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Exchange Traded Funds (ETF’s)


Diversification made easy (with low fees!)

 

created by John Cahill

23 December 2010

 

What is an ETF?

ETF’s are ‘Exchange Traded Funds’. ETF’s are ‘managed’ funds that are traded on an exchange...in Australia that exchange being the ASX (Australian Stock Exchange).


ETF’s are very similar to buying into a managed fund provided by companies such as Colonial, Perpetual and UBS, but have several major differences.


An Exchange Traded fund is an (index) fund that mimics a particular index (or collection of shares), such as the ASX200 or the Dow Jones/S&P500, so by buying 1 ETF unit you actually give yourself exposure to hundreds of different shares, so your risks are reduced.


There are ETF’s that track markets in Australia, USA, China, Hong Kong, Singapore, South Korea, Taiwan and Japan, just to name a few.

There are ETF’s that track regions such as Asia, Europe, Emerging Markets, BRIC (Brazil, Russia, India and China), and the Global market.

here are Sector ETF’s that track sectors in the Australian markets including Banks (Financials), Resources, Metals and Mining, Real Estate and Energy.

There are even Commodity ETF’s (known as ETC’s) that track commodities including gold, silver, platinum and palladium.

 

ETF’s – the next big thing?

You may have only just started hearing about ETF’s in the media and this is because it has only been in the last couple of years that different ETF’s have become available in Australia.


ETF’s have been around for about 10 years in the US and Europe, so it is interesting to examine the trends there as a guide as to what to expect in Australia. The ETF market in the US has grown to a point that there are over 700 different ETF’s with nearly US$1 trillion invested. Even more amazingly, every day there is more than $40 billion in turnover of the US’s largest ETF (SPDR S&P 500). This compares to the most actively traded stock – Apple, which only manages a modest average of US$6 billion.


What’s more, nearly 80% of all new capital being invested in the US share market is going into ETF’s and ETF’s in the US are now attracting more capital infows than managed (mutual) funds.

 

How much does it cost?

ETF’s are very low cost.

As a comparison :

    The SPDR ASX2000 ETF has a management fee of 0.28%. (No Minimum)

  • The Colonial Wholesale Australian Index Fund has management fees of 0.41% ($100,000 minimum investment). This is a passively managed wholesale index fund.

The Colonial Retail Australian Share Fund has management fees of 1.78% ($1,000 minimum). This is an actively managed retail fund.

So the difference in management fees on a $50,000 investment between the ETF and equivalent retail fund is $140 as opposed to $890 which is 1.5% or $750 every year.

 

How do ETF’s work?

In the case of the SPDR ASX200 ETF (stock code STW.ASX) the funds manager attempts to exactly replicate the performance of the ASX200. So (without accounting for fees) if the ASX200 goes up 1% the ETF goes up 1%.

In order to replicate (or track) the index, the funds manager needs to buy the underlying stocks that make up the index in exactly the same proportions as the index. Standard & Poors provide data detailing what stocks make up the index in Australia and the US by taking the market capitilisation (share price multiplied by the number of shares on issue) of each of the top 200 stocks (for the ASX200) and adding them together to get a total. They then take a particular stock and divide the market capitalisation of the stock by the total of all stocks to get an index weighting.
For example, BHP currently makes up approximately 13% of the ASX200, so if buying $1,000 of ASX200 ETF’s, you are effectively buying $130 of BHP shares.

 

Passive investing vs Active Investing

There are two primary methods funds managers use to invest. One is Passive Management and the other is Active Management.

Passive management is where the funds manager attempts to replicate the results of an index. ETF’s are an example of passive management.

Active management is where the funds manager tries to beat the index.

Many people say that it is impossible for a funds manager to beat the index over the long term. In the short term, a funds manager may outperform, but it is not possible to outperform the index in the long term and therefore passive management will give better returns.

There is a long and ongoing debate about whether active or passive is better, and different people will have different points of view, although you can be sure a funds manager will say active management is better because that’s what keeps them in a job! Our view is that ETF’s should form part of a diversified portfolio consisting of both actively and passively managed funds.

One needs to always remember that a passive investment strategy is simple mathematics and is all administered by computers. The index says you need x percent in a stock so the computer automatically allocates that portion of your portfolio to that stock. Active management on the other hand is largely human administered and requires many extra costs such as stock analysts and research teams which inevitably always means that there are more costs and so you pay higher fees. Thus, passive management not only needs to beat the index, they need to outperform even more to pay for all the extra costs involved.

We do not favour active or passive investing...both have their place. However now that you know the difference it may help guide you to manage your portfolio in the most effective way.

 

Advantages of ETF’s

Diversification - ETF’s provide diversification through one stock...providing exposure to many different stocks.

    No Minimums – As opposed to managed funds, there is no minimum investment. Wholesale Managed funds usually require more than $100,000 to access the low fees, however you can invest in ETF’s with only $1,000 if you want.

    Cost Effective - Amongst the cheapest form of investing in a fund of stocks. Compares very favourably against the typical managed funds offered by funds managers such as Colonial and Perpetual.Highly Liquid - As the funds are listed on the ASX, they are highly liquid and can be bought and sold immediately, any time the ASX is open.

    What you see, is what you get - As the price is listed, you know the price that you are buying or selling at. This is different to managed funds where you often don’t know the exact price...especially when have to mail off an application which may be processed several days later.

    Accurate Value - As opposed to other listed funds managers, ETF’s reflect the value of the underlying assets. There is no premium paid for using a particular manager.

    Tax Effective – There is much less churn in ETF’s meaning that there are less capital gains being realised. That means you pay less tax and the value of you assets are not diminished.

     

  • Disadvantages of ETF’s

As the funds are listed on the ASX, you require a brokerage account, such as those offered by full service brokers (eg: Macquarie, JB Were) or discount brokers (eg : Comsec, E*Trade). Effectively buying 1 unit (share) in an ETF is the same process as if you wanted to buy 1 share in BHP, Woolworths or any other share listed on the ASX.

    When you buy or sell shares on the ASX through a broker you have to pay brokerage fees. These fees vary from 0.001% up to 2.0% depending on whether you use a discount broker or a full service broker, and the size of the purchase . The standard rate for a discount broker is around 0.12%

     

  • Who provides ETF’s in Australia?

There are four companies that provide ETF’s in Australia :

iShares and SPDR’s are the largest and most popular ETF’s and are backed by large international companies.

 

Are ETF’s just a fad?

No. They are a serious alternative to managed funds, offering greater diversification and lower fees.

In Australia we are about 10 years behind the rest of the world with regards to ETF’s. In the US, they went a bit ETF crazy and set up far too many ETF’s for obscure things. As a result they could not get the capital invested in these ETF’s and there has been a rationalisation of the ETF offerings in the market. In Australia we are really just at the beginning and we can expect to see many more ETF offerings in the new year. Ishares have already identified several new ETF’s that they will be releasing very early in the new year. In the future there may be hedged ETF’s, more commodity ETF’s, international sector ETF’s and even ETF’s based on new index’s devised by using fundamentals rather than market capitalisation.

 

Are ETF’s high risk?

All investments contain a varying degree of risk. Even having money in a bank account, is risky, albeit low risk, as there is the risk that the bank will fail and not be able to pay your money back. Whilst ETF’s are considered riskier than cash, they are not inherently high risk and as part of a diversified portfolio they can actually lower your risk.

 

Do ETF’s mean there is no need for a financial planner?

Whilst the ETF has been around for a while, they are only just beginning to be adopted by financial planners as part of a diversified portfolio. There are many reasons for this but largely it has been because the products are either not understood or there have not been the appropriate type of products available.

At Fusion Partners we do not see the ETF as a replacement or all encompassing solution. If using ETF’s we prefer to use a ‘Core and Satellite’ approach whereby a mixture of ETF’s create a core portfolio and we use more specialised ‘satellite’ investments to complete the portfolio.

Further Resources

ASX – Information of ETF’s and ETC’s
State Street SPDR ETF’s
Vanguard Investments ETF’s
Australian Index Investors
Russell Investments

 

Disclaimer

* Risk - although gauged to be a low risk investment the FHSA is still subject to legislative risk (risk that the government of Australia cannot or will not contribute the 17%) and corporate risk (the risk that the deposit taking institution or bank either fails and the account balance is lost or it cannot or will not pay interest  on any balances).
This article has been prepared for clients of Fusion Partners Central Coast (FPCC) ABN 37 113 405 218 and others on request.

This article has been prepared for clients of Fusion Partners Central Coast (FPCC) ABN 37 113 405 218 and others on request.

The article is based upon generally available information and is not intended to be, or to replace specialist advice in the areas covered but rather, the article is intended to be informative and educational only.

Although the information is derived from sources considered and believed to be reliable and accurate, FPCC, its employees, consultants, advisers and officers to the maximum extent permitted by the law disclaim all liability and responsibility for any opinion expressed or for any error or omission that may have occurred in this document.

This article may contain general advice which is defined in the Corporations Act to mean that we have not taken into account any of your personal circumstances, needs or objectives. It is therefore imperative that you determine, before you proceed with any investment or enter into any transactions, whether the investment or transaction is suitable for you in consideration of your objectives, financial situation or needs and you must therefore, before acting on any information included in this article, consider the appropriateness of the information having regard to your personal situation. FPCC recommends that you obtain financial and tax or accounting advice based on your personal situation before making an investment decision.

All investments should be made with consideration of risk after reading the FSG and PDS of the product provider, and after obtaining professional advice from a financial planner.

This article was created by John Cahill, based on legislation in place at the time.  Legislative changes may mean that this information is no longer current.  You should speak to your financial adviser.