Not all ETFs are created equal

As competition in exchange-traded funds increases, it is important for financial advisers and investors to know exactly what they are buying and from whom, according to Tom Keenan. 

Competition is rapidly increasing in the Australian exchange-traded funds (ETF) market, with two new local issuers launching ETFs recently. Other issuers are expected to enter the market this year.

The Australian ETF market saw spectacular growth in 2009 with market capitalisation rising 151 per cent, according to the Australian Securities Exchange (ASX). There are now 32 ETFs listed on the ASX.

Growth of the ETF market in Australia is expected to continue to outpace BlackRock’s estimate of 25 per cent to 30 per cent global ETF market growth over the next five years, as the market matures and more investors understand the benefits.

This is good news for investors and financial advisers, as more competition creates greater product choice, however, it also means that investors must look closely at not just the ETF, but who is issuing it.

Many investors mistakenly believe all ETFs are the same because they replicate an index, however, ETFs can have important differences, and the expertise and support offered by the issuer is crucial.

As more providers emerge, investors will have to think carefully about the structure and objectives of the ETF. The most important considerations are:

• How is the ETF structured?
• What is the issuer’s track record?
• Does the issuer have extensive experience in managing index investments?
• Is the issuer dedicated to providing support, education and other resources for investors?

Product and structure

ETFs offer liquidity, transparency through to the underlying stocks and low costs. These benefits allow ETFs to be a useful tool for investors. An increasing number of investors like the do-it-yourself ease of trading ETFs like shares on the ASX.

All the ETFs listed on the ASX are physically backed by the underlying stocks. This means that investors are purchasing a portion of the underlying companies in the weightings that correspond to the index.

The ETFs listed on the ASX provide a vast array of exposures: global, regional, single country and sector exposure to overseas markets, and local broad and sector specific options.

Although ETFs generally aim to track an index, there are differences in what this means for investors. Some ETFs provide exposure to overseas currencies, as well as overseas markets, others are domiciled in Australia and provide access to franking credits.

Another ETF tracks an index based entirely on private company research.

These differences mean that it is important for advisers and investors to look 'under the hood'.

The economies of scale

Scale is vital. Local ETF issuers that can leverage off their parent’s global product suites are well placed to offer lower management costs for investors in ASX-listed ETFs.

Scale can also lead to tighter bid/ask spreads for an ETF’s market price. The difference between an ETF’s buy and sell price is usually lower for larger funds with more assets under management and higher daily trading volumes.

New ETF issuers may experience lower liquidity if they are not well known or if their products cover unfamiliar indices. Lower liquidity could lead to a wider bid/ask spread, thus higher trading costs. Advisers should always assess the expected liquidity of a new ETF before investing.

Scale provides another key benefit:

• More expertise within the ETF issuer to accurately capture a particular market or asset class through sound ETF construction and management; and
• Lower tracking errors — the degree to which an ETF deviates from an underlying index.

Demand for ETFs

Australia’s ETF market is driven by some powerful trends that also affect ETF markets in some other advanced economies including:

• Strong interest in low-cost investments that are simple, transparent and flexible;
• Growing awareness of the role of index or passive investing in portfolios and strategies — such as core and satellite — that use index in the core to replicate market returns, combined with satellite investments to outperform markets; and
• Financial reforms to ban commissions to financial advisers.

Self-managed superannuation fund investors are among the largest retail segment in Australia using ETFs, attracted to the easy way they can include ETFs in a portfolio and achieve international exposure.

Australian institutions and sovereign wealth funds are also increasingly using ETFs as useful investment tools for tactical portfolio adjustments and achieving market exposure to countries such as emerging markets, Europe, America and China.

According to a Greenwich Associates survey conducted on US institutions in April 2010, more than half of all institutions that already use ETFs in the US expect their usage to increase over the next three years.

In addition, the Federal Government reforms that ban commission payments are a welcome development, and are expected to lead to greater use of ETFs as more advisers adopt fee-based payment structures.

The move of many financial advisers in the United States to a fee-based payment structure was a catalyst for huge growth in the ETF market there.

Other considerations

Other important questions investors should ask before using ETFs are:

• Is the index well known to the local investors?
• Is the ETF a true fund, investing into the shares and holding them direct, passing on dividends to investors — or does it include complexities such as leverage or derivatives?
• Does the index track the market or, if not, what underlying index is the ETF tracking?
• Are the securities in the underlying index liquid?
• Are there clear benchmarks to compare index performance? What is behind the index — do a handful of securities dominate?

There are many reasons to buy an ETF — the benefits that drove their growth overseas and during the global financial crisis are just the beginning.

But as the local market focuses on this growing sector, Australian investors will need to become more knowledgeable about ETFs, particularly as they offer some of the most logical exposures to local and international markets.

Tom Keenan is director of ETF specialist iShares.