ETFs for every taste

PORTFOLIO POINT: There is an ETF to suit every risk appetite, and they offer DIY funds a simple way of building a portfolio.

Investors have every right to be wary of exchange traded funds (ETFs) in the wake of the huge losses they sustained during the GFC, and the role played by complex financial products such as CDOs in that disaster.

But before you tarnish all ETFs with the same brush, it’s worth examining the different varieties available and how they can deliver low-cost exposure to the one of the best-performing asset classes over the long term: equities.

For the most part ETFs, which have been around for the past 21 years, are no different to index funds that are bought and sold on the ASX and, in our opinion, represent an important leap forward in financial services.

When we wind back the clock, there are surprisingly few innovations that can truly claim to have reshaped the investing landscape for the better.

The first company to issue stock, the Dutch East India Company, was formed in 1602 and the world’s first stock exchange was opened in Amsterdam soon after. The Dutch exported these concepts to their fledgling colony, New Amsterdam, which was later renamed New York by the British, where the concepts were developed.

In the late 19th century, two reporters from New York, Charles Dow and Edward Jones, created the first market index to measure stock price movements, which they published in a small newsletter with a circulation of several thousand.

The named the index the Dow Jones Index and the small newsletter eventually become the Wall Street Journal.

Not long after that, in the early 20th century, a group of Boston academics pooled their knowledge and wealth to create the world’s first actively managed fund, and in 1975 Jack Bogle put his theory about passive investing into practice and launched the world’s first index fund, the Vanguard 500.

At the time, each of these innovations challenged the prevailing school of thought but, once introduced, quickly developed from heresy to accepted investing dogma. What ETFs do is bring all of these concepts together, into a single product.

The first ETF was born in 1989 in Canada and was known as the Toronto Index Participation Fund (or TIP 35). A year later State Street created the first US ETF.

The first Australian ETFs were introduced by State Street in 2001: one based on the top 200 companies, the SPDR S&P/ASX 200 Fund, and one based on the large caps, the SPDR S&P/ASX 50 Fund.

Today the Australian ETF market has grown in tandem with the global demand for low-cost investments and today there are 29 local ETFs (and 21 cross listed ETFs or ETFs listed on other bourses).

ETF advocates argue they are a refreshingly cheap and simple way to invest, whose success is threatening the traditional funds management and stockbroking industries.
Opponents of ETFs argue they are an inherently risky financial innovation, which could lead to the next market collapse.

These positions are clearly polar opposites and leave many investors perplexed. Both can’t be right, or can they?

In reality, the answer lies somewhere in between.

Not all ETFs are created equally

ETFs, like icecream, come in two basic flavours – plain vanilla (basic) and exotic (every other possible flavour combination). Vanilla ETFs are the most simple and widely chosen option. As the names suggest, exotic ETFs are more risky than vanilla ETFs, and understanding the difference is important.

Vanilla ETFs are the original ETF and they replicate an equity index’s returns (such as the ASX 200) by physically buying and holding a basket of the underlying securities in that index (BHP, Westpac, etc).

Instead of holding the underlying shares, exotic (or synthetic) ETFs enter into a contract (“swap agreement”) with a third party (a counterparty such as a bank) who promises to pay investors the index return (eg, the ASX 200).

These ETFs “synthetically” give investors the index return without owning the underlying shares (although collateral is typically held). This approach may be fine if the swap contract is with Goldman Sachs, but if your contract is with Lehman Brothers you may find yourself with a problem.

Other types of exotic ETFs include leveraged ETFs, actively managed ETFs, Bond ETFs, currency ETFs, commodity ETFs and even Shari’ah ETFs.

So the answer to the question whether ETFs are safe or risky is they can be either. It all depends on the flavour you choose.

Read the fine print

Exotic ETFs on overseas markets have attracted the attention of global regulators and have been the subject of articles highlighting the risks of ETFs.

While these exotic, risky ETFs proliferate on overseas markets, ETFs in Australia today are largely (but not entirely!) vanilla ETFs. While this will change as the Australian ETF market develops, unless you are comfortable with higher risk, we believe investors should generally stick to vanilla ETFs.

As new ETFs come to market, read the product disclosure statements in detail to determine how the ETF achieves exposure to index or commodity it aims to replicate (or read Tony Rumble’s fortnightly column in Eureka Report).

Why this matters to you

SMSFs have been keen, early adopters of ETFs: 30–40% of all investors in Australian ETFs are SMSFs. SMSF investors have flocked to ETFs due to their low costs, instant diversification, transparency and liquidity.

SMSF investors who may previously have owned a convoluted portfolio of 25 or more securities appreciate the significant reduction in complexity and paperwork an ETF-based portfolio provides.

SMSF investors with managed funds and expensive platforms now enjoy much reduced ongoing fees via their ETF portfolio.

Unsurprisingly, with demand for their products impacted, stockbrokers and active fund managers have become more vocal critics of ETFs.

Intelligent SMSF trustees realise that asset allocation is the key decision they face, however many spend enormous amounts of time, effort and money selecting individual shares or managed funds and relatively little time deciding their appropriate asset allocation, when it should be just the opposite.

Asset allocation is not easy, but has the potential to provide rewards to the diligent investor.

Making strategy easier to implement

ETFs provide the ideal tools for investors to easily and precisely construct portfolios based on asset allocation, enabling you to create efficient portfolios in a modular way as easily as snapping Lego pieces together. ETFs increasingly cover most asset classes and are cheap, liquid, and reliable and can help you become a more efficient investor.

Many SMSFs lack a coherent and current strategy across their entire portfolio. However, while some investors may be able to explain why a particular investment was made six months ago (“it was cheap”), they often struggle to explain what that investment adds to the portfolio strategy now and will continue to in the future.

ETFs help address this problem. Each individual ETF held forms a key theme within the overall portfolio. For example, with as little as eight investments you can put together a wonderfully simple, diversified, cheap and coherent ETF portfolio based on these investing themes:

• Blue chip shares
• Broad index shares
• Commercial property
• Resource (or financial) shares
• Small cap shares
• High dividend / imputation shares
• Emerging markets shares
• Global healthcare

Many SMSF investors adopt a core-and-satellite strategy. The core of the portfolio consists of diversified, low-cost ETFs, and the satellite investments comprise high-conviction investing ideas (such as direct shares or funds you think will outperform).

This provides the best of both worlds: you save fees in the passive core complemented with active, investing ideas in the satellites.

As you weigh up the pros and cons of using ETFs, consider the responses from two legends when asked for some general advice for the millions of investors out there trying to get ahead.

Just buy a low-cost index fund and keep buying it regularly over time '¦ if you have 2% a year of your funds being eaten up by fees you're going to have a hard time matching an index fund. – Warren Buffett

Buy index funds and ETFs. That might not seem like enough action to a 25-year-old, but it's the smartest thing to do. – Charles Schwab

Claire and Tim Mackay are directors and wealth advisers at Quantum Financial Services.