The surge of interest in exchange traded funds shows no signs of abating. However, van Eyk Research has sounded a note of caution for planners and their clients. Not all ETFs are alike. Greg Bright reports.

After a slow start in Australia, exchange-traded funds (ETFs) have taken off in the past couple of years. There are now 41 products with total assets of $4.1 billion. Six were launched in December last year, and another one in early February. The market grew by 42 per cent in the 12 months to last October and 161 per cent in the previous 12 months. Impressive numbers.

But, according to new research from van Eyk Research, planners and investors should do their homework before jumping on the bandwagon.

The 20-page paper, Exchange Traded Funds Explained, details the global trend and, importantly, the risks associated with the various types of products. With the addition of synthetic ETFs to the range, for instance, investors now have to consider counterparty risks, along with other issues.

For traditional buyers of managed funds, ETFs are appealing. Most, but not all, are cheap and easily traded. In fact, the mishmash of administration systems used by the big managed fund providers – who have been inching, painfully, towards straight-through processing for years – remains a frustration for many planners.

Van Eyk says that while there are currently six ETF providers in Australia, “two or three are expected to come to the market in 2011 alone”.

In the US, the ETF market is split roughly 50:50 between institutional and retail investors, but in Australia it is the retail sector which dominates. And ETFs have mostly been bought by self-managed super funds (SMSFs) and individual direct investors trading through online brokerage accounts.

Investment through financial advisers and platforms has not been a major aspect of ETF demand to date, the paper says.

“However, the number of planners advising on ETFs is growing rapidly, due partly to the industry shift towards a fee-for-service model. This is also due to retail investors seeking simpler, more transparent and cost-effective investment solutions with more direct control of their investments.”

ETFs generally have a lower MER than the comparable index fund but comparisons are not always easy to make because index funds have a sliding fee scale. Once you get into emerging markets, the index funds are generally cheaper.

Since they are traded on exchanges using market makers, ETFs will also attract brokerage, which can be as high as 2.5 per cent for small investments using full-service brokers, down to 0.12 per cent for online accounts and larger investments.

There will also be a bid-offer spread. Open-ended managed funds have a fixed bid-offer spread determined by the fund manager for applications and redemptions. ETF spreads are linked to the liquidity of the underlying securities and the availability of efficient hedging products that market makers can use to manage risk.

The van Eyk paper, written by investment analyst James Armstrong, says that Australian ETFs have generally traded with bid-offer spreads in line with their underlying securities, which is the way it should be. But international ETFs trading on the ASX may have much wider bid-offer spreads because of the lack of an observable intra-day index price.

ETFs are often promoted as being relatively tax-efficient.

The key differentiating features that potentially advantage ETFs relate to overall fund turnover and the process of creating and redeeming units. Basically, managed fund distributions generally consist of a higher proportion of capital gains; plus ETFs provide an additional opportunity in the primary market process to minimise capital gains to other unit-holders.

While liquidity is not an issue that is peculiar to ETFs, most retail investors in Australia are essentially confined to trading in the secondary market – so the actions of market makers is critical, the paper says.

“With the current regulatory market maker requirements, Australian investors can generally be assured of sufficient secondary market liquidity. However, it is possible that in some shock event, market makers absent the market and liquidity temporarily dries up.

“This happened with some ETFs in the US in the May 6, 2010 ‘Flash Crash’. Many ETFs temporarily traded substantially below their NAV [net asset value] as market makers exited the market and some market sell orders were executed at highly discounted levels.

“ETF products that have a lower level of overall secondary market turnover rely substantially on market makers to provide liquidity events, and this should be assessed for each ETF product.”

With synthetic ETFs – which are now available in Australia – there will be an additional counterparty risk associated with swaps and other derivatives used. The amount of counterparty risk will be affected by several factors such as the volatility of the index, how closely the collateral securities match the index, the credit quality of the counterparty and how often the swap is cash settled.

There are a number of other risks discussed in the paper, the main one being market risk, which is the same as for other index funds. The investor does not have the possible protection of active management to avoid the worst of a correction.

Similarly, with the advent of sector and regional ETFs, individual investors will have to give some consideration to whether they have adequate diversification. Some sector funds may have high concentration, high volatility and low liquidity in the underlying securities.

The ability of the manager to track the index is obviously important, and the experience, process and infrastructure of the manager should be looked at. Things such as cashflow management can also affect return and tracking error. When derivatives are thrown into the mix they can also introduce basis risk, rollover risk and counterparty risk.

The paper concludes that ETFs can be simple, transparent, flexible, cost-effective, liquid and low-risk. But such characteristics are certainly not a given.

“ETFs are a lot more complicated and technical than many investors recognise and they should be viewed with due caution.

“There are many factors that contribute to the overall quality of an ETF and this will also be dependent on an investor’s objectives. The key drivers include ETF structure, market structure and ETF management.”