Some investors are too busy to stay glued to a computer watching every movement in the sharemarket. Others simply want to minimise time spent investing and maximise enjoying precious free time. In any case, most of us want a relatively stable base for our portfolio, upon which to build more elaborate strategies.
That’s where passive investment products such as index funds and the increasingly popular exchange-traded funds come in – potentially providing the core of a portfolio around which more active “satellite” investments can float.
While these instruments don’t remove the risk from investing – no product can do that – they do offer a simple and cheap way to invest in shares, commodities, precious metals and many other asset classes. (Fixed-income ETFs are on the way and there’s a possibility direct property could eventually be an option as well.)
ETFs tend to mirror an index, so you’d expect one to closely match the performance of the underlying index. If the resources index goes up 8 per cent in a year you’d assume your ETF to go close to that mark, for instance, minus the costs associated with the fund. Of course should the underlying index fall, then you’d also predict the value of your investment would go down.
Passive investing also tends to be low cost. The active style of investing many fund managers still use is heavy on research and fund managers charge a premium for their service. That may be OK if they deliver but it can leave a sour taste if the fund manager doesn’t match the performance of the sector as a whole.
However even passive investors have to make some decisions. There are more than 60 ETFs listed on the Australian Stock Exchange, with more to come, and you need to consider how many to invest in, and how much to put into each one.
To help you decide whether ETFs should provide an anchor for your portfolio, Financial Review Smart Investor put 10 key questions to some industry experts.
What’s the purpose of ETFs?
The head of investment strategy at BetaShares, Drew Corbett, says ETFs can provide low-cost access to diversified asset classes. Like any share, they can be bought on the ASX. Historically Australian investors would buy BHP Billiton (BHP) or Rio Tinto (RIO) shares if they wanted exposure to the resources boom. Now they can buy an ETF to gain exposure to all the stocks in the resources index.
“The purpose of ETFs is to bring the benefits of low-cost access to diversified asset classes to all investors through the simplicity of buying and selling shares of the fund on the stock exchange, like any normal share purchase. Through ETFs, retail investors and self-managed super fund trustees now have low-cost access to the types of investment only available to institutional managers in the past,” Corbett says. In other words, it gives smaller investors the opportunity to participate in investments once reserved for top-end investors.
How does the weighting of an index affect an ETF?
An index will have certain characteristics due to the securities it covers. So two ETFs that look similar may well have different returns because of a heavier weighting to stocks in a certain industry.
Frank Henze, head of ETFs, Asia-Pacific, for State Street Global Advisors, says the big financial institutions usually pay some of the highest dividends among listed companies. “As a result, dividend-weighted indices tend to be overweight financials, which is then reflected in the ETFs that are benchmarked to those indices,” he says.
Investors should also know the split between growth and value stocks in an index and related ETFs. “It’s not to say that any one index or weighting methodology is superior to another, but it is critical that investors ensure that the exposure a given index provides aligns with the exposure they seek,” Henze says.
Does the ETF hold physical securities?
There are various ways an ETF can be constructed. One is that the manager who runs the ETF will buy all the shares in the index in the same weight or proportion as the underlying index. That should produce an ETF which reflects that index. Provided the manager continues to adjust for changes in that underlying index and deals with cash flow from dividends, the ETF should be a “replication”, as it’s known in the industry, and there should be a close approximation to the performance of the index.
However, investing in more obscure asset classes might not produce that close result even if it replicates the index.
Another model a manager can use is the representative or optimised approach. That still involves buying actual securities but the ETF resembles rather than replicates the index. That method should reduce trading costs because fewer shares have to be bought and sold to mimic the index but there could be a bigger difference in the returns generated by the ETF.
There are also synthetic ETFs, which don’t necessarily replicate the securities in an index but aim to simulate the performance of the index through the use of derivatives such as swap agreements or futures contracts.
One feature of ETFs is they’re an open-ended investment structure, which means the ETF provider can issue units at any time without the share price being affected by the additional units.
What’s the fund’s tracking error?
Investors look to ETFs to provide a return very similar to an underlying index, so one of the critical questions is how far those models deviate over time.
ETFs are designed to track an index. However, if they fall substantially below that mark, it will hurt your investment plans.
The technical term for this difference between the performance of the fund and the index is the tracking error.
There are various ways of measuring tracking error but one is to compare the net asset value (NAV) of the fund with the total return of the index.
This approach uses NAV rather than the market price of the ETF because the latter will be influenced by daily demand and supply.
Tracking error can be monitored regularly to get a handle on whether the ETF will deliver the desired returns relative to its underlying index.
Are ETFs different from index funds?
Index funds offer similar features to ETFs in that they can provide diversification, are low cost and allow you to track a market you’re interested in following.
UBS Wealth Management investment analyst Abby Macnish says a key difference between the two is the method of investing. To invest in a traditional managed index fund, you’d normally have to go through an administration platform or wrap account. However ETFs are traded through a broker. Also ETFs generally have more up-to-date pricing because they’re traded during the day whereas index funds tend to be priced at the close of trading.
Why invest in ETFs rather than traditional managed funds?
BetaShares’ Corbett says some investors opt for ETFs because of the ease of access, low cost, transparency and liquidity. He says one of the main ways to enhance the performance of a portfolio is to lower costs, which is usually an advantage ETFs have over active managed funds.
ETF investors can also generate outperformance through their asset allocation. By putting 10 per cent in agriculture and 90 per cent in Australian equities an investor would have bettered the S&P/ASX 200 by 1.6 percentage points in the past five years, he says. That won’t necessarily recur in the future, but it shows that asset allocation within ETFs can help overall return.
Why should I check the name carefully?
ETFs are listed on the ASX and are regulated by the Australian Securities and Investments Commission. But investors should be aware there are products with similar sounding names that are different to ETFs – structured products such as exchange-traded commodities and exchange-traded notes.
Will ETFs fit with the rest of my portfolio?
William Buck’s director of wealth advisory, Fausto Pastro, thinks ETFs can comfortably occupy about 30 per cent of a portfolio. They’re particularly popular and useful for self-managed super fund investors, he says.
But Pastro does issue a note of caution. While ETFs’ fees are reasonable, he thinks the cost comparison should be with other passive investments rather than with active managed funds, as is sometimes the case. It’s important to compare oranges with oranges, he says.
What are the weaknesses of ETFs?
There’s always the risk that the return of the ETF will be less than the return of the underlying index it’s trying to replicate, UBS’s Macnish says.
Also, the treatment of dividends can detract from ETF performance. They’ll pay dividends received from investments periodically, which often leaves them with a cash balance.
Index funds normally reinvest the income, Macnish says. And because ETFs are traded on the ASX, their price can fluctuate away from NAV if liquidity is low or there are motivated sellers. Investors need to consider whether that fits with their overall strategy.
How secure are ETFs?
BetaShares’ Corbett says that, like all managed investments, the assets of an ETF are held in separate custody accounts for the benefit of the investors. This means those assets are held apart from the assets of the product issuer.
No ETF failed during the global financial crisis and there were no instances of ETFs being liquidated or investor capital being lost through the default of an ETF, he says.
In respect of ASX-listed ETFs, the regulations require that these ETFs are backed by physical assets such as cash, equities or precious metals.
The compound annual growth rate in the exchange-traded fund industry since 2004 is 28 per cent. Growth has been driven by the listing of more products, with 61 ETFs now available for investors compared with only 19 three years ago. In 2011, market volatility stunted growth of the sector, but the ETF industry is expected to continue its upward trend in 2012.