Exchange-traded funds have experienced a meteoric rise since emerging on the investment scene a few years ago. They’ve developed a following among advisers, who are drawn to their low cost compared with managed funds. But as products and fee structures become more varied and complex, more care is required in determining which offerings are best for clients, and the impact of ETFs on share prices has come into question.

ETFs have more than doubled in value since 2014. There are now 175 listed on the Australian Securities Exchange; a new fund is launched each month, on average, driven by demand from retail investors and financial planners seeking low-cost equity strategies for their clients.

The momentum is expected to continue this year. Australian investors are tipped to pour $5 billion more into these products in 2018, taking funds under management in this asset class to $45 billion by December.

The Financial Planning Association of Australia’s head of policy, Ben Marshan, says planners and advisers are strong adopters of ETFs because they require less paperwork and provide cheaper access to equities than managed funds.

“You get the same assets and management at a cheaper price,” Marshan says.

ETFs also have the benefit of being more transparent and timely with information about underlying shares than managed funds, he explains, and they allow advisers to devote more time to clients’ financial plans and strategies.

Marshan says planners are looking to more listed products that replicate the management style of managed funds, which he expects to mean more interest for new managed fund ETFs on the Australian market.

Wave of new products

Until recently, ETFs have been mostly cap-weighted, well-diversified funds that track well-known indices. But as Australia’s largest providers increase their offerings, a wave of new products is expected to expand on these options, based on themes, fixed income, industry sectors and other assets.

Vanguard Investments, Australia’s second-largest ETF provider, launched four new products in November, giving investors access to portfolios based on their risk appetite. Each diversified index fund in conservative, balanced, growth and high-growth portfolios provides exposure to 6500 companies and 5000 fixed income securities, charged at 20 basis points, Vanguard states.

BetaShares also recently launched new products, including its actively managed hybrid securities fund (HBRD), which provides exposure to a diversified portfolio of hybrid securities managed by an independent fixed income manager.

In December, BetaShares launched an ethical fund (FAIR), which exposes investors to sustainable, ethical Australian companies. ETF Securities Australia recently launched the ROBO fund, which provides exposure to global companies innovating through robotics, automation and artificial intelligence.

This year, providers are expected to issue more floating-rate note ETFs and smart beta products, which will adopt multi-factor metrics such as sales, cash flow, book value and dividend payments for public companies.

“The vast majority of ETFs are index-tracking but there are new products coming into the market that have more active management capability and active choice,” Vanguard Investments head of market strategy Robin Bowerman says. “The active ETFs market is still in relatively early stages of development, not just in Australia but also in the US and Europe, but we’ll see [more of it] in the next two to five years, as the system develops.”

Buyer beware

All this choice comes with caveats. ETFs are great tools for realising the power of asset allocation and unlocking markets for retail investors where only institutional players had access 10 to 15 years ago, Bowerman says. But he warns financial advisers and their clients of the need to understand what they are buying in the new wave of products, be it a theme, sector or narrow industry focus, because it can be counter to the notion of diversification.

“Investors need to understand the risk factors they take on with these products as they become more specialised,” he says. “You look under the hood to see if it suits the client.”

Part of this is understanding the fee structure, as some newer products are charging extra for outperforming.

Even so, financial advisers are expected to continue to drive the ETF juggernaut, with seven out of 10 planners recommending them to clients or intending to do so in the future, and many exhibiting a “strong appetite for actively managed ETFs”, the 2017 BetaShares Investment Trends ETF Report states.

Managed funds still a factor

As ETFs continue their surge, managed funds still have a place for investors who trade frequently because ETFs require brokerage fees, which start at about $20 a transaction and can become prohibitive, the FPA’s Marshan says.

Managed funds charge member, administration and management fees but spruik delivery of higher returns than passive funds such as ETFs, and members can generally buy more units for no extra cost. Managed fund fees can start at 1 per cent annually, while ETFs charge a management fee as a percentage of the cost for each unit, which can be from 0.1 per cent to 1 per cent of the unit price.

ETF provider VanEck Australia expects advisers and planners to adopt smart beta ETFs in the same way they have used index-tracking funds for their clients. VanEck Australia managing director Arian Neiron says the market is near the tipping point, when smart beta ETFs will become as prevalent as the cap-weighted variety.

Instability warning

The tsunami of investor flows into ETFs has sparked warnings that they are creating instability in global markets because demand is driving up the share prices of underlying stocks.

Chicago-based Brian Singer, a partner with global investment banker and asset manager William Blair, warned of the risks of ETFs at the 2017 Conexus Financial Absolute Returns Conference.

Rules-based investment strategies, including passive ETFs and smart beta products, are making both credit and equity markets more fragile, Singer says.

“There’s a lot of flow coming into the marketplace from these things,” he says. “We’ve got ourselves into a place where the market itself is very fragile and with each day of activity like this, it’s becoming increasingly fragile.”

But others, including ETF Securities Australia’s Kristian Walesby, have countered criticism, saying Australian investors are not using ETFs as trading instruments like their counterparts in the US and Europe.

Walesby argues that ETFs, while growing rapidly as an investment choice, still represent a small portion of the equities market at $35 billion, or almost 2 per cent of Australia’s $1.8 trillion sharemarket value.

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Meredith Booth is a former Adelaide-based reporter for The Australian, where she battled to change national perceptions that everyone in South Australia is either jobless or retired. This has allowed to her explore the complex and sometimes fascinating world of superannuation and its regulation. It helps that she has had 15 years of finance and business reporting experience with her previous employer, Adelaide's daily newspaper The Advertiser.