Low fees, easy access, diverse exposures. What’s not to like about ETFs?
Ten years ago if you mentioned an ETF most people would have thought you were confused about the acronym for an Electronic Funds Transfer. Since then, the market for Exchange Traded Funds has exploded, with predictions that it will grow to exceed the size of the market for traditional managed funds. In 2006 funds invested in Australian-listed ETFs were around $1 billion with fewer than five products available, all domestic shares. Now there are over 170 funds totalling more than $36 billion and the proliferation of products includes global shares, global and domestic bonds, sector exposures, commodities, currencies, smart beta and multi-asset products.
The largest proportion of the ETFs on offer are indexed ETFs, which is to say that they aim to track the performance of a benchmark (S&P/ASX 200, MSCI World ex Australia, Bloomberg AusBond Composite 0+ Yr Index) and achieve this objective by buying all or most of the shares or bonds in that benchmark. They’re effectively the same as an index fund, except for the method by which an investor can access the product. Some ETFs don’t buy the actual shares or bonds but attain exposure to them with derivatives. It can be argued that these types of derivative-based ETFs carry additional risks as compared to ETFs that use physical securities. For this discussion we’ll focus on physical ETFs.
So one the one hand you have traditional investment funds and the other you have ETFs. The major difference, as mentioned, is the method by which these funds are bought and sold by investors. With traditional managed funds you complete some paperwork and receive units in an investment trust at the end-of-day net asset value of the fund. With ETFs you trade them directly on the stock market just as you would regular shares in BHP or CBA. ETFs, then, are listed assets, and their prices move continually throughout the day. You can pick up your mobile phone and trade an ETF any time the market is open for the price at which it’s currently trading.
The largest ETFs in Australia track broad-market indices. So when you buy an ETF you can get exposure to around 200 domestic shares or 2,000 global shares with one transaction; with bonds the number of securities is even larger. You can also narrow your focus to sectors, commodities, currencies or multi-asset diversified funds.
Whatever type of investment you’d like to make there’s probably an ETF that will suit your needs. Innovation and product development continue apace in this sector and new exposures are being released regularly.
What could be easier than buying or selling any time you desire from your mobile phone or the internet? ETFs, being listed on the ASX, can be bought or sold whenever the stock market is open. With just a few clicks you can trade pretty much all the largest companies in the developed world, and at a time that’s convenient to you with no paperwork.
Access also means that it’s easy to buy and sell from a liquidity point of view. Liquidity means being able to trade any number of shares without greatly affecting their price. ETFs have a built-in source of liquidity due to the way they are structured in arrangements between the ETF provider and specialised brokers who will stand in the market and quote prices for any value of the ETF you want to trade. If you’re wanting to trade in very large amounts a phone call to the ETF provider (iShares, Vanguard, Beta Shares, for example) is all it takes for them to arrange a transaction for you.
Fund managers like to offer ETFs because the administration side of operations is outsourced by them to a share registry such as Computershare. The managers don’t have to maintain a database with every holder of their ETF and don’t have to send them statements and other correspondence. Therefore, ETFs save costs. These savings are passed on to investors in lower fees. In fact, fund managers who offer both a traditional managed fund and an equivalent ETF all charge a lower fee for the ETF. As a major contributor to your eventual return on investment who doesn’t want lower fees?
So given these three benefits — broadly diversified exposures, easy access and liquidity and lower fees — what’s not to like about ETFs?
I broadly agree with your comments, but you need to check that the ETF is of sufficient size, is traded frequently and in sufficient volumes. Some of the ETFs are quite small and trade only a few times a day. In these circumstances liquidity may be assumed but not guaranteed. ETFs have not really been tested under stressed circumstances like a market crash. For instance, the Vanguard FTSE Asia ex Japan ETF is only around $50m and on some days volumes are quite thin (e.g. as I write this in the first 2 hours of trade today the volume is sitting at 30 shares or roughly $2000). If I were to put through a big order there could be a significant price impact.
I also don’t like the fact that market makers are trading in ETFs making money through arbitrage. There is an informational asymmetry here that means that professional traders are making money at the expense of individual/retail investors. ETFs promote the market makers as ensuring accurate pricing, but it is more complicated than that and they are not doing it for nothing. I am more comfortable that the price calculated by the managed fund is the actual fair value and the managed fund is not making a profit from my trading at my expense.
Most of the ETFs are also in investments (e.g. equities) which you should really hold for 5-7 years. I don’t think that pushing an argument that ETFs can be traded on a minute by minute basis is a positive step. My managed fund investments are held for years and rarely if ever traded.
You also don’t mention that a lot of managed funds now offer BPay and telephone redemptions. So while the initial investment involves paperwork, once you are invested, a managed fund and a listed fund can be quite similar in ease of access. Investors can also access managed funds through platforms which can be more expensive but also offer greater ease of access.
ETFs are an interesting option, but I have decided to stick with managed funds for my portfolio. If I was starting again now I might have a different view, but I guess my main comment is that as a financial literacy blog I think this article would have been better if it provided both sides of the argument.
Thanks, Steve, for your insights and comments.
You’re right about low liquidity in some smaller ETFs, and I should have made that clear in the post. Some ETFs don’t have sufficient turnover for them to be classified as adequately liquid and investors should be mindful of that.
You’re also correct that being able to trade at any price throughout the day does seem to go against the tenet that investment in both equities an bonds is a long term prospect, so continuous trading is possibly not required or, in some cases, desirable. Vanguard’s founder and former CEO Jack Bogle voiced exactly that concern when Vanguard entered the ETF market in the US, after staying out of it until quite late compared to competitors.
I’ll be more mindful in future of giving both sides of the story, and I’m grateful that you’ve pointed this out to me.