Making sense of ETFs

Due largely to the diversification they offer, plus access to overseas markets, the ability to avoid the costs associated with either financial advice or active fund managers and their costly administrative platforms, it's hardly surprising that Australian investors have embraced exchange traded funds (ETFs) over the last 15 years, especially self-managed super funds (SMSFs) which now account for around 41% of all ETF investors.

But while the number of ETF investors increased 37% to an estimated 202,000 in 2015, a BetaShares/Investment Trends Exchange Traded Fund Report expects a

record number (110,000) of investors to make their first ETF investment in the next 12 months.

Easy access – low-cost alternative

What's attracting investors to around 140 domestic and internationally-based ETFs listed on the ASX, is cheap underlying exposure to the performance of an index within a variety of markets and sectors.

Investors also like the ease with which they can enter and exit ETFs without penalty, and while many index funds offered by active fund managers require a minimum up-front investment – sometimes $100,000-plus – with an ETF you can invest as little as $500 across the broader market.

Similarly, while the biggest portion of ETF money flows into stocks on the ASX-100 Index, ETFs also offer inexpensive access to overseas markets through offshore domiciled funds listed on the ASX.

In addition to not incurring entry/exit fees, ETFs also avoid paying upfront or trailing commissions to investment advisers. While investors do pay normal brokerage fees when buying or selling an ETF, the management fee can be as low as 0.09% annually.

How they operate

Seen by many investors as one of the greatest financial innovations in the last 20 years, an ETF's primary investment objective is to provide investment returns that closely track the returns of an index, commodity or currency, rather than attempting to alter the return of the index, commodity or currency.

The most common ETFs are index-tracking.

An index contains a selection of securities determined by applying a specific set of rules. Understanding the index's rules is the key to understanding what sets one ETF apart from another.

An index is calculated and published by an index provider such as S&P, MVIS, FTSE, MSCI and Morningstar.

Three structures

For the uninitiated, ETFs listed on the ASX deploy one of three structures.

Referred to as 'full replication', the simplest of these is where an ETF provider buys all the assets comprising an index – be it shares, commodities or currency and holds all 200 stocks that make up the ASX 200 index – with the size of each holding reflecting its weighting on the index.

The other two structures are what are known as 'partial and synthetic replication' respectively – with the former providing a representative sample of the underlying assets of an index.

By comparison, ETF providers using a 'synthetic replication' structure buy the underlying shares (or other assets) but also enter into an additional derivatives contract – usually a swap, with a third party like an investment bank – in return for a fee.

Acting somewhat akin to an insurance product, the swap arrangement ensures the bank covers any shortfall between the ETF returns and the index it's tracking, and if the ETF outperforms the index, the bank is rewarded accordingly.

International shares dominate

The ETF market in Australia grew 66% last year to $17.8 billion, with the single largest sector, international shares accounting for $6.9 billion.

There are now 10-plus issuers of ETFs, but the four largest competitors – iShares, SPDR, Vanguard, and BetsShares collectively account for 91% of funds under management (FUM).

While international share ETFs returned 28% on average over the last year, the international sector ETFs at large return 36% on average over the year, with the best performing markets being the US, Hong Kong and China.

The iShares FTSE China large-cap ETF was the best performing ETF having returned 55%, while the worst performing ETF was the Betashares Crude Oil Index ETF-Currency Hedged Synthetic ETF which lost 53%.

New offerings

One of the more exciting developments for the exchange traded product industry has been the launch of exchange traded managed funds (TMFs).

More domestic asset managers are expected to issue their own TMFs this year, following the 2015 launch by Magellan Asset Management of its Magellan Global Equities Fund which mimics exactly the Magellan Global Fund.

We've also seen the launch of a range of ETFs offering investors outcome-oriented objectives, including strategic or 'smart' beta, with an emphasis on quality international companies, which could be attractive to investors within the current low earnings environment.

But with more complex products being launched on the ASX, you need to do your homework on individual products, especially smart-beta ETFs commanding higher costs.

Comparing ETFs

The best way to compare two or more ETFs that are linked to the same index delivering identical returns is to look at both the costs and the financial institution providing it.

You also need to understand (the three) ETF structures, and the risks/benefits they provide.

While ETFs that invest in international equities provide exposure to the underlying shares, you also need to query how they manage exposure to the currency they're listed in.

Given that ETFs currently operating in Australia typically aren't hedged, if you believe the A$ will rise against major currencies, ETF performance will continue being undermined by currency movement, and the opposite is also true.

So it's important to find out how Australia's ETF players plan to provide a currency hedge solution so the pure investment exposure can be retained.

Defensive ETFs

With the ASX All Ords continuing to be dragged down by the dismal performance of big miners and the uncertainty surrounding banks, Australian small-cap ETFs, and more defensive ETFs such as fixed income and gold ETFs, and are likely to capture the market's attention this year.

Alongside the lift in the price of gold, BlackRock reported record fund inflows of $US7.2 billion ($9.4 billion) for gold ETFs globally during the month of February. This represents an increase in fund flows of more than 10% of the total $US66.8 billion market across the month.