“And it’s worth knowing that all the Vanguard ETFs in Australia currently are separately listed share classes of their unlisted managed funds.
“So it’s a different way that they have structured their ETFs, whereas State Street have a full replication process, where they hold every stock in the index.”
The index replication approach has implications for the return characteristics of an ETF, Lay says.
As a general rule, a full-replication approach has lower tracking error, but it may incur relatively high transaction costs (particularly if the index in question has many stocks in it, or if some of those stocks are illiquid). On the other hand, an optimised sampling approach may reduce transaction costs (because it does not hold every stock in an index) but it exposes investors to “alpha risk” – the risk that it may not accurately track the underlying index.
“Planners need to be aware of what the exposure is in an ETF,” Lay says.
“The portfolio may be tracking a chosen index, but the portfolio may have less stocks in it than the index.
“Advisers should be aware that this ETF tracks an index, but don’t think that you’re getting full replication of it – there are stocks that have been removed.”
Full replication works when “all the stocks [in an index] are sufficiently liquid, so they do not need to cut particular stocks out”, Lay says.
‘Just because you can, doesn’t mean you should. Advisers are going to have to look behind the label a little bit’
Higgins says that fundamentally, investors and advisers “need to know what an ETF is designed to do”. But before even exploring an ETF as an appropriate solution for a client, they need to be sure that a passive approach is what they want. He says not even that is a given.
“One of the things I’ve noticed from advisers is that they are not all that interested in an index play at the moment,” Higgins says.
“But if they are a fan of passive, ETFs do pretty well at that. The only curve-ball is that advisers need to be careful about what index they’re getting into. Some are not very mainstream indices; some of them are very narrow. In looking at some of the ones that are operating, one of the things that occurs to me is, OK, it’s useful for some people to get liquid, low-cost exposure to these markets, but the fact that these vehicles are there doesn’t necessarily mean it’s a great way of doing it.
“Because there’s not a lot of competition yet – there’s only one ETF [covering] Taiwan and I think there’s only one ETF giving you exposure to South Korea – the question is, is it necessarily giving you good exposure? Are they very heavily weighted towards the mega-caps?
“Just because you can, doesn’t mean you should. Advisers are going to have to look behind the label a little bit.
“Then, to take a step on from that, you have to look at the indexes – how they are constructed, and who is constructing them.”
And finally, a close look needs to be taken at the ETF providers themselves.
“Managers in any sector are not all created equal,” Higgins says. The “risks of partnering some of the entities that are around” is greater than partnering with some others, he says.
Wallis says S&P’s ETF research methodology is “similar in some respects to what we do in the funds research space”.
“There’s a number of different factors we look at: the parent, obviously, looking at the ETF issuer and how that is as a business; and identify any issues in relation to the business and their needing to outsource things like custody or implementation, or things like that.
“Once we get the compliance thing with the parent ticked off, you’re looking into the physical products. The big thing about ETFs is, I guess, there’s two ways to look at it. You can look at it for a short-term investment opportunity for specific sector exposure or specific exposure that you need or don’t have in your portfolio already; and there’s one for a more long-term holding, and you buy an index just for that beta exposure.
“For the more long-term holding, you’re looking for an index that makes sense; it’s actually a factor of the market, it’s not something that the product provider has just built to be self-serving.
“The STW ETF, which tracks the S&P/ ASX200 Index, if you’re an investor looking for market exposure, that’s a very suitable ETF. The index makes sense, there’s no holes in it, in the way the index is created or in the way State Street implement that portfolio.
“That’s an important part too: the implementation. The index creator might have an effective way of building that index, but whether or not the ETF provider can implement and run that, and manage it effectively, is a different story.
“A number of lessons have been learned in other markets, particularly the US, around the implementation issues that have popped up. It’s been interesting to see some of the tracking error risk on some products, particularly some of the ‘nichey’ type indexes; the tracking error has blown out substantially.
“It comes back to the parent being experienced and having a portfolio implementation and management capability that’s proven and robust. It’s typically, to date, the managers who have had success in the passive funds space who have had success in that regard.”
Higgins says planners also need to be wary of products that are too specialised – the Wound Care ETF is a case in point. Picking an ETF that fails to attract enough money might mean it cannot operate efficiently (and so costs more than it should), or has to close down altogether. While investors would probably not lose money if an ETF shut down, it can be a hassle to have to revamp a strategy or to find an alternative investment option.
When you add so-called cross-listed ETFs into the picture, it becomes more complicated again.
Wallis says that “there’s a few things we’re trying to make clear to our adviser clients, and first and foremost is understanding the nature of the product, which is the index”.
“Things like emerging markets and BRIC and China, it’s all been publicised that it’s working well, but there are certain characteristics to investing offshore with ETFs at the moment that investors need to be aware of – particularly with the iShares products, which are cross-listed from the US,” he says.
“Australian investors are just getting an Australian-dollar version of a US outcome. If you bought an S&P500 ETF, the Australian dollar has rallied [against the US dollar], so Australian investors have had a negative experience there. Because the S&P is more or less flat and the Australian dollar has gone up, they’ve lost money.
“It’s quite common to get the complaint that we saw the index do XYX, yet my outcome is this. And you have to explain that over the period that you’ve suffered some sort of currency translation loss on that transaction.
“There’s also some tax implications on investing in cross-listed securities; Australian investors are subject to withholding tax on cross-listed ETFs, so there’s a 15 per cent tax on income. And they’re also subject to estate tax, should the investment amount on an inheritance from a deceased estate go past a threshold limit, which is $US60,000. So for example, if your parents passed away and they had $US100,000 in US S&P500 ETFs, there would be tax implications for every dollar invested in excess of $US60,000. And that’s something that’s not widely known.”
Wallis adds that the exact treatment also depends on what type of investor you are, and how you invest in the ETF – for example, whether you’re investing as an individual, or as self-managed super fund (SMSF).
“iShares are very transparent in providing information around that,” he says.
