Foundations for a good portfolio

John Collett points out the positives and the perils of exchange traded funds.

John Collett points out the positives and the perils of exchange traded funds.

Disillusion with traditional managed funds' high fees and poor performances is likely to see a continuing shift among financial planners and small investors to a type of listed managed fund called an exchange traded fund (ETFs).

The value of ETFs in Australia is approaching $5 billion from only $1.5 billion at the end of the 2008. ETFs are listed on the Australian sharemarket and trade just like other shares. Their supporters say they offer investors easy and cheap exposure to investment markets.

"ETFs are a cost-effective way to build a portfolio for a client," says a financial planner at Australian Money Planners, Michael Houlihan. "Most managed funds, even at wholesale rates, are close to 1 per cent, with ETFs at about 0.2 per cent."

Most of the more than 60 ETFs listed on the Australian sharemarket invest in broad-based indices such as the largest 200 companies listed on the Australian sharemarket or in the 200 companies that make up the small companies index.

As tracker funds they will never underperform the market, nor will they beat the market.

But buying the market cheaply can lead to better outcomes for clients than taking punts on active managers, those that try to beat the market returns after their fees.

Some planners are using a "core plus satellite" approach, where they build a base or core of a portfolio using broad-based, low-cost ETFs and then use managed funds that are actively managed and invest in markets where the managers are more likely to be able to add value after fees.

A financial planner and managing director of Bell Partners Wealth Creation and Financial Advisory, Brett Taggart, has been using ETFs for his clients for three years.

He says a typical client portfolio will have an ETF that tracks the biggest 200 companies of the Australian sharemarket or one that tracks the largest 50 companies and perhaps an ETF that tracks the performance of the Australian listed real estate sector. The client may also have an ETF that tracks global shares and one that tracks shares listed in emerging markets.

Most actively managed large-company share funds in Australia fail to beat their benchmarks consistently after fees. But Taggart will recommend actively managed funds to his clients where the manager is investing in those markets, such as Australian smaller companies, where good managers can add value after fees.

Taggart also likes the liquidity of ETFs. A drawback of managed funds is that during periods of volatility he could not be sure of the price he would be getting for units being redeemed. "By the time you log the sale [with the fund manager] you may get today's market price or the price in a couple of days' time," he says.

ETFs can be sold almost immediately through a broker and Taggart knows straight away the price the client will be getting.

The pitfalls

ETFs have their drawbacks. As they are traded just like shares, the investors must pay share brokerage every time the ETFs are bought and sold. Managed funds, on the other hand, usually have saving plans where money can be dripped periodically into the fund at no direct cost to the investor.

ETFs are just another way of accessing indexing, says the principal of corporate affairs and market development at Vanguard Investments Australia, Robin Bowerman.

"Someone with a lot of direct equities may prefer to have their portfolio listed on an exchange where they can see how it is trading," he says.

Most managed funds are accessed through financial planners. With ETFs, it is easy for any investor to buy them through a broker or an online discount broking service.

ETF providers appoint "market makers" whose job is to buy them from those wanting to sell when there are few other buyers. One of the potential pitfalls of ETFs is that the "buy-sell" spread can widen.

A spread may widen because the ETF is new with low trading volumes or because of market volatility.

Another reason could be that the market tracked by the ETF has low liquidity. However, in times of normal market volatility ETF buy-sell spreads are typically smaller than the spreads on managed funds, which are fixed. Bowerman says investors need to be conscious of the ETF spreads and it is something a good broker should be able to help with.

Another issue has been with "synthetic" ETFs. The better structure is when a fund actually owns the basket of shares it is tracking. Synthetics are when derivatives contracts are used to mimic the returns of the market that the ETF tracks. The biggest potential problem with synthetics is counterparty risk - the risk that the counterparty to the trade will not fulfil their obligations.

The market for ETFs has developed much more slowly here than in the US and Europe. The Australian Securities Exchange and the Australian Securities and Investments Commission have learnt from overseas experiences and have restrictions and rules on ETFs listed in Australia. The equities ETFs listed in Australia are backed by actual shares.

Synthetic ETFs in Australia are rare but are more likely to occur in ETFs that track commodities.

The rules require synthetic ETFs to hold collateral for its derivative contracts. The amount of counterparty risk must be limited to 10 per cent of the net asset value of the ETF.

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