Although they may seem to have sprung out of nowhere in recent months, exchange-traded funds (ETFs) have been around for about 15 years now. According to Morgan Stanley, there were 1053 ETFs worldwide at 30 September, 2007, managed by 70 fund managers and listed on 42 exchanges. At our Investment Conference last October, Barclays Global Investors’ Tim Bradbury noted that approximately $US750.0 billion is invested in ETFs globally, predicted by Morgan Stanley to increase to about $US2.0 trillion by the end of 2011.
Local trading volumes have not been high, although they’re increasing. The ASX’s latest Listed Managed Investments Update, published for the month to 30 November, 2007, showed that average monthly ETF trades have increased in number from 740 in November 2005, to 1444 a year later, and then to 3051 for the month of November 2007.
There are several probable reasons why ETFs haven’t been more popular in this market so far. Firstly, they appear to have fallen between financial advisers most familiar with managed funds but not fully geared up to dealing with sharemarkets, and stockbrokers still coming to grips with an investment that picks stocks for them. ETFs don’t pay upfront or ongoing commissions, making them less attractive to advisers with commission-based business models. And finally, the choice has been limited – until mid-way through last year, for instance, no ETFs were available providing exposure beyond Australia’s shores.
Three groups of ETFs are now available in Australia. The first are those tracking segments of the local sharemarket. These include the State Street SPDRs which follow the S&P/ASX50 Index, as well as the S&P/ASX200 Index, and the S&P/ASX200 Listed Property Index. The second group are the Barclays Global Investors iShares ETFs over developed world market indices, such as the S&P500 Index of the biggest US companies, or the Russell 2000 Index of the smallest. The third group of ETFs offered locally provide exposure to the developed and developing Asian markets.
What Are the Pros?
The biggest thing ETFs have going for them are their ultra-low ongoing costs compared to traditional unlisted managed funds. Few index funds are available in Australia, and these ETFs are cheaper still. Figure 1 shows the Barclays Global Investors and State Street ETFs and the average cost for equivalent wholesale managed funds, showing clearly the cost advantages the ETFs offer.
Another principal benefit is the ease with which ETFs enable exposure to a market segment, country, or region to be added to a client’s existing portfolio. If, for instance, your client is already invested in one or more diversified world share funds, purchasing shares in an emerging markets ETF would quickly and cheaply add exposure to the developing world as well.
ETFs are also highly-transparent investment vehicles when compared to unlisted managed funds. It’s easy to see through to the ETF’s underlying stockholdings. Many Australian fund managers, by contrast, are reluctant to disclose regular, comprehensive portfolio holdings for their funds. This means it can be difficult to understand exactly where your client’s money is invested, and where a managed fund’s underlying holdings overlap with a client’s direct stockholdings.
Another advantage ETFs possess is that they’re low-turnover investments. The basket of stocks the ETF tracks only changes when companies are added to or removed from the underlying index, unlike actively-managed funds, where the fund manager often buys and sells stocks regularly. This low turnover is something clients may find attractive when tax time comes around.
And the Cons?
Like index managed funds, ETFs don’t offer the potential for above-market value-add which comes with investing in an actively-managed fund. Tracking a market index also means that ETFs don’t have the potential to minimise the effects of market downturns.
The principal drawback to many of the ETFs currently available here is that their focus is narrow, tracking a single country or region’s sharemarket. (This is even more pronounced in the US, where investors can buy ETFs tracking extremely narrow market segments, such as healthcare or technology stocks.) This means that investing clients in a country- or region-specific ETF should be combined with investment in a diversified global share fund or ETF giving exposure to a wider opportunity set of regions, industries, and individual companies. It’s also worth looking closely at the individual stocks an ETF tracks before deciding whether or not to add the ETF to a client’s portfolio. If the client already has one or several unlisted global share funds, they may already have exposure to many of the same stocks.
Liquidity is another important issue to consider with ETFs. Although they do offer the convenience and flexibility of trading on the stock exchange, the flipside is that an ETF’s price is determined by market supply and demand. Like shares, your clients can track the price of their ETF(s) throughout the day, and leave orders to buy or sell at a specified price. But if the market doesn’t have reasonable liquidity, then your client may not be able to trade at the price they want.
Many investors also value the additional features and services which come with investing in traditional managed funds – among them website access, the ability to get unit prices by telephone, and regularly-updated communications such as newsletters – but not with ETF investing.
Making it work
Although their low ongoing costs are undoubtedly an attractive feature, let’s look more closely at how a client might make an investment in an ETF work effectively using a frequently-used strategy like dollar cost averaging. Each time the client wants to buy and sell shares in an ETF, they’ll have to pay brokerage, perhaps at $A30 per trade. Regular investments of $A500 per month would mean the client would be paying 6 per cent of the amount they’re investing each time they added to their investment. Over a year – 12 monthly contributions of $A500 at $A30 brokerage for each contribution – this means the client would be surrendering $A360 of their $A6000 total investment in transaction costs. For this reason, if a client wants to invest in ETFs, it may be better to structure quarterly, six-monthly, or annual transactions, taking advantage of greater economies of scale from investing larger amounts.
Potential
ETFs certainly have a lot of potential when constructing portfolios for clients. They’re ultra-low-cost, efficient ways of achieving market exposure. But remember that many of the options currently available in Australia invest in narrow and potentially volatile areas of world sharemarkets. Don’t overlook the benefits many clients have come to expect from investing in traditional managed funds. And keep in mind that the advantages from low ongoing costs can be offset by brokerage fees on small transactions. Hopefully, though, the arrival of real competition in the cost area will lead Australian investors to pay greater attention to what they’re paying, and put pressure on fund managers to reassess what they’re charging, increasing the possibility of lower costs for ETF and unlisted managed fund investors alike.
