ETFs are not always simple index trackers

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Exchange Traded Funds (ETFs) have existed in Australia since 2001, and have grown rapidly in popularity, now exceeding $32 billion in value. Within NAB’s online broking platform, nabtrade, which is heavily dominated by retail investors, ASX-listed ETF trades grew at an annual rate of 59% over the last four years, compared to 20% year-on-year growth for other securities. As investors discover the extraordinary range of exchange traded instruments on global markets, their preferences and trading behaviour are starting to shift. While ETFs may offer the world, they may not be just the simple solution to stock selection challenges that many investors expect.

ETF growth and trading characteristics

The growth of ETFs in Australia can be attributed to the successful marketing of three key features: embedded diversification, a passive approach to asset selection and low cost.

Most share investor now loosely conflate ETFs with index investing, and index investing with being an inexpensive way to access a diversified portfolio. This hypothesis is supported by data from the nabtrade portfolio: the four most heavily-traded ETFs on the domestic market over the four years to August 2017 track the ASX300, ASX200, the US Total Market and US S&P500 respectively. The trades placed to acquire these ETFs were substantially larger than trade sizes for most other direct equities. Turnover is also lower, suggesting that investors are happy to buy and hold these instruments as a simple way to access market returns (less a small fee).

The emerging trend in ETF investing is revealed by the ASX-listed ETF with the fifth highest confirmations, the BetaShares Strong Bear Fund (BBOZ). This product allows investors to take a leveraged short position on the performance of the ASX, generating a 2.0-2.75% return for each 1% fall in the Australian market on a given day. The management costs of the product are 1.38%. This product is neither passive, in the traditional sense of replicating a long-only benchmark, nor inexpensive. It offers an exposure that, prior to the evolution of the ETF market, investors would have had to create utilising Exchange Traded Options.

With the advent of low cost, direct access to international markets, this trend toward more targeted investment selection has grown significantly. nabtrade launched its international trading offer in March 2015. Since that date, domestic investors have traded over 580 individual international ETFs, primarily in the US, and the majority of these do not track the major indices.

Trends in the use of global ETFs

More recently, the top 10 international ETFs traded on the nabtrade platform has included Robotics and Artificial Intelligence, Aerospace and Defence, Biotechnology and Lithium and Battery Technology.  As this list demonstrates, investors are using the ETF structure to access sectors and market positions that would otherwise be difficult or impossible to access in Australia. Of the top 20 most traded international ETFs, only one is broad market long only. The rest offer sector specific, short or leveraged options across a range of markets, instruments and commodities. It’s a far cry from the low-cost passive image ETFs may conjure.

Investors have now witnessed the second-longest bull run in US equity market history, and with global valuations at elevated levels, it is not surprising that investors are either hedging against a downturn or seeking specific assets which they believe have greater growth potential than the wider market. Inexperienced or naïve investors may wish to pursue the sectors that are currently media and market darlings with a relatively limited understanding of both the underlying sector and the relevant instrument. Over 80% of international ETF trades are buys; most investors are new to buying directly on global markets and choose to hold rather than trade their investments.

Low cost does not equal low risk

A word of caution for those who wish to pursue a theme or strategy that ETFs have only recently made possible. Record low volatility may have led some investors to believe that a passive, low cost strategy is also low risk. ETFs now offer the opportunity to benefit from movements, both positive and negative, in a broad range of assets. This exposure comes with a commensurate cost and risk. Many indices the ETF seeks to replicate were constructed with the express purpose of developing a subsequent ETF, effectively making them active investments. The weightings of the underlying investments may be anything but passive.

None of these factors is fundamentally problematic so long as investors have a full understanding of the risks and costs of their investments. Each ETF must disclose a summary of its investment selection methodology and its fees. At the bare minimum, investors should be confident that their objectives align with those of the ETF manager.

Factors to consider in selecting ETFs

Investors accessing sectors or markets via ETFs should consider:

1. What are your investment objectives?

All investments are only useful to the extent they help to achieve an overall investment objective. If your overall investment objective is to exceed inflation, your investment selection will look different to someone aiming to exceed a relevant benchmark (e.g. the ASX 200) or achieve a target rate of return to provide for their retirement. A hot topic or market opportunity, however popular or exciting it sounds, has no place in your portfolio if it introduces a level of risk you do not require or are not comfortable with.

2. What objective is the ETF designed to achieve?

Traditional long-only benchmark ETFs are designed to generate benchmark returns, less a fee. By definition, these products underperform the benchmark, but due to their low-cost nature, generally by only a small amount. There is little to no risk they will generate significantly lower returns than the overall market unless there is a counterparty event (see Synthetics, below). Newer and more sophisticated offerings can be markedly different. The popular ROBO ETF, for example, is designed to ‘provide investors with a liquid, cost-effective and diversified way to gain access to rapidly evolving robotics technology and AI’. Be conscious of short and leveraged ETFs: investors with little or no experience with shorting and leverage may find themselves unprepared for the volatility and potential losses these instruments deliver.

3. Is the ETF replicating a benchmark or actively managed, or some combination of the two?

A passive strategy describes the process of replicating an existing benchmark. It is a basket of securities at ‘market weight’. For example, the S&P500 is universally familiar and many competing managers offer S&P500 ETFs. Investors can be confident their investments will deliver to their benchmark.  At the other end of the spectrum, the popular Blackstone Group Unit Trust ETF is a hedge fund, which by definition is actively managed and does not track a benchmark or index. Other ETFs may use a rules-based approach to investing, or use a new or more sophisticated benchmark. In many cases, this can amount to active management. The ROBO ETF described above, for example, seeks to ‘provide investment results that, before fees and expenses, correspond generally to the price and yield performance of the ROBOGlobal® Robotics and Automation Index’. This index is created and maintained by ROBOGlobal, the creator of the ROBO ETF. Given the relatively recent emergence of this field it is not surprising that no traditional index existed, but where the manager both creates and replicates an index. Investors should take care to understand how that index is constructed and take a deeper look at the underlying investments than they may need to do with a more widely recognised benchmark.

4. What are the underlying investments of the fund?

With more sophisticated ETFs, the investor should undertake a due diligence on the investment strategy and underlying investments of the product to ensure they have a full understanding of the investment they are making. Each ETF provider publishes a fund summary, a prospectus and a summary prospectus, as well as plenty of information on their websites to assist investors in understanding their portfolios. The popular Lithium and Battery Tech ETF, for example, has a hosted webinar on lithium on its website, along with videos and white papers for prospective investors. Investors should look at the underlying companies in the portfolio, where they are domiciled, their returns and prospects and so on. An investor may believe themselves to have made a relatively vanilla investment, although the underlying portfolio may be volatile or highly speculative.

5. Is the product ‘real’ or synthetic?

A synthetic ETF is one which does not purchase the underlying index securities on behalf of the investor, but instead guarantees the return of that benchmark by using derivatives or other instruments to execute an agreement between the ETF and a counterparty. There is a risk that the counterparty (usually an investment bank) may default, called counterparty risk, and the investor is left with nothing, as they are not entitled to any underlying securities. Much has been written on this subject and it does not apply to most commonly purchased ETFs, especially in Australia, however investors should ensure they are aware of this issue before they consider any investment.

6. How much does it cost?

ETFs are generally perceived to be an inexpensive way to access a basket of securities or pooled investments. As the products on offer become increasingly diverse and sophisticated, this is often no longer the case. The fees for popular sector-based ETFs are sometimes in excess of 1%, which may bring them closer to (and in some cases, exceed) the fees charged by active fund managers. While cost should not be the primary driver of any investment, cost fundamentally impacts the net return (a fact which the ETF industry has successfully impressed upon investors who have used them to purchase traditional indices). Some of these fees may be justified given the complexity of the underlying portfolio, but for others, the price may result in suboptimal returns to the investor.

This list is not exhaustive, but the trend toward sector-specific and targeted instruments offers investors an unprecedented opportunity to invest or trade according to their convictions. However, a misunderstanding of the structure in which the assets are housed may result in more risk than investors appreciate.

 

Gemma Dale is Director, SMSF & Investor Behaviour at nabtrade, a sponsor of Cuffelinks. nabtrade offers free independent research on each ETF available via its platform, both domestic and international. This article is general information and does not consider the circumstances of any investor.

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2 Responses to ETFs are not always simple index trackers

  1. Ramani November 9, 2017 at 3:32 PM #

    I have found the unseemly feuding (real or stage-managed) between ETFs (a deemed proxy for passive investing) and active managed funds in search of the elusive beta counter-productive. There is a case to explain / argue active and passive styles but taking polarised positions is counter-productive, especially if we have to crack pervasive disengagement and resulting illiteracy.

    Sensible active managers will take a passive style if they judge the market overvalued, too illiquid or choppy. Equally ETFs and passives are not totally passive: they offer active choices in terms of industries, style, region, currency hedging, markets and stock positioning therein etc. This calls for the investor to choose actively, and get things right / wrong / in between.

    The extreme passive investment would be not to invest at all (stuff money into pillows).

    Some balance would be nice.

  2. Steve Martin November 15, 2017 at 3:32 PM #

    A great article. ETFs are a maze with the variety and choice of funds on offer. They are incredibly enticing; even the index funds. I must admit, despite their popularity since the GFC, ($3 trillion in the US and about $25 Billion in Oz), I have steered clear. Their growth since the GFC makes me worried about what happens when there is a down turn/ correction/ recession. This volume of money in open end funds held by at least in part, unsophisticated retail investors, just looks to me like a stampede waiting to happen. The index funds have to sell. I assume the active funds will have to sell to meet redemptions. The short funds will be like a mosquito that hits an artery, and the additional funds shorting the market will add to the stampede. I suspect it will be the ETFs that will be the cause of much reflection after the next major dip. I am going to wait until they have been stress tested on a downturn before I get into them.

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