No looking back now: ETFs ready to take off

PORTFOLIO POINT: Amid uncertainty and volatility of an unknowable duration, investors naturally want to hedge their risk. It’s worth looking at ways beyond cash and fixed interest and it’s time to re-examine ETFs.

Like four-letter words, three-letter acronyms (a.k.a. TLAs) are often thought to be best avoided. But as with the former, life can be pretty dull without them. Despite the well-deserved ignominy that the dark arts of financial engineering have earned with the creation of CDOs, CDSs and, of course, MBAs, not all TLAs are made equally. WTF (where’s the fruitcake?) you might ask, but one of these, the much-maligned ETF, does deserve closer scrutiny.

Exchange-traded funds were developed in response to the crash of 1987 (for more on the anniversary of that event, see today’s Video of the Week), with investors wanting to gain a long or short exposure to a much wider diversity of stocks without being overly exposed to the idiosyncrasy of a particular security. With ETFs these days being more associated with creating, or at least exacerbating, market risk, however, the industry’s founders are no doubt shaking their heads.

I spoke to one of those founders, Jim Ross from State Street Global Advisors in Boston, who visited Australia this week. State Street, which runs the SPDR group of ETFs, is one of the biggest providers in the world, managing about $US244 billion. Ross, who was also the architect of Australia’s first ETF, the SPDR S&P/ASX 200 Fund (STW), described the situation as more of a case of consumers not understanding the product than ETFs being a danger.

“I don’t think they’ve gone to evil,” he says with a laugh. “When I look at it, I've heard the assertion, primarily in the US, about leveraged and inverse ETFs contributing to end-of-day volatility, but I haven't seen any facts – on either side – that has been able to say whether [ETFs] give a portion of late-day volatility, or whether it's high-frequency traders.

“And I think it's challenging to think, considering the size of the markets and the size of daily moves, whether ETFs would have that much of an impact anyway.”

Indeed, most ETFs that retail investors would come across will be, in the industry argot, “plain vanilla”, based on real, underlying assets and traded throughout the day. As you can see from the tables below the biggest locally focused ETF on the ASX is the $2 billion SPDR S&P/ASX 200, the biggest globally focused fund is the $29 billion iShares MSCI EAFE ( European, Australasian and Far Eastern markets).

As for leveraged and inverse ETFs, while these are available to investors willing and able to purchase securities on exchanges such as New York and London, the ASX at present does not list any of these products.

-ETFs in Australia: Many flavours, all vanilla
Australian Broad-based ETFs	Code	Market cap. (m)	Return (1 year)	Benchmark	MER*	Listed	Yield
iShares S&P/ASX 20	ILC	$39	N/A	S&P/ASX 20	0.24%	Dec-10	1.34%
iShares MSCI Australia 200	IOZ	$36	N/A	MSCI Australia 200	0.19%	Dec-10	1.83%
iShares S&P/ASX Small Ordinaries	ISO	$26	N/A	S&P/ASX Small Ordinaries	0.55%	Dec-10	2.06%
SPDR S&P/ASX 50	SFY	$256	-9.74%	S&P/ASX 50	0.29%	Aug-01	4.19%
SPDR S&P/ASX 200	STW	$2,041	-10.29%	S&P/ASX 200	0.29%	Aug-01	4.46%
SPDR S&P/ASX 200 Small Ordinaries Fund	SSO	$6	N/A	S&P/ASX 200 Small Ordinaries	0.50%	Apr-11	0.30%
Vanguard Australian Shares Index	VAS	$189	-10.52%	S&P/ASX 300	0.15%	May-09	4.51%
Vanguard MSCI Australian Large Companies	VLC	$6	N/A	MSCI Australian Large Cap Index	0.20%	May-11	0.03%
Vanguard MSCI Australian Small Companies	VSO	$6	N/A	MSCI Australian Small Cap Index	0.30%	May-11	1.02%
Australian Sector ETFs
Aii S&P 200 Financials X-A-REITs	FIX	$2	-5.79%	S&P/ASX 200 Financials X- A-REITs	0.43%	Apr-10	N/A
Aii S&P200 Energy	ENY	$3	-10.33%	S&P/ASX 200 Energy	0.43%	Apr-10	N/A
Aii S&P 200 Financials	FIN	$3	-8.57%	S&P/ASX 200 Financials	0.43%	Mar-10	N/A
Aii S&P 300 Metals and Mining	MAM	$3	-14.29%	S&P/ASX 300 Metals & Mining	0.43%	Apr-10	N/A
Aii S&P 200 Industrials and Mining	IDD	$1	-13.77%	S&P/ASX 200 Industrials	0.43%	Apr-10	N/A
Aii S&P 200 Resources	RSR	$7	-14.78%	S&P/ASX 200 Resources	0.43%	Mar-10	N/A
BetaShares S&P/ASX 200 Financials ETF	QFN	$34	N/A	S&P/ASX 200 Financials	0.39%	Dec-10	1.00%
BetaShares S&P/ASX 200 Resources ETF	QRE	$30	N/A	S&P/ASX 200 Resources	0.39%	Dec-10	0.62%
SPDR S&P 200 Financials X-A-REITs Fund	OZF	$9	N/A	S&P/ASX 200 Financials X- A-REITs	0.40%	Apr-11	N/A
SPDR S&P 200 Resources Fund	OZR	$8	N/A	S&P/ASX 200 Resources	0.40%	Apr-11	N/A
Vanguard Australian Property Securities ETF	VAP	$12	-10.48%	S&P/ASX 300 A-REITs	0.25%	Oct-10	4.87%
SPRD S&P/ASX 200 Listed Property Fund	SLF	$278	-10.58%	S&P/ASX 300 A-REITs	0.40%	Feb-02	5.65%
Australian Strategy-based ETFs
iShares S&P/ASX High Dividend	IHD	$25	N/A	S&P/ASX Dividend Index	0.30%	Dec-10	2.66%
Russell High Dividend Australian Shares ETF	RDV	$125	-9.91%	Russell High Dividend Index	0.46%	May-10	N/A
Russell Australian Value ETF	RVL	$11	N/A	Russell Australian Value Index	0.34%	Mar-11	N/A
SPDR MSCI Australia Select High Dividend	SYI	$47	-7.42%	MSCI Australian Select Index	0.35%	Sep-10	3.24%
Vanguard Australian Shares High Yield ETF	VHY	$13	N/A	FTSE ASFA Australia High Div Index	0.25%	May-11	0.29%
Currency ETFs
BetaShares US Dollar ETF	USD	$11	N/A	US Dollar	0.45%	Feb-11	N/A
BetaShares British Pound ETF	POU	$2	N/A	British Pound	0.45%	Jul-11	N/A
BetaShares Euro ETF	EEU	$1	N/A	Euro	0.45%	Jul-11	N/A
International Broad-based ETFs
iShares S&P Asia 50	IAA	$65	-13.41%	S&P Asia 50 Index	0.52%	Sep-08	N/A
iShares MSCI BRIC	IBK	$131	-29.34%	MSCI BRIC	0.72%	Sep-09	N/A
iShares MSCI Taiwan	ITW	$2,285	-8.70%	MSCI Taiwan	0.82%	Nov-07	N/A
iShares MSCI South Korea	IKO	$2,716	-4.86%	MSCI South Korea	0.65%	Nov-07	N/A
iShares MSCI Hong Kong	IHK	$1,813	-22.57%	MSCI Hong Kong	0.55%	Nov-07	N/A
iShares MSCI Singapore	ISG	$1,629	-17.95%	MSCI Singapore	0.55%	Nov-07	N/A
iShares Russell 2000	IRU	$10,194	-3.25%	Russell 2000	0.28%	Nov-07	N/A
iShares FTSE China 25	IZZ	$4,113	-31.90%	FTSE/Xinhua China 25	0.72%	Nov-07	N/A
iShares MSCI Japan	IJP	$7,645	-10.49%	MSCI Japan	0.56%	Oct-07	N/A
iShares MSCI Emerging Markets	IEM	$15,951	-20.26%	MSCI Emerging Markets	0.72%	Oct-07	N/A
iShares S&P Global 100	IOO	$593	-10.03%	S&P Global 100	0.40%	Oct-07	N/A
iShares S&P 500	IVV	$13,586	-3.21%	S&P 500	0.09%	Oct-07	N/A
iShares S&P Midcap 400	IJH	$4,586	-4.42%	S&P Mid Cap 400	0.22%	Oct-07	N/A
iShares S&P Smallcap 600	IJR	$4,374	-3.34%	S&P Small Cap 600	0.20%	Oct-07	N/A
iShares MSCI EAFE	IVE	$29,189	-15.33%	MSCI EAFE	0.35%	Oct-07	N/A
iShares S&P Europe 350	IEU	$1,717	-16.09%	S&P Europe 350	0.60%	Oct-07	N/A
Vanguard All-World ex-US Shares ETF	VEU	$26	-15.51%	FTSE All World ex-US	0.25%	May-09	N/A
Vanguard US Total Market Shares ETF	VTS	$13	-1.38%	MSCI US Broad Market	0.07%	May-09	N/A
International Sector ETFs
iShares S&P Global Consumer Staples	IXI	$300	0.49%	S&P Global Consumer Staples	0.48%	Mar-09	N/A
iShares S&P Global Healthcare	IXJ	$676	-2.94%	S&P Global Healthcare	0.48%	Mar-09	N/A
iShares S&P Global Telecommunications	IXP	$248	-6.93%	S&P Global Telecommunications	0.48%	Mar-09	N/A
Exchange Traded Commodities
BetaShares Gold Bullion ETF (A$ Hedged)	QAU	$15	N/A	Gold (hedged)	0.39%	May-11	N/A
ETFS Physical Precious Metal Basket	ETPMPM	N/A	13.21%	Basket of precious metals	0.43%	Jan-09	N/A
ETFS Physical Platinum	ETPMPT	N/A	-12.60%	Platinum	0.49%	Jan-09	N/A
ETFS Physical Silver	ETPMAG	N/A	23.96%	Silver	0.49%	Jan-09	N/A
ETFS Physical Palladium	ETPMPD	N/A	-0.24%	Palladium	0.49%	Jan-09	N/A
ETFS Physical Gold	GOLD	$617	15.28%	Gold	0.39%	Mar-03	N/A
Perth Mint	PMGOLD	$5,134	N/A	Gold	0.15%	Dec-10	N/A

Source: ASX, Stock Doctor, * Management Expense Ratio

From the exhaustive list above, the first thing that stands out is that while none of Australia’s listed ETFs are inverse or leveraged, many have smaller market capitalisations than even the tiniest listed companies and are thus not without significant liquidity risk. The second thing that stands out is that although management fees – when compared with many unlisted funds – are generally low, not all are equal, ranging from seven basis points in the case of the Vanguard US Total Market Shares ETF, to 72 basis points in the case of the iShares BRIC and iShares FTSE China 25 ETFs.

And while the ease of trading ETFS Physical Gold on the ASX has been a boon for many investors in a tough year, delivering a 15.28% gain in the past 12 months, ETFs are no silver bullet when it comes to diversifying risk when all markets are virtually correlated.

In the US, a range of leveraged and inverse ETFs have been created to provide an opposite return to the underlying index, whether based on a futures or a swap contract issued by the ETF provider, but in Australia an easier solution is to take a short position on one of the more conventional “long” ETFs rather than trying to ferret out one of the more exotic and synthetic alternatives. And while the idea of short selling a stock may be anathema to many investors having seen what the practice of naked short selling allegedly did in the global financial crisis, the practice – like ETFs – can, in addition to being quite easy, add much-needed liquidity and price discovery to the market.

Shorting the worst-performing ETF on the list above, iShares FTSE China 25, would have delivered more than double the gains of gold, adjusted for Australian dollars (for the latest on my thoughts on the Chinese economy, see China risks out of the shadows). This proves the point that bears do make money.

Understanding the nuts and bolts of ETFs, their underlying structure, characteristics and risks is important to any investor seeking to delve into the product and, as Ross points out, considering that most ETFs by value are pretty basic in their construction, the issue for the industry is more one of investor education than government regulation. As with any type of investment, there are of course dangers and investors should be cognisant of counterparty and liquidity risk, considering how small some funds might be, but groups like iShares, owned by British bank Barclays, SPDR, owned by State Street, and Vanguard, a major index fund provider, enjoy safety in volume and depth.

As Tony Rumble wrote in August (click here) and Claire and Tim Mackay wrote in July (click here), it's important not to paint all ETFs with the same brush because the right product can add a huge amount of diversity to your portfolio with minimum cost. And like with direct equity investing, you wouldn’t go and buy a share sight unseen and nor should you with an ETF. The ASX has a free online course to understanding ETFs and the Australian Securities and Investments Commission has published a factsheet outlining the risks. Eureka Report also ran a popular webinar on ETFs in July, the recording of which is available to all subscribers (click here) and we have published product reviews of some of Australia’s handful of synthetic ETFs as well (click here, here and here).

What’s more, as Ross pointed out, ETFs are here to stay and they’re growing fast. While synthetic products have certainly attracted their fair share of controversy, they too are becoming more mainstream and seen as a legitimate avenue for diversification and hedging. While product issuers, including SPDR, are for obvious reasons keeping their cards close to their chest in terms of future product offerings, the example of the New York Stock Exchange, where there are over 20,000 listed Exchange Traded Products, including 850 primary ETFs, shows the shape of things to come.

In New York for instance, investors can not only slice and dice the market by region, country, capitalisation, product type and industry – as they can in Australia – but on whether the basket of underlying securities are market-weighted or equal-weighted, on whether the securities meet ethical or environmental criteria, and on whether they correspond to a certain macroeconomic theme, not to mention things like leverage and inversion. Some of the more unusual examples include PowerShares' appropriately minuscule Lux NanoTech ETF (NYSE:PXN); Merrill Lynch's Internet Holdrs (NYSE:HHH), which tracks the performance of internet companies; the iPath Dow Jones-UBS Livestock Subindex Total Return exchange traded note (NYSE:COW), which speaks for itself; and the highly niche Global X Fishing Industry ETF (NYSE:FISN), with net assets of $US1.6 million, mainly invested in Japanese and Norwegian fisheries.

And who could forget the $106 million Teucrium Corn Fund (NYSE:CORN), one of the hottest ETFs of recent times, The Global X Lithium (NYSE:LIT), which offers an alternative exposure to the future of energy other than Toyota or obscure Aussie miners (see Tim Treadgold’s Mercurial small metals), and the First Trust Smartphone Index (NASDAQ:FONE), which gives you diversified exposure to companies like iPhone contract manufacturer Foxconn International, South Korea's Samsung and America's Apple.

But as far as engineered products go, most conventional ETFs are more of the steam engine than stealth bomber variety. Still, whether you wish to trade on macro thematics in a market informed more by the risk-on/risk-off dynamic of political economy than fundamental valuation, or whether you’re just a fan of buy-and-hold index-style investing, ETFs can be a good choice with a lot of empirical evidence to recommend them.