Explaining ETFs

ETFs are primarily passive investments as they replicate indices with no active management value-add. The themed ETFs may be semi-active in that they may apply an independently-compiled index but with differing rules on how to define the theme.

While most ETFs available to Australian investors today track an index, some active managers also see an ETF as an attractive structure for growth and have made their strategies available as an actively managed ETF.

They are open-ended (i.e. they can create more units as demand requires) so in that regard they are similar to managed funds but ETFs have the advantage of greater transparency and liquidity through trading on the stock exchange.

ETFs also have an advantage over listed investment companies (LICs) in that they can be bought and sold for close to the value of the underlying asset (i.e. index) and do not suffer the discount/premium that being subject to demand places on LIC share prices. This usually results in the ETF price very closely matching the performance of the asset.

However, a buy/sell spread of prices does exist for ETFs. It can be quite narrow for large, liquid funds but wider when the underlying asset is less liquid (for example, some commodities), or if the market for its assets trades in a different time zone (i.e. international indices) meaning there is a risk premium paid to the ETF trader to cover unknown pricing outcomes.

If the ETF’s underlying assets produce income, investors will receive regular income distributions. Like managed funds, ETFs pass on this income untaxed and franking credits can also be passed through.

Management expense ratios (MERs) are quite low compared to managed funds, ranging from as little as 0.15% to 1.0% for some international share offerings.

Given the strong growth in ETFs, the range of products on offer has become very wide. New ETF providers entering the market are providing different choices to suit all types of investors, providing an opportunity to access new "themes" such as ESG, Climate Change, Cloud Computing, Robotics, etc. Importantly, prior to investing into any type of ETF it is imperative the investor understands the nature and risks of that ETF product.

Investment strategies using ETFs

The benefit of investing in ETFs is that it gives the investor access to markets that are not easily accessible in Australia and/or are not cost efficient such as international shares (particularly region or theme specific), currencies and commodities.

Diversification is gained across sectors in a cost-efficient manner (i.e. you like the outlook for Energy but don’t have the funds to buy more than one or two companies and don’t want the risk of picking an underperformer).

An investor can invest small amounts in a broadly diversified basket ETF as a low cost way to get exposure to the Australian sharemarket, or in addition to the Australian sharemarket to enhance diversification.

Use limit orders rather than market orders to better ensure a more favourable execution from a price perspective (speak to your broker or adviser about this).

An investor can also transition funds into the market without having to pick individual company exposure. This may be useful if you have large amounts to invest and want to do this over time and/or if you are uncertain which sectors may perform going forward but still want exposure to the sharemarket.

This has been a relevant strategy during the period when resources have outperformed but many investors were uncomfortable investing in them directly given their cyclical nature. An investment in the broader index would have meant not missing out on one sector’s significant contribution.

In summary, ETFs are a useful investment vehicle for:

  • Transparency – you know what companies and/or exposure you have through a published index.
  • Cost efficiency – low MERs compared to unlisted managed funds.
  • Tax efficiency – passed through dividends and franking credits. Often low turnover usually only based on index changes so that forced capital gains are not a feature of ETFs.
  • Liquidity – ETFs trade on a T+2 basis and are required to always have a buy/sell price on screen when the market is trading (achieved through a market maker).
  • Diversification – allowing you more options to invest in baskets or specific themes/sectors.

However, you should also be aware of some of the risks:

  • Structure – there are many different structures used by ETFs and some of these may expose investors to third party default risk. Investors need to examine the security of the issuer, whether the fund is physically-backed by assets, the custodial arrangement for the assets, the use of derivatives or security lending, and other issues.
  • Passive investment – while many ETFs will provide broad or specific market returns they are still a passive investment. An astute investment adviser should add value to your portfolio returns through the active management of your investments.

Feel free to speak with your Morgans adviser to learn more about Exchange Traded Funds (ETFs) and whether they might be an appropriate investment choice for you.

Reference: Morningstar Australasia Pty Ltd, 2015

Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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