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ETFs can grow wealth and manage risk

Exchange-traded funds have become more popular over the past 15 years and continue to cover a greater range of asset classes. Andrew Doherty examines how investing in them can minimise risk while generating good returns, as well as some fundamental elements to consider.

Exchange-traded funds (ETF) are a highly effective complement to an investor’s direct securities holdings. ETFs assist investors to extend exposures to various asset classes, control risks and achieve portfolio outcomes suiting their specific goals.

Too many investors have little diversity across asset classes. There is often a heavy weighting to Australian shares, the risk being many investors are at risk of not being able to fund their lifestyle should equity markets fall just before retirement. Also, there is often too little exposure to more defensive-type assets, such as government bonds, that provide more certain returns.

ETFs are an opportunity for investors to extend exposures to a variety of asset classes, such as Australian and international equities, fixed interest, property, cash and commodities, as well as equity sectors and certain investment styles. Investors can now construct multi-asset portfolios that produce risk and return profiles suiting their particular needs.

Diversification helps smooth returns over the longer term and limit downside risk as various asset classes tend to behave differently over time. Equities and property values typically rise in value faster than fixed income and cash, but their returns are more volatile.

It is important to get the asset allocation right. Factors to consider are the investor’s stage of life, planned term of investment, requirement for income and tolerance of volatility. For example, a higher weighting to more volatile growth-style assets like equities and property makes sense the longer the investment period, the lesser the need for income, the more extensive the investment experience and the greater the acceptance of price swings.

Accessible, transparent and lower cost

An ETF is a security traded on an exchange that tracks an index or basket of stocks, bonds, commodities or other assets. They trade like a stock in that their prices are updated continuously during market hours, unlike managed funds, which are typically valued only daily. ETFs are also easily accessed as they can be traded on market via existing broker relationships. They are highly transparent in that holdings and weights are published daily, enabling easy oversight of the investment mix.

Costs are significantly lower for portfolios made up of ETFs coupled with direct securities. ETF product fees are typically considerably lower than fees charged by managed funds. For example, exposure to the US S&P 500 can be accessed for a yearly product fee of only 0.07 per cent. This compares to managed fund fees that are often well over 1 per cent a year. There are no product costs associated with direct securities.

Another way ETFs may be more beneficial than managed funds is that turnover of underlying holdings within ETFs is usually less, enabling associated tax savings.

We expect investment returns to be lower in the next few years than experienced in the past five due to the fullness of the asset process and weakness of global growth. It makes more sense than ever to be sure expenses are not biting too deeply into investment proceeds.

Key principles guiding ETF selection

To be sure of choosing the appropriate ETF, the first step is to decide the choice of asset classes and appropriate allocation to suit the investment goals. Investors should preference ETFs from the most financially secure product issuers with the greatest market liquidity so they can be confident their holdings can be readily sold at the appropriate time.

Investors should also favour ETFs with low tracking error, or deviation of ETF returns from market returns, so their investment experience more closely matches targeted exposures.

We are wary of ETFs that are geared or have derivative exposures due to risks relating to counterparties, magnified returns and trading error. All other things being equal, lower fee offerings are preferred.

Among the most popular of investment vehicles

ETFs have been available for over 20 years globally and 15 years in Australia. Now they are among the most popular of investment vehicles. The number and variety of ETFs is growing rapidly. Funds invested in ETFs exceed US$3 trillion internationally, growing by over US$250 billion in the US alone in 2015. There are now around 140 ETFs listed on the Australian Securities Exchange.

Numerous strategy-based or ‘factor-based smart beta’ ETFs are emerging with intended biases in the selection of underlying securities based on size, momentum, value and other fundamental characteristics.

Many factor-based investing strategies appear sound enough, but as always, investors should be aware of what they are investing in. An ETF targeting high-yielding companies, for instance, may contain a heavy exposure to beaten-down resources stocks that may cut their dividends and make the investment carry higher risk than the investor intended.

Similarly, empirical studies and our own experience demonstrate a high-quality bias is more likely to outperform over time, so factor-based ETFs focused on high-quality companies have appeal. However, valuation should never be overlooked. High quality can become expensive, which may limit the performance of this style of ETF for extended periods.

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