Exchange Traded Funds – 7 questions answered?

Chris Forrest- Senior Partner and Principal Adviser

Sovereign Wealth Partners

 

 

1. What are Exchange Traded Funds (ETF’s)?

ETF’s are a unit trust (like a managed fund) traded on a stock exchange. Like a managed fund they are open ended, meaning new units are issued when someone invests in the ETF, and units are redeemed when someone sells their interest. This means the number of units is not fixed. This means you do not need to rely on someone being willing to sell their units to you – the issuer of the ETF makes a market (i.e. provides a buy and sell price) and buys or sells units on demand.

 

2.What do ETF’s invest in?

ETF’s typically invest in a pool of traded assets and their performance will also track an index.

The earliest and perhaps most common ETF’s track a whole market, such as the US stock market. To do this, they invest in the stocks used to calculate the index in the same weighting. For example, an ETF tracking the US stock market may track the S&P500® index – as the name suggests, there are 500 shares in the index, the largest of which is Apple, making up around 6.5% – this means around 6.5% of the ETF will be invested in Apple shares. An example of this would be iShares S&P500 ETF.

ETF’s can also be more specific such, as the  BetaShares Global Cybersecurity ETF   which invests in cybersecurity shares listed on the NASDAQ which track the Nasdaq Consumer Technology Association Cybersecurity Index.

ETF’s can trade in shares, bonds, property, commodities as well as other traded assets.

 

3.How do ETF’s invest?

ETF’s invest in what is known as a ‘passive’ style. This means rules for investing are established and the fund must follow these rules. There is no room for a decision to be made in any other way.

The most common is the market capitalisation rule, which means the fund must invest in exactly the same way as the underlying index is calculated. The S&P500® ETF is an example.

Another may be a qualitative set of rules such as VanEck Vectors MSCI World ex Australian Quality ETF which tracks the underlying index of the same name. It is the index which is made up of shares which are chosen based on quality scores relating to a company’s balance sheet and cashflow.

Other rules can involve ethical investing, industry segment, company size and country.

Other strategies may involve currency, mulit sector, volatility management, synthetic investments and gearing.

 

4. Are ETF’s cheap?

It depends.

They are a cost-efficient way to purchase a diversified portfolio of shares but the strategy you are buying needs to be considered. Is it the right one for you? Is it consistent with achieving your portfolio objectives?

The abovementioned S&P500® ETF costs just 0.04%pa. The BetaShares cybersecurity ETF, by contrast, costs a hefty 0.67%pa. That said, if these are the investments you want, and you want them managed to a set of rules, it’s likely to be cheaper than you could do it yourself. It’s also a lot less hassle.

How are they so cheap? Aside from accessing institutional pricing, ETF operators can engage in other portfolio related activity such as lending stock. An ETF operator may lend stock to a short seller and in return they receive a fee which subsidises the operation of the ETF. (Some might question the ethics of lending stock to someone who is betting against their investors).

The question to be asked is, what is the alternative, does it cost more and what do you get?

The alternative is active management. Active management costs more because it is more labour intensive – you are paying for a team of analysts and portfolio managers to scour the market for investments which, as a portfolio, will do better than the market. Passive management buys the market and captures the very best and the very worst. Active management seeks to filter out the very worst and thereby increase the likelihood of outperformance which more than mitigates the marginally higher fee.

 

5. Which is better? Active v. Passive management

This is another highly contentious debate.

The bottom line is that each has its place and investment strategies should be judged on their merit and suitability to a portfolio’s objectives.

The myth that an active manager can’t outperform the market is easily dispelled by the plethora of managers who do just this. The index investing sales pitch that you cannot outperform the market, therefore cheap is best, misleads investors into abandoning any strategic approach to their portfolios.

 

6. What are the advantages of investing in an ETF?

Advantages include:

  • Efficient and quick acquisition of a portfolio with a specific strategy;
  • They are relatively inexpensive.
  • Transparency – the portfolio constituents are completely transparent i.e. you can see the entire portfolio. Also, the net asset value is published daily on the ASX.
  • There is no brokerage on underlying share trades;
  • There are no performance fees;
  • Capturing the best performers in the sector;
  • Buy/sell spread may be lower than managed fund counterparts;
  • They are easy to trade. They trade and settle on the stock exchange like regular shares.

 

7. What are the disadvantages of investing in an ETF?

Disadvantages include:

  • Brokerage is incurred buying into and selling out of an ETF;
  • By definition, they cannot outperform;
  • Capturing the worst performers in the sector;
  • Liquidity risk – some ETF’s may invest in assets which have low liquidity which means there is a risk the operator may not be able to create or redeem units i.e. they can’t make a market.
  • Market or sector risk – the sector in which the ETF operates may have a general decline e.g. the property trust sector may experience a general decline and so the ETF will follow accordingly.

 

Summary

Exchange traded funds are a large part of the market and enable investors to inexpensively purchase a diversified portfolio of assets. There are many different exchange traded funds and investors need to assess whether the strategy of a given fund is consistent with their objectives – price is a secondary consideration. It is more likely that an ETF will be one of a number of assets in a diversified portfolio constructed to meet investor objectives.

 

 

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