the skill of the manager behind it.

Performance of the ETF

It's worth checking out the past performance of the ETF, but keep in mind the well-worn saying, "past performance is no guarantee of future performance."

Remember also that an ETF that tracks an index or sector is not trying to shoot the lights out but is striving to achieve similar returns to the index or sector it represents. In other words, if the S&P/ASX 200 Index returns 10 per cent for the year, then the ETF that tracks this index is also looking to achieve 10 per cent. Not 15 or 20 per cent. Had this ETF achieved 5 per cent for the year, then that's clearly a poor return.

But had the market returned - 3 per cent and the ETF similarly garnered - 3 per cent - you have no right to throw stones. The ETF has achieved its mandate.

Actively managed ETFs, however, have a different agenda in mind. This variety is trying a bit harder to please you, so you can be a bit tougher on them if returns start to sag.

Most actively ETFs will invest according to an investment style, such as value or growth, and often performance can be attributed to this style of investing moving in and out of favour with the market.
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