Riding the ETF train

Exchange traded funds (ETFs) have been around for a number of years, and investor adoption has been growing strongly. In the past year, the market in Australia has grown by 46 per cent from $8.4bn in July 2013 to $12.3bn in July 2014. As more and more investors become aware of ETFs and their benefits, many advisers are being asked by their clients to explain how they can use ETFs in their portfolios. 

This is not surprising, as ETFs are increasingly becoming a larger component of the overall investment universe.  Over the past 20 years, exchange traded products (ETPs), of which ETFs are the largest part, have grown into a $2.6 trillion investment industry, and this growth shows no sign of abating.  Indeed, in recent months, flows into fixed income and non-US equity ETPs have increased, with fixed income ETP flows on track for a record year, passing US$400 billion in May.  Meanwhile, European equities are on pace for their best year since 2009. 

Advisers therefore have a vital role to play in ensuring their clients understand this growing area, and have the ability to assess and choose the right approach for their own investment portfolio. 

Although the terminology may sound complicated to your clients, ETFs are simply managed funds that can be bought and sold in the same way as listed shares. 

The managed fund structure of an ETF is the same structure that Australian investors have been using to invest for decades. An ETF incorporates all the investor protections of a traditional managed fund, and the ETF assets are held for the benefit of security holders. This managed fund structure is then listed on a securities exchange, allowing investors to buy and sell units in the ETF through their brokerage account, in the same way as other listed investments. 

This attribute of being a managed fund that trades like a security means the ETF provides a simple way for investors to maintain control over their investments in a very familiar way.  

Essentially, the ETF is a structure that packages up individual securities and makes them available on an exchange. Interestingly enough, the example of the shipping container is a useful analogy to how ETFs work. The invention of the shipping container in the 1950s transformed global trade.  Before that, longshoreman would load up bays of wheat manually and individually. It was a system that was inefficient and cumbersome.  The introduction of the shipping container changed all that and revolutionised global trade at the same time. 

Similarly, ETFs “package up” financial assets into the one structure and significantly improve the efficiency of the investment process, by making multiple capital market exposures available in the one “container” on an exchange. And just as the shipping container transformed global trade, so has the ETF transformed investing and portfolio construction.  

Why should investorsconsider ETFs? 

ETFs provide an easy way for investors to maintain control over their investments in a straightforward and cost-effective manner.  

ETFs reduce complexity as they provide diversification though one simple trade on the Australian Securities Exchange (ASX). Without an ETF, investors seeking international diversification, for example, would have to consider making investments in many companies, trading on different exchanges, in multiple countries. 

But by buying one ETF, investors can own a whole portfolio of international securities, giving them a diversified exposure to an entire asset class in an efficient, simple and low-cost manner. It also offers the benefit of liquidity. 

There are different layers to ETF liquidity.  The first is the natural secondary market, that is, buying and selling ETFs. Just like any other listed security, holders of the ETF’s buy and sell units in the investment on the securities exchange. 

Another level of ETF liquidity is the primary market. This is the process that creates new units in the ETF, by buying the underlying shares, or redeems them by selling them.  This creation and redemption process happens every day, ensuring that the ETF is generally as liquid as the portfolio of securities it holds. It also helps to ensure that the ETF price closely tracks the net asset value. 

This liquidity and pricing transparency can be particularly attractive for investors wishing to access asset classes such as emerging markets or fixed interest, which usually don’t provide daily price transparency. 

Benefits for advisers 

There are benefits for advisers who use ETFs, as it is a structure that can help them more efficiently scale their business.  With multiple benchmarks available, advisers can construct fully diversified, cost-efficient portfolios for their clients.   

Following is an example of how an adviser can use ETFs, such as those provided by iShares, to improve investment outcomes. 

As is common practice, the adviser in this example has been using three active managers to build an international equities allocation for a client. However, the adviser was experiencing a number of difficulties managing this portfolio. Re-balancing the active managers was expensive and time-consuming, and the process was also clunky due to the minimums required. 

But by incorporating a small allocation to three ETFs (see Chart B), that broadly matches the active manager portfolios, the adviser now has an easy, low-cost way to control changes in the client’s portfolio. 

Re-balances can now be done simply by trading on the exchange, without going through the administration and expense of changing active manager allocations. 

It has also reduced the cost to the client, as the ETFs used are between one third to one half of the cost of the incumbent active managers, a development that allows the adviser to further demonstrate the value proposition being provided to clients through the advice process. 

It is worth noting that with this strategy it is also possible to add single country ETF exposures in order to play current investment themes, while maintaining a low cost core allocation to international equities. 

In short, ETFs make it easier for advisers to control the risk and return characteristics of a portfolio using specific asset classes. They can round out an incomplete portfolio and provide efficient diversification at the total portfolio level. 

The evolution of the ETF marketplace has provided the flexibility for advisers to use a number of different investment options - including managed funds and individual securities along with ETFs - to finely tune a portfolio’s total risk and returns. 

Jon Howie is head of ETF product and strategy at BlackRock.