on June 30, 2016 Trading & Investing

The rise and rise of Exchange Traded Funds

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Exchange Traded Funds (ETFs) rode into Australia on the coattails of the GFC, when investors had been pummelled by unfriendly investment markets and many were questioning the fees paid to ‘active’ fund managers for ‘losing’ their money.

While those in the know understand that investment markets are cyclical and that what goes down generally comes back up (eventually), investor behaviour isn’t always rational. And some investors simply don’t have the luxury of time – especially those close to or in retirement.

At the low point of the GFC, the S&P500 dropped approximately 50%, and the S&PASX-200 54% from its highest recorded value on 1 November 2007. When you consider that a drop of 50% requires a gain of 100% just to get back to square one, such falls can have a catastrophic impact on an investor’s portfolio.

Enter the humble ETF. As a passive investment option, ETFs aim to track the returns from a given market index, rather than seeking to generate outperformance through active stock or asset class decisions. What a fabulous idea – replicate an index so that investors retain a diversified exposure to a specific asset class. Keep fees low. Offer transparency. What’s not to like?

The stellar growth of ETFs in the Australian market

ETFs have been around in the US since 1983 and at the end of February this year, numbered 1,585 with nearly US$2 trillion under management (to put that in perspective, Australia’s total superannuation pool recently reached A$2 trillion!) While a little late to the party, since the first ETF was launched in 2010, Australian investors have embraced the trend.

The ASX bundles stats under ‘exchange traded products’ (ETPs), which include ETFs, exchange traded managed funds and structured products. Whichever way you look at it, the growth of ETPs since their emergence in 2010 has been remarkable.

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Source: ASX Funds Monthly Update, May 2016

According to a report by BetaShares/Investment Trends released earlier this year, Australian investors continue to switch out of managed funds and direct shares into ETFs; the number of Australians invested in ETFs grew 37% over the past year to 202,000, with 41% of investors holding an ETF through an SMSF. Globally, 2015 was the biggest year on record for money leaving actively managed funds for index funds and ETFs.

Unlike some other investment vehicles, ETFs have been embraced by all parties in the advice chain – financial planners, stockbrokers, self-managed superannuation funds and investors. They are reviewed by research houses and added to investment platform and managed account menus.

The attraction of ETFs

While a knee jerk response to the GFC might explain the initial take up of ETFs, there are obviously a number of benefits that have supported this continued growth, both in Australia and abroad:

  • Diversification – ETFs provide low cost, diversified market exposure to an underlying index or asset class
  • Transparency – most ETF issuers publish holdings on a daily basis
  • Flexibility – ETFs trade on an exchange and can be bought and sold like shares, with investors able to place limit and stop orders
  • Breadth – ETFs are available for traditional asset classes, as well as a range of sector and niche investments
  • Tax efficiency – ETFs generally have lower levels of portfolio turnover and investors aren’t subject to capital gains tax triggered by the action of other investors, as is the case with most unit trust structures
  • Cost efficiency – ETFs can be a cost effective way to gain exposure to a diversified portfolio of securities. The direct costs associated with ETFs are generally lower than those associated with investment in an equivalent actively managed fund or from trading multiple securities
  • Liquidity – with primary and secondary markets available to investors, ETFs can be bought and sold easily.

Those are the pros…what about cons?

The first ETFs launched in Australia were based on equity indices and relatively straight forward – a global index such as the S&P500 or MSCI All World Index, or the more domestically focused ASX indices.

I was interested to read a report released earlier this year that the 16 fixed income ETFs available in Australia attracted more than half of the inflows so far this year (with equities accounting for 48% of inflows).

The ASX didn’t green light the launch of fixed income ETFs until 2012, a good two years after the first equity ETFs hit the market. The interesting thing about fixed income indices is that they are generally most heavily weighted to the biggest debtors. Take the average global fixed income index – it measures two exposures; country exposure, generally weighted towards those countries that have issued the most debt, and security exposure, also weighted toward those that have issued the most debt.

Given that fixed income investments typically form part of the defensive component of an investor’s portfolio, a passive strategy that mirrors an index may result in investors being overly exposed to debt-burdened assets.

The other important thing to remember is that ETFs generally mirror a specific index – and what goes up generally comes down. The same rules apply to ETFs as all other investments – a decline in value can require a significant gain to get back to square one. With an ETF there is no careful stock selection, hedging strategies or other tactics that an active fund manager might apply to mitigate against loss of value in down markets.

There’s an ETF for that…

In the 1980s, most managed funds featured traditional assets – equities, global and domestic, fixed income, property, and a few niche products such as resources. As the 1990s bull market gathered steam, a greater number of specialist products were launched: small caps, microcaps, technology, health, biotech, concentrated funds…if there was a quorum of investment opportunities, there was a fund.

The world of ETFs is no different. Bloomberg recently suggested that 2016 is turning into the year of the ‘thematic ETF’ and recently reported on three new thematic US-based ETFs:

  1. OLD – an ageing based ETF that invests globally in companies positioned to profit from providing long-term care to the ageing population; those owning or operating senior living facilities, nursing services, specialty hospitals, senior housing, and biotech companies for age-related illnesses
  2. SLIM – an obesity thematic that invests globally in companies that could benefit from the fight the global obesity epidemic; these might include biotechnology, pharmaceutical, healthcare and medical device companies
  3. FIT – if you’re not into obesity, you might be more interested in investing in health and fitness; this one invests in companies focused on fitness technology and equipment, sports apparel, nutrition, and sports/fitness facilities.

(As an aside, the all caps words are the genuine tickers for each of these ETFs!)

Unrelated to these global themes – or, maybe it is – the whiskey ETF recently lodged with the US SEC. It intends to invest across a wide variety of industries that are involved in the overall ‘Bourbon and Whiskey Economy’; this includes producers of crops that go into the production, the ageing of whiskey, by-product management through – investment right through the value chain.

Closer to home, BetaShares last week announced the launch of FUEL, an energy-based ETF and announced its plans to release a number of global ETFs tracking sectors that include agriculture, healthcare, gold and banks.

There is indeed an ETF for just about anything.

The future

The BetaShares/Investment Trends research highlights continued growth for the ETF sector, measured by stated intentions of both investors and financial advisers. In the latter group, 44% of financial advisers regularly recommend ETFs, representing 79% of all financial advisers that directed new client money into direct equities in 2015. The research suggests this will continue to grow.

However…enter stage right, the new generation of ETPs – the exchange traded managed fund. Since Magellan launched its popular Global Equities Fund as an exchange traded product in March 2015, the landscape has shifted. The opportunity to benefit from an exchange traded product that is actively managed has captured the imagination of many and a number of investment managers are bringing their funds to market in the same way, potentially grabbing back market share lost to ETFs over the past six years.

Such products have the power to cannibalise both traditional managed funds and ETFs…is this the future of managed investments?

Tracey Franks (OM blogger)

Tracey Franks is an experienced freelance writer, communicator and marketer. She has worked in financial services for over 20 years, for businesses spanning stockbroking, funds management, research and consulting, as well as financial planning. When not writing about finance-related topics, Tracey is working on her first novel.