Exchange Traded Funds

07 Mar 2014

By Shadforth Financial Group

What are they?

Exchange Traded Funds (ETFs) are funds that hold a portfolio of securities managed to match the performance of an underlying index. Because they are index based, they are generally an efficient, liquid and cost-effective way to get exposure to various equity and bond markets.

Instead of issuing units like a managed fund, ETFs issue shares which trade throughout the day at prevailing market prices, like other securities on the ASX. With the exception of voting arrangements, investors generally have the same rights as investors in shares. All economic benefits such as dividends, bonus issues, rights issues, etc, flow through to investors.

What is available?

There are different types of ETFs available in Australia including: global equity funds; global sector funds such as consumer staples stocks and telecoms stocks; commodity funds such as gold, or 'baskets' of various commodity futures; Australian share funds based on indices such as the S&P/ASX 50 or S&P/ASX 200 stocks; Australian sector funds such as resources, financials and property indices; and Australian fixed interest funds.

Fees

An ETF typically costs less than a comparable actively managed fund, but can vary substantially depending on the underlying asset. Typical ETF fees range from 0.2% per annum for a fixed interest index ETF to 2.25% per annum for a commodity fund ETF.

As with the purchase of stocks, investors who buy an ETF incur a bid/ask spread, or the difference in the market price to buy the ETF and the market price to sell the ETF. There may also be brokerage commissions associated with buying or selling the ETF, as with any stock.

How does an ETF differ from an index managed fund?

On the surface, ETFs appear very similar to index managed funds, which also track an index. However, there is one important difference. The market price of a managed fund does not fluctuate during the trading day and investors only pay the net asset value struck at the end of each trading session. There is no premium (or discount) between the price of a unit in a managed fund and its net asset value.

ETFs, on the other hand, trade like shares throughout the day. Their prices may fluctuate, but the net asset value at which shares are issued or redeemed is only determined at the end of each day. This can create a problem. The market price of an ETF is supposed to mirror the value of the underlying stocks in the index. Sometimes however, the two prices can widely diverge. This is because the net asset value of an ETF is set at the end of each local trading day, but those ETFs can then trade all over the world while the local markets are closed. If the price is higher than the net asset value, investors are essentially paying a premium.

Good points

ETFs are low cost relative to both passive and actively-managed funds.

ETFs typically have a low turnover relative to most actively-managed funds, with turnover reflecting the changes to the underlying indices. They are thus more tax efficient than most actively-managed funds.

Most managed funds are structured as unit trusts where investors buy unlisted units in a fund. ETFs however, offer investors liquidity via the ASX.

Unlike a listed investment company, which has a fixed supply of shares on issue, ETFs have a share creation/redemption facility. The number of issued shares for each ETF can be increased or decreased on a daily basis according to individual investor demand. The actions of one investor are quarantined from other investors; redemption by one investor does not trigger a tax event for other investors. The creation/redemption feature also means that the ETF share price is usually kept reasonably in line with the net asset value of the fund.

Risks

The 'vanilla' ETFs available in Australia are relatively low risk, ignoring normal market-related risks. They will all track the performance of their particular index relatively closely. However, investors can buy ETFs with more complex structures that have the potential to be disastrous in the wrong market conditions. These ETFs can be highly leveraged, difficult to implement and illiquid. Five examples are discussed below:

  • Commodities ETFs (as opposed to precious metals ETFs, which are backed by actual, physical metal) usually hold futures contracts because the indexes they track are typically made up of such contracts. This can lead to problems. An ETF will lose money in falling markets every time it rolls over from a near-month contract to a further-dated contract.
  • Fixed-interest ETFs may seem like a good idea, with very low fees giving them a big advantage in the usually low-return bond market. However, keeping fixed-interest ETF returns in line with their underlying indexes can be difficult. For most bonds, there is no centralised exchange matching bond buyers and sellers, and different market players can assign very different prices to the same bonds. Many bonds do not trade for days at a time and, when they do, they can be costly to buy and sell.
  • Some ETFs may be invested in more niche share markets and can suffer from illiquidity as a result of the relatively 'thin' trade in those countries' stock markets. In bad times, it may be difficult to exit these products.
  • Geared and inverse ETFs carry additional risk due to the nature of such securities having multiples of exposure or a 'short' exposure to the underlying index. Such ETFs are popular with speculators and those seeking enhanced returns, but are substantially more volatile.
  • ETFs investing in global shares are typically not hedged. Consequently, their returns will be impacted by the relative currency movements between the Australian dollar and the foreign currency of the underlying securities during the investment period. 

How they should be used

ETFs are suited to those investors who believe the market provides an efficient long-term return. Given the flexibility offered by ETFs, investors can use them as low-cost core holdings or to complement other active strategies.

Promoters of ETFs have made much about their potential use in tactical asset allocation. There is a risk that ETFs are bought simply on the basis of their recent past performance, with little consideration given to the inherent risks and valuations in the indices underpinning these ETFs, or their future prospects. For example, an ETF based on the Resources index may look good during a period when mining stocks are booming but represent a big bet in just one sector.

ETFs work well when they are based on deep and liquid markets. We strongly caution against investing in the more obscure types of ETFs that invest in niche markets and sectors, or which are leveraged. There are serious risks inherent in these funds and there is no guarantee that they will remain liquid or accurately priced.

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