ETFs: Transparent, cheaper and liquid

EVERYONE’S looking out for the next big investment theme and exchange-traded funds (ETFs) are one of them according to highly regarded fund manager Robert Kapito.

As the founder of fund-management giant Blackrock, which has a staggering $10 trillion under management, his words carry weight.

Kapito’s vision of the immediate future? “Everything that can be ETF-ed will be ETF-ed. They are transparent, cheaper and liquid; and a better wrapper for any investment.”

No excuses

Transparency is important because, as State Street’s Meaghan Victor says, “The ability to take a look under the hood at an individual stock level allows investors to truly understand their portfolio holdings, the overall cost of their investments and make timely, informed investment decisions.” Investors therefore have few excuses to not know exactly what they are holding in each ETF.

In addition, Victor – the head of SPDR ETFs (Australia and Singapore) for State Street Global Advisors – says, “Taking advantage of the transparent structure of ETFs can help investors take charge of their investment goals.

“Transparency provides investors with the tools to clearly understand where their ETF portfolio is invested. Additionally, it is important for investors to capitalise on this transparency to ensure the stocks held in each fund align to their stated investment strategy.”

This alignment is especially important for self-managed super fund trustees, given the Australian Taxation Office’s focus on ensuring that an SMSF’s investment portfolio aligns with a meaningful and written-down diversified investment strategy.

This diversification is made easier by the changes that have taken place in ETFs since their inception.

Traditionally ETFs were used as a tool to gain market-cap exposure, such as accessing Australia’s largest 200 securities in a single trade. Over the years, this has evolved to include smart-beta or factor investing.

These strategies seek to capture specific factors or investment characteristics that active managers commonly seek exposure to, while preserving the benefits of traditional indexed investments.

Income stream

Today, with the increased proliferation of ETFs, investors can access a number of market segments and asset classes such as real-estate investment trusts (REITs), global equities, emerging markets, currency, fixed income, commodities and smart beta.

This means that in a low-interest rate environment, many investors can turn to certain ETFs to provide an income stream.

Traditionally, accessing the top 100 stocks based on dividend yield would be expensive and difficult for many investors but new ETFs have provided an easy and cost-efficient way to access this opportunity.

Humble beginnings

Another market segment that ETFs can access is small caps, which many investors choose to invest in because they can offer explosive growth opportunities – after all, most of today’s large successful companies started small – but the drawback is that many of them also fail.

By investing in a broad-based small caps ETF, investors can balance out the risk and, if small caps as an asset class do rise, benefit from this overall increase.

Another tempting asset class that ETFs make easily accessible is emerging markets.

These are economies such as China and India that, since 2000, have grown materially faster than developed economies.

For example, between 2000 and 2018, China’s gross domestic product grew more than 11 times and India’s sixfold. Over the same period, the US grew by a factor of 2 and Australia by 3.6.

Not only is the rate of growth impressive but also China grew by more than the US in absolute terms and India added twice Australia’s absolute GDP growth.

A rare combination

Research shows that cheap stocks with sound businesses tend to outperform more expensive stocks (value), healthy companies tend to tend to outperform less healthy companies (quality) and lower volatility stocks tend to generate a higher risk-adjusted return than high volatility stocks.

In today’s environment of heightened market uncertainty, this combination of characteristics offers both defensive risk and growth potential.

Until recently, finding an investment vehicle in the local market that seeks to capture multiple factors was impossible.

But with the introduction of smart-beta ETFs, retail investors now have access to sophisticated portfolio-tilting strategies that were only available to institutional investors.

One of these ETFs is the SPDR MSCI World Quality Mix Fund (QMIX).

ETFs can also help manage your currency exposure, which is important because foreign exchange fluctuations impact unhedged international equity returns.

An ETF that covers large and mid-cap companies outside Australia can hedge away currency exposure.

LICs licked

Some investors may consider listed investment companies (LICs) as an alternative to ETFs.

These are listed companies that invest in the shares of other listed companies.

Unlike ETFs they are “closed ended” with a limited number of shares on issue, while ETFs are open ended.

This means ETFs are more liquid because they issue and redeem units on a daily basis, based on investor demand.

Also, few LICs disclose their full investment portfolio and some don’t pay fully franked dividends.

It’s therefore no surprise that in the September 2019 quarter the combined market caps of the approximately 100 Australian listed LICs retreated by $827 million to $43.8 billion compared with $4 billion of inflows into ETFs, which now account for $60 billion of market assets locally.

A word of caution

Not all ETFs are the same! While there are many things investors should consider before investing in ETFs, State Street’s Victor says there are a few things to take into consideration.

In a low-yield environment every cent and every percentage point counts, so it’s vital to look beyond the headline up-front cost of any investment and consider the total cost of ownership (TCO).

Victor says, “To determine an ETF’s TCO, ‘go beyond the expense ratio’. It’s a phrase we repeat often at State Street Global Advisors and during meeting with clients: when selecting an ETF you need to look beyond the expense ratio to determine a fund’s total cost of ownership. Why? Because using the expense ratio as the sole factor when selecting an ETF without considering additional variables, especially how you will invest and trade that fund, could wind up costing you more money in the long run.”

She says the way to do this, is to be sure to “evaluate the ETF’s management expense ratio (MER), trading commissions and the bid/ask spread, as together they make up the ETF’s TCO”.

It’s also important to remember that these days not every ETF is physically backed by the assets it tracks.

Physical ETFs typically invest in all the securities in the index or a representative sample; a synthetic ETF uses derivative products to replicate the index methodology.

Legacy

State Street’s expertise in ETFs is largely due to the man known as “The Godfather of ETFs”, Jim Ross.

He joined State Street in 1992 and was instrumental in creating, developing and bringing to market many of the world’s first ETFs.

Although he announced his retirement in November 2019, he leaves behind a powerful legacy.

By investing in ETFs, investors now have the opportunity to take the lead and make more informed decisions to shape their portfolios with greater accuracy.

The information provided is the opinion of the author. The AJN recommends that readers seek independent financial advice.

Wealth management