As exchange-traded funds take off, and product specialisation increases, there’s a growing demand for information on how these vehicles work. Research houses are responding.
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In keeping with the “only in America” cliché, earlier this year a highly-specialised exchange-traded fund (ETF) was launched. Called the Wound Care ETF, it was exactly what the name suggests.
“It only invested in companies that provided wound care, such as bandages, sutures and that kind of thing,” says Zac Wallis, ETF strategist for Morningstar.
“It was a very limited universe and the ETF subsequently received very little support and actually was shut down.
“Obviously Australia is nowhere near the maturity of the US [ETF market], and I think a lot of the ETFs that will come to market in the next year or so will be based broadly on common, widely-known and more popular indices.”
The Wound Care ETF illustrates an issue that is likely to become bigger for financial planners as the market develops beyond the plain-vanilla, big, liquid index ETF concept. The next step will inevitably involve products that are more complicated or esoteric than current ones.
Already overseas there are – among others – leveraged ETFs, inverse ETFs (where the return from the ETF is the inverse of the underlying index) and synthetic ETFs that do not hold physical stock at all.
While the market is holding its breath waiting for the Australian Securities Exchange (ASX) to change its listing rules to allow fixed income ETFs to be listed, Professional Planner understands that synthetic ETFs are likely to be available to Australian investors before year’s end. A newcomer to the ETF space is reportedly posed to launch four new products, structured in a way that Australian investors have not seen before.
To date, ETFs available to local investors have adopted either a full-replication approach (where the ETF holds every stock, in the same proportions, as an underlying index), or “optimised sampling” (where a subset of index constituents are put together to mirror the index characteristics).
‘There’s another method that’s not necessarily widely known in Australia at the moment, and that’s around synthetic application’
“There’s another method that’s not necessarily widely known in Australia at the moment, and that’s around synthetic application,” Wallis says.
“That is a tricky one. Elsewhere [overseas] they have become popular, because there are some very attractive prices on these; and what it basically is, is a product provider entering into a swap contract with, typically, an investment bank.
“It’s a total-return swap for the index outcome. So there’s no tracking error, and you will get the index outcome. But there is counterparty risk associated with that investment bank. And that’s a scary thing for a lot of investors.
“Obviously, there’s collateral being posted by the investment banks to reduce some of that counterparty risk and, post-GFC, counterparty risk has become a big issue and it’s more front-of-mind when entering these types of things.
“But collateral today, versus, say, two or three years ago, is of a higher quality, and the credit standards that are imposed are more stringent. So counterparty risk is less of a concern today than it was two or three years ago, but it’s still a risk.”
Keeping up with these developments, and unravelling the different structures – both of the ETF providers themselves, and the underlying indexes – is a full-time job. Leading research houses are moving to meet demand for information by launching ETF ratings and research services.
Dug Higgins, senior investment analyst for Zenith Investment Partners, says the newer entrants to the ETF research game are, in fact, those more likely to be familiar to financial planners.
“It’s interesting from the point of view of the provision of research in the Australian market [that] there’s been some guys coming out of the US who have been in this market for some time…and some stockbrokers,” Higgins says.
“Up to now the ‘mainstream’ fund management researchers, like ourselves and S&P and the like, haven’t been in this space.
“A lot of the other groups are looking at ETFs from the point of view of being equities, so they are issuing ‘buy’,‘sell’ or ‘hold’ recommendations. The managed funds guys, on the other hand, are going down the path of rating ETFs like managed funds.”
So instead of issuing things like price targets or earnings targets, as with traditional stock research, the fund research cohort are focusing on issues and putting out ratings far more familiar to planners.
“It’s looking at it much more from the point of view of saying, firstly, what is the index I am getting exposure to? Who is providing the index construction, and is it worthwhile getting into?” Higgins says.
As Professional Planner was finalising this article, S&P issued its first ETF rating; it put out a “very strong” rating on the SPDR S&P/ASX 200 Fund (ASX code: STW) – an ETF managed by State Street Global Advisors (SSgA).
The rating would be familiar to anyone who has read an S&P managed fund report; in part, it said: “The rating reflects a combination of very low direct and indirect costs, a highly liquid secondary market, a simple and transparent portfolio-construction approach and historical performance that has been very true to style.
“Additionally, STW has proven, and will likely continue to be, a highly tax-efficient investment vehicle; in a comparative sense, it may generate superior after-tax returns for investors with anything other than a zero per cent marginal tax rate.” Rodney Lay, a director of fund services at S&P – and the analyst behind the STW rating – says it’s easy to think that all ETFs and all ETF providers are created more or less equal. But they’re not, and Lay says that understanding the nuances of different ETFs, both their structure and underlying indexes, is critical for planners.
Lay says planners’ general knowledge of ETFs is “probably reasonably good”, but there are a lot of subtle differences that lurk beneath the surface between products and issuers.
Lay says that even the taxation status of ETFs is full of potential traps for the unwary. The taxation of an ETF can be very different from that of an unlisted managed fund, even if the underlying index or portfolio is identical, because of the redemption and creation process that underpins the ETF market.
That’s the theory – but in practice, Lay says, because demand in the local market for the creation of new ETF units has to date generally outstripped redemptions, those differences have not yet really been shown up.
“In theory the ETF should be more tax-efficient, but they haven’t been as efficient as the theory would say,” Lay says.
Although the products may superficially look similar, Wallis says it is “definitely a common misconception” that they are all, in fact, the same.
“There are a number of different ways to skin a cat; the same applies to ETFs in regards to the way they’re structured,” Wallis says.
“If you just look at the market currently, Vanguard use an optimised sampling approach to create an ETF…so they mirror the key risk and return characteristics of the underlying index by holding more or less of certain stocks in that index, to avoid having a long tail and [to avoid] churning the portfolio at reconstitution dates. And they’ve proven to be quite successful at doing that over time. It’s exactly the same approach they apply [to their unlisted index funds]. They have strong experience in doing that.
