ETFs boom. Why am I not surprised?

Think back to 2002. John Howard was Prime Minister. Ansett Airlines went into liquidation, and an Aussie speed skater took out gold in the winter Olympics when all the other competitors in the race crashed in front of him. 

But behind the scenes, an event occurred that you'll be hard-pressed to find in many almanacs of 2002.  

That was the year that exchange-traded funds (ETFs) arrived on the ASX for the first time. Two decades down the track and we can see what a massive game changer they have proven to be. 

This month, the ASX announced that ETFs have almost hit a record market capitalisation of $200 billion, up from $10 billion a decade ago. It's extraordinary growth and with it has come increased choice for investors.  

Today, we can mix and match from more than 350 ETFs spanning all the major asset classes plus commodities, currencies and cryptocurrency as well as opportunities to invest in line with a theme.    

Low-cost diversification 

The success of ETFs comes as no surprise to me.   

Managed funds have been around for decades - far longer than ETFs. However, like ETFs, they have always offered the appeal of diversification.  

ETFs, however, took the idea of 'index' investing into the mainstream.  

Not all investors are fans of the index or 'passive' approach, where a fund aims to match market returns. This was especially the case back in 2002 when the concept was still relatively new.  

It is perfectly reasonable to want to beat market returns. It's just exceptionally difficult to do year after year.  This has been highlighted many times by the SPIVA Australia Scorecard, which measures the performance of actively managed funds in Australia relative to benchmarks over various timeframes.  

The year-end 2023 SPIVA report found more than three-quarters of actively managed Aussie share funds failed to match the 12.4% gains of the ASX 200 last year. Underperformance rates are even higher over the long term.   

Pushing fees down 

The real strength of ETFs has been their influence on fund fees. A quick check of the ASX website shows many ETFs charge annual fees below 0.5%. Some even charge fees of less than 0.05%. That's incredibly low.  

To put this in perspective, back in 2002 I wrote in my book Making Money that managed funds charge entry fees of up to 5%, ongoing fees of up to 3%, and exit fees as high as 2%. With those sorts of fees, an investor may have needed to earn a fund return of at least 10% just to break even. 

These sorts of fees seemed perfectly acceptable at the time. Looking back, I shake my head at what investors were asked to pay. 

The importance of fees can't be overplayed. Returns are uncertain. Fees are set in stone. They act as a drag on returns, and you will pay fees no matter whether a fund delivers a loss or a gain.  

What lies ahead? 

There is no doubt that ETFs have been one of the most exciting innovations we've seen in investing in many years.  

Of course, no investment is without its downsides. While it's possible to build a portfolio based largely, or entirely, around ETFs, it's important to avoid doubling up. A global shares ETF, for example, may have a high weighting to US tech stocks. So, if you also invest in a tech-focused ETF you could be looking at a fair bit of overlap, which can increase the risk and reduce the diversity of your portfolio.   

This year saw ASIC update its ETF labelling requirements, which is helpful for investors to know what they are putting money into. That said, there is no substitute for checking an ETF's online factsheet for a clear picture of the fund's underlying investments.  

As ETFs have become popular, actively managed funds have started to list on the ASX. An easy way to know a fund's approach is to jump onto the exchange-traded products page of the ASX website, which notes if ETFs are 'index tracking' or if they aim to 'outperform' (actively managed). Just being listed as 'outperform' is no guarantee a fund will achieve this.  

The main point is that ETFs are continuing to evolve. How much of a role they play in your portfolio is a matter of personal choice.  The 2023 ASX Investor Study found that 20% of Australia's 7.7 million on-exchange investors hold one or more ETFs, and I expect this figure will grow over time.