What's an ETF and why you need to know

Stick within your ‘circle of competence’, says the Oracle of Omaha. But, as a more conventional investor, his advice might present you with a thorny issue. Stick to what you know well and you risk being insufficiently diversified. Potentially underpriced opportunities could also go begging.

The solution, perhaps, is to outsource. As an Australian investor, you might feel comfortable buying domestic industrial stocks, but not international or resources stocks (this analyst falls into this category). So you might actively manage a portfolio of Australian industrial stocks yourself, but pay someone else to manage the international or resources component (should you choose to have this exposure).

Traditionally, you would have bought an unlisted managed fund or a listed investment company (LIC) to fulfil this purpose. Being unlisted, the former can be a hassle to buy and redeem, while the latter often trade at a price very different to their underlying asset value (as shareholders in Wilson Investment Fund and others will know). Managed funds and LICs can also be costly, with management expense ratios frequently well above 1%.

Exchange-traded funds, or ETFs, aim to overcome these issues. ETFs are, as their name implies, funds that trade on a stock exchange, so purchase and sale is simple. And they are structured in such a way that their prices shouldn’t stray too far from their underlying asset value for very long (we’ll spare you the details of how this works, but it boils down to institutions that are able to arbitrage any difference away).

ETFs should be lower cost than a managed fund. But they’re sometimes not that much lower – the management expense ratios we reviewed ranged between 0.29% and 0.73%. As usual, Australians seem to get a raw deal. We’re aware of overseas-based ETFs that have management expense ratios lower than 0.1%, although greater size probably explains much of the difference.

Being relatively new, only about 40 ETFs currently trade on the ASX. Providers include iShares, Russell Investments, State Street Global Advisers, and Vanguard. When financial advisor commissions cease from 2012, the playing field for ETFs and managed funds should be much more level, with fewer incentives for advisors to recommend the latter over the former.

Index funds

Most ETFs are ‘index funds’, which aim to replicate a stockmarket index, such as the Australian S&P/ASX 200 index (we covered an early ETF which does just that, StreetTRACKS, back on 6 Dec 06). If you want nothing more and nothing less than set-and-forget index performance (except for fees, of course), then one of these conventional index-based ETFs could be suitable for you.

For a dyed-in-the-wool value investor, however, the very nature of index investing presents a conundrum. The reason you do-it-yourself is because you believe you can beat the index, even though research clearly shows that most investors – big and small – fail this hurdle. Rightly or wrongly, some investors hate the idea of effectively owning stocks that are clearly overpriced, as some of the underlying stocks in any particular index fund must be.

Leaving that aside, there will occasionally be periods where entire markets are cheap. If you believe that US stocks are generally inexpensive, for example, then you might consider an ETF that is based on the US S&P 500 index, such as iShares S&P 500 (ASX code IVV). Or, if you thought markets in the ‘BRIC’ economies (Brazil, Russia, India and China) were underpriced, then you might buy iShares MSCI BRIC index fund (ASX code: IBK). Or perhaps Taiwanese, South Korean, or US small cap stocks take your fancy. Where there’s a fee, you can bet there’ll be a product. You’ll find a full list of ETFs on the ASX site.

Sector ETFs are also available. In the past, Australian investors who wanted exposure to consumer brands might buy a managed fund such as Platinum Asset Management’s International Brands fund. Now they can buy the iShares S&P Global Consumer Staples ETF (ASX code: IXI).

Solid gold?

Also worth considering are exchange-traded commodities (ETCs), which provide exposure to metals such as gold, silver, platinum and palladium. We discussed the ETF Gold Bullion Securities (ASX code: GOLD) in our special report The case for gold. Be aware that some ETCs may use futures trading strategies rather than own the underlying physical commodity, however, which introduces another element of risk.

ETFs and ETCs, then, are mainly a diversification tool. To that end, what you buy will depend on your own portfolio and the type of exposure you are trying to achieve. If you don’t own any international stocks, want some exposure and are happy with index-only performance, then you should seek out a low-cost ETF that meets that exposure. Just be aware that currency movements will also affect your returns, as ETFs tend not to be hedged.

Dyed-in-the-wool value investors might use ETFs much more opportunistically. Economic crises, debt defaults and wars occasionally create opportunities in specific stockmarkets. Picking whether individual stockmarkets – as opposed to companies – are cheap is fraught with danger. But it’s possible Greek, Irish or Spanish stockmarkets, for example, are passing through the valley of death (although there aren’t currently any specific Australian-based ETFs for these markets).

As ETFs are mainly an asset allocation tool, the particular investment decisions will depend on your portfolio and preferences. As an easier and lower cost alternative to managed funds, though, they’re worth considering if you’re looking for specific diversification.