The first phase of the development of the exchange-traded fund (ETF) market in Australia is drawing to a close. While still small compared to other types of managed investments, ETFs are clearly here to stay, and will build on their toehold in the years ahead.
The financial planning industry’s early adopters have moved, and there is close to $4 billion invested in the products. Now, ETF providers are starting to think about how to tailor the basic ETF structure to meet the growing demand from investors and advisers.
In May this year, Russell launched the Russell High Dividend Australian Shares ETF. What sets this ETF apart from many of the others is that it was created to meet the specific demands of self-managed super funds (SMSFs), identified in extensive research carried out by Russell.
That research found SMSFs wanted five things from an investment: income; a high level of franking credits; capital growth; diversification; and capital protection.
Amanda Skelly, Russell’s director of ETF product development, says the company thought it could satisfy four of those five requirements. In response, it commissioned Russell’s in-house index team to custom-build an index – the Russell Australia High Dividend Index – and then it built the ETF to track the index.
Skelly says the index comprises 50 stocks taken from the 100 largest companies listed on the ASX. This ensures that the ETF tracks an index made up of very liquid securities – a critical element in how an ETF is structured and in its efficient operation.
Exactly where liquidity exists in the ETF market is an issue that is still often misunderstood. Liquidity in an ETF exists at two levels: market liquidity, where shares in ETFs are traded between investors like any other shares; but a second layer exists where market makers and authorised participants operate to ensure an orderly market.
“One of the big questions often raised about ETFs is why they trade so consistently at NAV”
This “dual-layer” liquidity profile is what helps set ETFs apart from unlisted managed funds and listed investment companies (LICs).
Andrew Baker, managing partner of Tria Investment Partners, says an ETF is “different to both a managed fund and a LIC – so let’s look at it in those terms”.
“It has the same fundamental structure as a managed fund: it’s a trust, it has a constitution, it has an RE [responsible entity], it’s open-ended, and trades at NAV [net asset value]. So in that sense it looks like a managed fund. But as we know, it’s listed on the stock exchange, it trades all day – instead of at a single price at the end of the day – and it’s liquid.
“A LIC is a company, not a trust, so it’s taxed at the company tax rate; it’s closed-ended and that means that the price is determined on the day by the number of buyers and sellers. There’s kind of a reference to NAV, but it’s indirect. It can trade at a premium – so AFIC and Argo tend to trade at a little bit of a premium – but most of them tend to trade at discounts, and those can be very deep. If you look at something like a Contango Microcap, 40 per cent discount.
“And that’s the problem. There’s no certainty about what that number is going to be when you need to exit. That’s been a real problem; there’s been a lot of capital raised in LICs over the years, and there’s been an unfortunate tendency for these things to go straight to a deep discount, and they stay there, and we’re all trying to work out how we solve that, and it hasn’t been a great investor experience.”