As recently as a few years ago, attempting to build a well-diversified portfolio across asset classes and strategies using fund vehicles available through the ASX was an impossible task. Today, it is feasible, given the significant and diverse growth of exchange-traded funds (ETFs), active ETFs, and listed investment companies/trusts (LICs/LITs). Growth of the ASX’s mFunds has further expanded the universe of products that provide at least some of the administration advantages of the ASX platform.
The greater choice of funds via the ASX has been welcomed by many investors (and advisers), particularly those with self-managed superannuation funds who prefer direct ownership of listed securities, enabling greater diversification and more robust portfolio construction.
Meanwhile, the growth of managed accounts has allowed advisers to implement full portfolio solutions more efficiently using such funds, often complementing a direct shares component. Not all investors or advisers are equipped to take full advantage of the arsenal of opportunity the listed funds space represents; if approached poorly, such vehicles will subtract, rather than add, value.
Common mistakes I see advisers make when it comes to executing portfolio strategies in the listed fund space relate to poor execution, chasing a hot LIC or ETF just because it has performed well, paying large net asset value (NAV) premiums on favoured LICs, and selling out of listed funds simply because recent returns have been poor, without understanding the drivers.
Poor execution usually amounts to placing market orders or hitting the bid/offer irrespective of the buy/sell spread size or the current/estimated NAV on a listed fund.
I plan to dig into many of the above common mistakes in a series of columns I will be writing for Professional Planner in coming months.
The increased array of listed vehicles can also create confusion amongst investors and advisers as to the relative advantages and disadvantages of each structure and how they can best be incorporated into portfolios. It also provides new challenges for other industry participants, including fund managers, researchers, platforms and regulators.
I outline some of these challenges below, but first, it’s worth taking a moment to provide a snapshot of the listed trust market to highlight how quickly it has grown and proliferated in recent years.
STATE OF THE LISTED PRODUCT MARKET
The ASX fund categories and their sizes:
- Listed investment companies and trusts (LICs and LITs): actively managed funds in a closed-end (mostly company) structure, although the number of LITs is growing. There are 110 LICs/LITs, with a market capitalisation of almost $42 billion.
- Exchange-traded funds (ETFs): mainly passive; there are more than 150 funds, with total funds under management/market capitalisation of about $40 billion.
- Active ETFs: also trade intraday on the ASX and, depending on your definition, there are now about 15 of these with FUM of over $2 billion, although this component will almost certainly grow rapidly.
- mFund: a range of over 200 unlisted active funds with combined FUM of almost $700 million, available through brokers and using the ASX CHESS system; while not ASX listed, they can make administration easier.
One could also include property and infrastructure funds, which are established components of the local listed fund market. The ASX states that there are 48 Australian real estate investment trusts and nine infrastructure vehicles, with market caps of $129 billion and $68 billion, respectively.
Across all the above, there are about 550 fund vehicles, with total assets of about $280 billion, covering all assets classes and a wide range of strategies, listed and unlisted underlying assets and active and passive (including smart beta). Clearly, this is a broad universe from which to select investments and build diversified portfolios. Of course, the return and risk prospects of these vehicles vary depending on structural elements, broad macro factors, absolute and relative valuation and individual characteristics, including quality of the manager. Further, I am not suggesting that this listed universe allows the creation of a perfect portfolio (is there such a thing?). Investors able to access the full universe of listed and unlisted fund options will have a larger opportunity set. Large institutional investors can also access direct unlisted assets and use their scale advantages to negotiate access, lower fees, etc. But this larger universe does not have the ease of access, lower administrative burden and pricing transparency that the ASX vehicles provide.
Further, advisers and investors who access these listed funds intelligently can have some other advantages not easily available to these larger players. Using vehicles such as ETFs, savvy advisers and investors can get into better position to quickly take advantage of periodic market/dynamic asset allocation; buying listed funds when they’re trading at discounts to their NAV and selling at a premium. Also little known is that the active ETF structure has a potential to generate additional market-making gains that can accrue to the vehicle, which can effectively transfer money from the impatient to the patient. Of course, this structure – discussed further below – can also result in losses. In this, my first contribution for PP, I’ll spend some time on what I think is the most vexed area within listed funds, a structure advisers and investors can often find themselves grappling with.
PRICES AND NAV
LICs are the oldest, and in some respects the most complex, of these listed fund structures. This partly reflects their company structure, although the gradual increase in the number of listed unit trusts (LITs) is a welcome development, given the familiar see-through tax structure.
The other complexity for LICs and LITs is their “closed end” nature, which means that the market price can vary, sometimes substantially, from the underlying NAV. Of course, this fluctuation creates both opportunities and risks for investors.
The other structures are aiming to ensure that investors enter and exit at close to the current NAV. This will always be so for mFund and unlisted funds generally (other than small buy/sell spreads) and it will usually be the case for ETFs and active ETFs; however, each of these latter two structures relies on market makers to buy and sell and create and redeem units to ensure that trading is close to NAV. The active ETF structure differs from standard ETFs in that the gains or losses from market-making accrue to the fund vehicle itself not to one or more external parties. In addition, unlike ETFs, which are usually based on an index and typically report their full portfolios frequently, active ETFs will only be required to report their portfolios quarterly and even then with a two-month lag, thereby protecting the manager’s intellectual property.
During extreme market volatility, there is a risk that bid/offer spreads on both ETFs and active ETFs may widen markedly with the result that investors sell or buy well below or above NAV. Funds can even be suspended from trading if the underlying assets cannot be easily priced. While such periods are likely to be rare, the likelihood that wide spreads and gapping risk may occur when markets are most stressed should not be dismissed lightly. This risk has a unique element in the case of active ETFs, given the possibility of a fund taking losses from its market-making activity (with resultant underperformance of the equivalent unlisted fund), which could cause a loss of confidence in the structure. I see this as a low risk but not one to be totally ruled out. In future columns I will look more closely at the various listed fund options discussed above and the changes and opportunities for investors and advisers in using them to build portfolios, along with implications for other industry participants and how this space may develop in the future.
Dominic McCormick is an investment consultant and observer with a focus on the listed investments space.