ETF: a tasty morsel

Volatility in the sharemarket and the realisation that even the experts can't always pick winners has investors flocking to the latest hot investment product exchange-traded funds (ETFs).

ETFs have been a growing phenomena in the US for more than a decade and, although first introduced in Australia in 2001, are just starting to hit a chord with investors looking for a low-cost, diversified share portfolio they can monitor themselves.

ETFs are index funds listed and traded on exchanges such as the Australian Securities Exchange in the same manner as shares.

Index funds avoid guessing which investments will outperform in the future by investing in all or most of the major securities available in a market or sector.

As fund managers are not being paid to outperform the index by picking sectors and shares they think will do well, the cost of index funds tends to be cheaper than the actively managed alternatives.

For example, an Australian investor can gain exposure to the top 200 companies by buying a single ASX-listed ETF with management expenses and fees of 0.28 per cent a year. According to ratings agency Morningstar, the average annual cost of the retail managed fund equivalent is 1.86 per cent.

There would, however, be brokerage costs because ETFs are traded through a broker.

A stockbroker at Ord Minnett, John Kimber, says ETFs are the "cheapest, most transparent, most liquid way of getting broad market exposure and limiting risk by diversifying across a broad range of stocks listed across a sector". The range of Australia-listed ETFs covers securities that may include Australian shares, international shares, commodities, listed property trusts or a combination of asset classes.

There is a handful of financial institutions issuing ETFs including the Barclay Global Investors-owned iShares, State Street's SPDRs, Vanguard Investments and ETF Securities' exchange-traded commodities.

The vice-president and head of the global structured products group at State Street Global Advisors, Susan Darroch, attributes the growing popularity of ETFs to a resurgence in indexing generally, as well as to a move away from commission-based financial advice to fee-for-service.

Darroch says a focus on investment returns after fees and taxes highlights the benefits of indexing. She says the investor's ability to gain access to a diversified portfolio of shares in one transaction is a further advantage of ETFs. And, like shares, ETFs may make regular income distributions.

WHEN TO USE THEM

A consultant with Melbourne financial planner Godfrey Pembroke Camberwell, Mike Ingham, uses ETFs to build a "core" exposure to specific asset classes when constructing a client's portfolio.

"ETFs are a much cheaper and more tax-effective way to capture the performance of a market when compared to an actively managed fund," Ingham says.

"I also like ETFs in these uncertain times because they are generally a lower-risk investment option for my clients. They give them exposure to a broad spread of securities in each sector and they are less susceptible to the performance movements of a single investment. They are also a safer option because an active fund manager may take the wrong investment bets and significantly underperform the market."

Ingham says clients also like them because they can track their price much as they would any other listed share on the ASX.

But wholesale managed index funds may be a preferred option over ETFs for clients with a regular investment strategy, such as dollar cost averaging, because the transaction costs are usually lower.

"The cost of a 'buy' spread on an index managed fund is usually less than the brokerage costs when regularly buying small holdings in an ETF. However, this is not necessarily the case when an investor cannot invest in a wholesale managed index fund because of the minimum investment requirement or they are not investing through a wrap account or master trust," Ingham says.

"In such cases I prefer ETFs because over the medium to long term their much lower ongoing management expense will more than compensate for the higher upfront transaction costs."

WHAT'S AVAILABLE

The list of ETFs is growing all the time, with three financial institutions and one independent group so far dominating their issuance in Australia.

The range includes about 30 ETFs covering Australian indices, international indices, commodities and sectors, all of which are traded under unique codes on the Australian Securities Exchange (ASX).

The issuers of broad-based Australian-indexed ETFs are State Street Global Advisors, whose ETFs trade under the brand name SPDRs, and Vanguard Investments.

The issuer of International ETFs is Barclays Global Investors (BGI), whose range of ETFs trade as iShares, while Vanguard also has a US and All-World ex-US ETF.

The sole issuer for Exchange Traded Commodities (ETCs) is ETF Securities, which has so far issued four precious metal ETCs including gold, platinum, palladium and silver as well as a basket of all four.

There are also four sector ETFs available to trade on the ASX offered by iShares and State Street Global Advisors, covering global healthcare, global consumer staples, global telecommunications and Australian Real Estate Investment Trusts.

PRECIOUS METALS

For the past three years gold has been the only exchange-traded commodity but recently silver, platinum, palladium and a basket of all four have become more accessible.

Similar to ETFs, Exchange Traded Commodities (ETCs) track the performance of an underlying physical commodity or commodity index. An ETC gives an investor direct exposure to the underlying commodity without the need to trade futures or take physical delivery of the commodity. In the case of gold, one ETC unit entitles the investor to 0.098062706 fine troy ounce and for silver it is one troy ounce.

The head of sales for Australia and New Zealand at ETF Securities, Nigel Phelan, says demand for ETCs has picked up since the financial crisis hit.

"There is no counter party or credit risk and investors can actually own the precious metal, which makes it a very attractive investment," Phelan says.

The market for ETCs is based on the underlying commodity itself, with so-called market makers making two-way prices over the course of each day. According to the ASX, the market makers help ensure the market price of the ETC tracks its net asset value (NAV). Phelan says ETCs replicate the performance of the underlying commodity or commodities index, which means the value would usually move alongside the price of the commodity or index.

For more on ETFs, see asx.com.au/products/etfsetcs/index.htm.

> PROS

Lower fees No entry or exit fees and low management expense ratios compared with unlisted index funds and managed share funds.

Liquid Like shares, you can buy and sell quickly. Market makers are obliged to make two-way prices daily.

Transparent ETFs are quoted on the ASX and can be traded whenever the exchange is open. With unlisted funds, investors learn the buy-sell price when they put in an application or redemption notice. The daily closing price is the likely sale price.

Tax Earnings are distributed untaxed to investors and may include franking credits. Capital gains taxes are lower due to less active trading.

> CONS

Stockbroker fees Fees are, in effect, like entry-exit costs.

No regular contributions If you want to add to your holding you have to go through a broker to buy more units, making additional investments potentially expensive. Investors in managed funds can make small, regular contributions to a fund at a lower cost.

Equity risks The price of an ETF unit will fluctuate according to how the underlying securities are performing and so prices can drop.

CASE STUDY

Financial consultant Ian Maxwell has invested in exchange-traded funds as part of a US investment portfolio for six years.

"One of the problems with the Australian market has been the under-representation on some sectors such as health care and food," he says. "At the time the US ETFs provided good diversification for my portfolio.

"As part of the diversification of my overall portfolio and discussion with my broker, it was decided I should have exposure to other markets and sectors through ETFs.

"My holdings are partly sectoral and partly geographical, including in Japan, Brazil and other emerging markets and in the energy and material sectors."

As the trustee of his own self-managed super fund, Ian finds ETFs more flexible, cost-effective and tax-efficient than managed funds.

While the investment horizon for his super fund might be long term, he also likes that ETFs are quoted and traded on a daily basis, making the prospect of a buy or sell transaction easier than selling units in a managed fund.

"ETFs are a flexible way of getting exposure to general markets or sectors which are not available on the stock exchange in other forms," he says.

The co-head of iShares Australia, Tim Bradbury, says ETFs combine the advantages of shares with the benefits of index funds: like shares, they are liquid, flexible and easy to use like index funds, they offer diversification, market tracking and cost-efficiency.