ETFs: time for a second look?

11 September 2018

As clients seek higher returns and lower fees, advisers could benefit from taking another look at the $40bn market in exchange traded funds, writes Zoe Fielding.

Good returns can be hard to find for Australian investors.

Interest rates are at record lows. Property prices are falling. Rent growth has stalled. And despite strong overall returns from Australia’s share market this year, blue chip stocks – the mainstay of many portfolios – have underperformed.

Compounding investors’ woes, non-discretionary household expenses such as energy and food are rising.

As inflation erodes buying power, advisers’ clients are demanding higher returns and lower fees.

In response, a growing number of advisers are turning to exchange traded funds (ETFs) to cost effectively deliver exposure to higher performing markets that may be difficult or expensive to access directly.

ETFs are listed securities that track an index or basket of assets.

They are traded on the market like any other share.

Most of the ETFs on the Australian Securities Exchange (ASX) are passive vehicles that invest in the physical assets that make up the index they follow. A handful of the ETFs listed on the ASX can invest in a proxy for the assets they are tracking, such as futures and derivatives.

These products are known as synthetic ETFs and under ASX rules they must include the word “synthetic” in their name.

Returns from ETFs typically match those of their benchmark within a few percentage points.

More than $1.1 billion in new investments poured into ETFs in the June quarter, according to Vanguard Investments Australia. Including market gains, their total value reached almost $40 billion.

“Managed funds have a lot of assets but ETFs have the growth,” says Vanguard head of product strategy Balaji Gopal.

There are now 177 local ETFs to choose from

In Australia, ETFs have been available for almost two decades. They were traditionally used for basic Australian equities exposure, while other vehicles provided active investments and asset class diversification.

But new variations are coming to market. There are now 177 ETFs listed on the ASX. The growing range means ETFs are becoming relevant to a wider range of clients and the fees they charge are attractive (Vanguard charges between 0.27 and 0.28 per cent for most of their global equity ETF’s).

ETFs focussing on specific themes or “mega-trends”, such as environmental, social and governance (ESG), and artificial intelligence – like ETF Securities Australia’s ROBO Global Robotics and Automation ETF are also coming to market, this broadens their appeal.

“Those types of products are starting to get a lot of attention from financial advisers who are trying to do something slightly different with small parts of their portfolios,” says Kris Walesby, head of ETF Securities Australia.

The appeal of exchange traded funds

One of the biggest drawcards of ETFs is their low cost, says Gopal.

Most ETFs passively track an index, meaning there is no need to pay fund managers to actively research or analyse potential investments before making a call on what to include in the portfolio.

Tracking an index also limits turnover as the portfolio only needs to be rebalanced when securities are added to or removed from the index. Low turnover keeps transaction costs down.

The costs of running an ETF are minimised as when an investor buy shares in the ETF, they place their trades with a broker and usually end up buying from an investor who is selling, so the ETF manager is not involved.

Specialised ETFs are more costly but few charge above 0.7 per cent.

The Australian ETF market predominantly consists of passive investment choices that are broadly cheaper than managed funds that incorporate many actively managed investments.

ETFs listed on the Australian market offer a cheap and efficient way to access exposure to global markets, where transaction costs can prove to be relatively expensive for Australian Investors. 

Other advantages of exchange traded funds

But Gopal says price is not the only attraction of ETFs.

“It’s the ease of use, simplicity and efficiency. With one trade you can get access to a variety of markets,” he says.

Envision Financial adviser Luke Smith uses ETFs as the backbone of most of his clients’ portfolios. “We use ETFs to gain international exposure, passive exposure to specific sectors, and to compliment more active positions in the portfolios,” Smith says.

He finds them useful for asset allocation with high balance clients, such as self-managed superannuation funds, and diversification for those with lower balances.

It’s importance to do your due-diligence

With so many ETFs on offer, advisers need to understand the products’ assets and strategies, according to ETF Securities’ Walesby.

ETFs are, of course, subject to market risk. Advisers need to appreciate the benchmark’s characteristics. Emerging markets, for example, can be volatile, while sector ETFs may concentrate industry-specific risks.

In most cases, ETFs are highly liquid. But this may not be true for niche products or synthetic ETFs as these types of products may have a smaller market and their underlying indices may be more volatile. Volatility may be magnified in a synthetic ETF compared with holding the underlying assets directly.

Advisers need to be aware that ETFs with similar objectives may take different approaches. There are several Australian yield-focused ETFs, for example, but each has its own methodology.

“The outcomes will be completely different,” Walesby says. “It’s like buying a car: each one has a different engine, chassis, and different features.”

As with any investment product, thorough research is essential. But for advisers looking for low-cost options for enhancing client returns, it’s worth examining the potential value of adding exchange traded funds to the suite of investments they offer.