ETF sector takes off as gateway to the world

As well as ETF securities covering the broad Australian market and specific indices, investors have access to a veritable smorgasbord of products that offer direct exposures to stocks in different countries and regions, to defined market segments, to commodities such as gold, and even to asset classes such as fixed interest.

Exchange traded funds — also known as exchange traded products — act like index funds. The product holds a basket of shares that mirrors an index, such as Nasdaq or the ASX 200. An ETF is simply a version of an index fund where the product itself is listed on the stock exchange.

And the ETFs list continues to grow. Since the start of August four more securities have joined the ASX boards, including three from the prolific ETF issuer BetaShares. They include one, with the ASX code HACK, the first fund in Australia providing dedicated ­exposure to the fast-growing global cybersecurity sector.

Separately, Blackrock, another key player in the market, announced a range of reductions in its ETF fees last week.

Shortly before, BetaShares launched a global healthcare ETF, DRUG, and another offering ­access to global agriculture companies ETF, FOOD.

In the US, which is home to around 1700 ETFs managing $2 trillion of funds, there are ETFs for almost every investment theme. Take SLIM, for example, an ETF launched last month that is investing in healthcare companies that could benefit as they fight the global obesity epidemic.

Fil Andronaco, a director of portfolio construction and consulting company InvestSense — which actively uses ETFs — believes there is still room for new products as our market matures.

“In the US you can buy an ETF that covers all of the industry sectors, different regions and market caps. There are others where you can buy into factor-based investment strategies such as momentum, value or growth,” Andronaco says. “We’re likely to see more of those products launching here too.”

Picking the trends

“The way that we think about the opportunity for the ETFs industry is to look at how people are constructing their portfolios,” says BetaShares managing director, Alex Vynokur, who notes that self-managed superannuation fund trustees often have very concentrated share portfolios.

“The great opportunity that ETFs can bring to the table is the ability to have a diversified portfolio that meets their specific investment objectives.”

Vynokur points out that “while it’s difficult to get excited about the growth prospects in our market”, ETFs are a gateway to the world. “It’s very important to look outside our backyard and to think globally.”

It seems that message isn’t being lost on Australian investors, and the investment tide does appear to be turning as the flow of funds into ASX-listed ETFs with global mandates continues to rise.

While there has been a rebalancing of investment capital across the ETFs sector, research by InvestSMART shows just over half of the roughly $24 billion of total funds under management remains focused on domestic stocks, fixed interest, property and cash.

And of about $9bn in funds directed into ETFs focused on international markets, sectors and investment strategies, about $7bn is held within just four ETFs — two directed at stocks on the US market, one at European stocks, and the other at the S&P Global 100 index.

The balance of ETFs investment capital has been spread across niche products focused on specific industries, commodities and currencies, accounting for more than $4bn overall.

Size problems

Of course, in common with any other financial product the ETFs sector is not perfect, investors should understand. For example, about half of the ETFs on the ASX manage less than $50 million in funds. Of these 60 or so ETFs, half have less than $10m in FUM. With relatively tiny fund sizes investors cannot hope to get the genuine long-term benefits that huge ETFs with very low fees sustain.

Moreover, those ETFs with billions of dollars of FUM, especially those investing into stocks in specific markets, have much greater capacity to construct a well-diversified portfolio.

Smaller ETFs are limited and, in some cases, unable to offer investors a broad exposure to the indices or sectors they are purporting to cover.

Separately, large ETFs from overseas with a local listing tend to be cheaper as they benefit from scale economies. However, depending on how you invest, you may have to fill out a foreign tax form. This often explains why ETFs with an entirely locally domiciled structure that invests in overseas assets will often be more expensive than an offshore ETF that appears to offer an identical exposure.

For the product owners, the financial viability of operating some of these smaller ETFs can be questionable too, and industry experts point to some ETFs having been quietly closed down when their numbers haven’t stacked up.

Vanguard’s head of ETF Capital Markets, Damien Sherman, says the breadth of the Australian ETFs product market is clear, and that the primary focus of issuers is to build funds under management.

“We definitely see a lot of room to grow in terms of FUM across the products,” he says. “A lot of that will come from greater institutional participation as they see the benefits.”

What you should know

For investors using ETFs, it is ­essential to understand what a fund is investing into, and where, and the investment philosophy behind the ETF.

Most ASX-listed ETFs provide detail performance data as well as a breakdown of their top shareholdings, the general objectives of the fund and their FUM.

Sherman says that ETFs compete on a range of levels, from quality of coverage to management expense ratios (MERs). High MERs — the fees taken by the EFT managers — will often lead to what is known as “tracking error”, where ETF prices will not exactly follow the price of the index or investments they are designed to track.

For investors, ETFs operating with significant tracking error will invariably trade below the net asset value of the stocks contained within the fund. An ETF trading above its net asset value is effectively trading above its actual worth. Another danger investors should be aware of is that ETFs with small amounts of FUM can have liquidity issues, meaning buy and sell spreads can be wide and that it can be difficult to sell out quickly. This can be a significant risk.

Then there are other factors to consider, such as the currency risk on unhedged ETFs with exposures to international markets and the potential impact of international tax laws on returns.

Yet, ETFs remain one of the most cost-effective ways for investors to diversify their portfolios into a broad basket of equities or other securities. And many have generated great returns over time.