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How to use ETFs in your investment portfolio

Bina Brown

Investors are putting more money into exchange traded funds (ETFs) than ever before. Growth in this area coincides with a massive shift from actively managed funds to lower cost passive funds as investors focus on minimising costs in an environment of low returns.

Australian Securities Exchange figures show that funds under management in ETFs increased to $6.14 billion by the end of October 2012, up almost 8 per cent from a month earlier and 25 per cent on a year previously.

Certainty

It’s an indication that investors would rather pay less and get market returns, than pay more for managers that may or may not outperform the market.

Some are taking advantage of a simple product that tracks major indices and others are using sophisticated strategies that ordinary investors would otherwise be unable to access, such as currency and futures market trading and high-yield investing.

ETFs are low-cost funds that track an index (either a benchmark index such as the S&P/ASX 200 or one set by product providers) and trade on the Australian Securities Exchange. There are also exchange traded commodities (ETCs, which are listed structured products that allow investors to speculate on the price of commodities).

Broad range

The ETFs listed on the ASX represent a broad range of investments – everything from the top 200 stocks, specific sectors, emerging markets, bonds to the price of gold – and reflect the increasing complexity of the ETF industry worldwide.

Some products hold true to the simple roots of ETFs – such as those tracking benchmark indices. But others should be used only by investors who really understand them – not only how the products work but the niche markets in which some of them invest (such as agricultural and metals ETFs).

An ETF that tracks the S&P/ASX 200 index is a simple product; one that tracks foreign exchange or the futures market in crude oil is not.

Niche offerings

The increase in demand for ETFs is drawing new players with niche offerings not yet seen in Australia’s young market.

Product innovation

“By global standards, the range of listed exposures available to Australian investors is still very narrow,” says BetaShares head of investment strategy Drew Corbett. “We expect continued product innovation over the coming year, such as more thematic and strategy-based ETFs.”

One such theme is the focus on income-based ETFs, with the larger retiree base in Australia being a key driver.

iShares Australia launched the first of several fixed-income ETFs earlier this year, building on existing high-yield equity ETFs and a cash ETF.

The UBS offering – its first in Australia – is slightly different to other equity-based ETFs in that it aims to replicate an index of Australian stocks which its analysts like, rather than replicate an index based on market capitalisation.

The UBS ETF will generally include 40 ASX-listed securities with a UBS equity research analyst “buy” rating.

Change of attitude

With volatile capital markets pushing superannuation fund boards to change their attitude to investment risk, indexing is growing in popularity and ETFs are a big part of that, says research house Rainmaker.

The significant growth in the ETF market in terms of size and offerings has coincided with a massive shift of investment flows from actively managed funds to lower cost passive (indexed) funds – a global trend which is likely to continue, predicts HSBC.

The HSBC view is that with interest rates and expected returns from all assets low, investors will increasingly focus on minimising expenses and “going passive” is the best way to do this.

Sophisticated investors, such as institutions or high-net-worth individuals, are expected to increasingly separate beta (the measure of risk in a security or portfolio compared to the overall market) and alpha (outperformance over the overall market).

80:20 solutions

One way to do this is through so-called 80:20 solutions – where 80 per cent of assets are in passive market-linked beta assets and 20 per cent are aggressively managed in alternative assets.

The beta portion is bought as cheaply as possible, which is where ETFs come into play.

According to research house Morningstar, the average annual fee charged by the nine broad-based Australian share ETFs is 0.3 per cent. That compares with 1.7 per cent charged by the average large-cap retail share fund. For large-cap wholesale funds the average annual fee is 0.85 per cent.

Retail investors using an adviser can also then expect to pay an advice fee of anywhere from 1 per cent upwards.

For retail investors high costs can be very damaging, particularly when returns are low.

Corbett says by investing across a number of ETFs it is possible to beat a stated benchmark – without the added stress of trying to pick winning stocks.

“The ETF may not be active but people can be active managers using the ETFs as their tools,” says Corbett.

Key drivers

Self-managed super funds have been key drivers of ETFs, say advisers.

“SMSFs look for a direct way of having exposure to a range of sectors and it is hard to beat the low cost of an ETF for core exposure to most sectors,” says Godfrey Pembroke adviser Mike Ingham.

While Ingham is one of many advisers who use ETFs as the core of a client investment portfolio, others use them as the satellite portion of a portfolio. Some advisers are creating portfolios entirely of ETFs and ETCs.

An important part of the growth in ETFs has come from the switch from commission-based selling by advisers to fee for service. Without a commission built in, ETFs are somewhat equal to managed funds.

Perhaps coincidentally, a growing number of ETFs now appear on the approved product lists of multiple dealer groups as well as the administration platforms used by advisers.

Approved products

State Street Global Advisors’ head of SPDR ETFs for Australia, Amanda Skelly, says that because many financial advisers can only recommend to their clients investment products that have been approved by their licensee, being on a licensee’s approved product list can have a substantial impact on ETF take-up by financial advisers.

SPDR ETFs account for almost half of every dollar invested in the Australian ETF industry.

Skelly says that among those licensees that have approved ETFs, State Street’s SPDR ETFs are well represented, including some parts of AMP’s and Commonwealth Bank of Australia’s adviser networks.

There are five major ETF providers: State Street with its domestic equity and fixed-income SPDR ETFs; Blackrock-owned iShares Australia with a range of domestic and international offers; Vanguard; BetaShares; and Russell Investments. Smaller providers are Market Vectors Australia (formerly Australian Index Investments) with domestic sector ETFs and ETF Securities with a range of ETCs. A recent newcomer is the DIGGA Australian Mining Fund. UBS Global Asset Management is no stranger to ETFs, with 75 available to investors in 13 countries.

Major trend

Skelly notes a major trend is the shift away from Australian equity ETFs to global equities with the iShares S&P 500 – designed to mirror the performance of American large-cap stocks – proving to be the most popular.

“Australians generally love Australian equities but are now looking at global equities, particularly the S&P 500 as people look to an element of quality and diversification as the US pulls itself out of the depths,” says Skelly.

Within the global equity space, investors have been attracted to those ETFs offering broad exposure to global markets or the US market, over emerging markets or specific sectors, she says.

According to the ASX, Australian-based strategies account for 47 per cent of ETF business. The use of locally listed ETFs to access and mirror international indices accounts for 16 per cent of ETF business.

Fixed-income ETFs, which were first introduced earlier this year, make up 7 per cent of the market.

Retirewell Financial Planning associate director Mark Holzworth says that given the performance history of active fund managers and the relevant volatility, many clients agree a tactical asset allocation across all sectors through the use of ETFs is the way forward.

Greater consistency

“Investors want greater security, greater consistency in the return and they are happy to pay for it. But the traditional advice and management propositions are too expensive and not responsive enough to the underlying investment demands,” he says.

Ingham says the move towards index funds and ETFs is a logical one for many investors who have lost money through underperforming funds in recent years.

“If you have been an investor within the last few years you have got enough problems with where the market has gone let alone the fund manager you are with making it worse,” says Ingham.

“Indexing is a lower risk way of gaining exposure to a market because it is eliminating the fund manager risk. It is not entirely eliminating risk but you are not trying to pick winners,” he says.

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