In defence of ETFs

Clime’s John Abernethy pointed out the pros of LICs and the cons of ETFs. Here’s the alternative view.

Summary: ETFs offer investors a number of advantages, such as lower fees than many actively managed funds, diversification and control over investment decisions. They also offer transparency on price, as they trade at or very close to their net asset value.

Key take-out: A number of dividend-focused ETFs have been launched, designed to meet the income needs of self-funded retirees.

Key beneficiaries: General investors. Category: Shares.

Clime Capital’s John Abernethy recently argued that listed investment companies have a key advantage compared to exchange-traded funds (see ETFs versus LICs, April 8). LICs are closed-end funds with permanent capital, while ETFs are open-ended funds and need to sell assets to meet withdrawals when faced with a large number of sellers. ETFs can’t match the nous of an active manager, particularly in times of falling markets, he suggested.

But ETFs have a number of advantages which are worth considering further.

Tracking an index

Active fund managers propose to investors that with their particular expertise, they should be able to perform better than a benchmark index, then charge a fee for the service. And many fund managers succeed over long periods of time, and are worth investigating. But still more funds fail to beat their benchmark index.

A report from Standard and Poor’s showed that over the year to December 2014, some 61 per cent of general Australian equity funds performed worse than the S&P/ASX 200. Over three years, 63 per cent of active funds underperformed the benchmark, while over five years the proportion of funds that underperformed rose to more than 77 per cent. Small cap funds did better overall, with more than 23 per cent underperforming their index in 2014. But among international equity funds, over 80 per cent did worse than their index over one year. “In 2014, the majority of funds in all categories, except Australian small-cap funds, underperformed their respective index benchmarks over the one-, three-, and five-year periods,” S&P report author Priscilla Luk wrote. “We have consistently observed that the majority of Australian active funds in most categories fail to beat the comparable benchmark indices over three- and five-year horizons.”

On these numbers, it’s not hard to see why index funds start to look attractive. In the minority of cases, investors have been better off – perhaps handsomely so – by investing with active managers. In the majority of cases, investors would have had a better return by purchasing an index fund.

Calculating fees

ETFs also traditionally offer investors lower fees than many actively managed funds. Many Australian equities ETFs have fees in the 0.2 per cent to 0.4 per cent range. Fees for US equities ETFs can be around the same level or even lower – for example, State Street, iShares and Vanguard offer baskets of US shares for fees between 0.05 and 0.1 per cent.

Expect to pay more for access to commodities or emerging markets, with some of these funds charging around 0.7 per cent.

Many LICs, particularly the new generation of actively managed LICs, have fees in the 1 per cent to 1.6 per cent range, often with additional performance fees payable if the LIC outperforms its benchmark. Of course, there are exceptions. Australian United Investment Company has fees of just 0.11 per cent (see LIC spotlight: AUI and DUI, December 10), while Australian Foundation Investment Company charges 0.17 per cent.

Giving investors control

Abernethy wrote that when markets fall and many investors want to exit, ETFs have to sell shares cheaply, while LICs can take a long-term view and buy shares cheaply instead. But BetaShares managing director Alex Vynokur says ETFs give investors control and allow investors to make their own decisions, rather than relying on every decision made by a fund manager. “One of the things which attracts SMSFs to exchange-traded funds is the fact that they are able to retain control over their own investment decisions. The reason why people leave large industry super funds or big corporate funds and set up an SMSF in the first place is that they want to have control,” he says.

In this line of thought, a long Australian equities ETF does not imply that being long Australian equities is the best trade – it simply provides a tool for an investor to go long Australian equities if they wish to do so. If the market falls, an individual investor has the option to decide whether or not to sell, and when to start buying again.

“We absolutely do not take the view of saying, ‘Investors should be buying this, or this, or that.’ That’s a job for themselves and that’s a job for their financial adviser,” Vynokur says. “Our objective is to provide investors with cost-effective, liquid and transparent investment tools that will enable them to implement their investment decision.”

Looking at a range of products

Exchange-traded fund providers offer a simple way to access not only a range of indices, but also specific sectors, commodities and currencies. Some funds offer exposure to indices in regions including Australia, the US, Europe, Asia and emerging markets. Other ETFs allow investors to buy only the Australian financials sector or the Australian resources sector, or a global basket of healthcare, consumer staples or telecommunications stocks. Gold, crude oil, bonds, the US dollar, the British pound and the euro are also available, as are fixed income funds. This means ETFs can allow investors to easily diversify their portfolio, says Jonathan Howie, head of BlackRock’s iShares Australia.

For investors who expect the Australian market is set to decline, BetaShares offers two products that aim to generate returns that are negatively correlated to the broader index. If the market falls, the Bear Fund and Strong Bear Fund should rise, allowing investors to protect their exposure or even profit. BetaShares created the newer Strong Bear Fund in response to investor demand for something with more capital efficiency than the original Bear Fund. Investors can expect a 1 per cent market fall to translate to an increase in the value of the Strong Bear Fund between 2 per cent and 2.75 per cent, due to the fund’s moderate level of gearing, meaning an investor who wants to protect a $100,000 portfolio doesn’t have to lay out $100,000 to do so.

Clarity on price

ETF providers say a key advantage of their offering is that the funds offer investors transparency on price. Given the fund manager buys or sells more units of the underlying shares in response to investor demand, ETFs trade at or very close to their net asset value. By contrast, listed investment companies are closed-end funds; investor demand pushes up the price for the limited available stock. This means LICs can trade at a premium or a discount, where investors are paying more or less for a basket of shares than those shares cost on the market.

Eureka Report previously pointed out the opportunity to buy listed investment company Argo when it was trading at a discount (see Argo’s golden cargo, December 16, 2011). “How do you know the discount’s not going to get bigger?” says iShares’ Howie. “The risk that potentially when you come to sell those assets they may be at a discount to the net asset value – that adds more complexity, more risk to that investment decision.”

BetaShares’ Vynokur points out that many LICs are currently trading at substantial discounts.

What about dividends?

ETF providers, like many others in the financial services sector, are well aware of self-funded retirees’ search for yield in response to declining interest rates, and are creating products in response. A number of dividend-focused exchange-traded funds aim to generate attractive yields, but it’s worth keeping in mind that these yields are often only partially franked, so are not strictly comparable with fully franked yields from Australian shares.

BetaShares launched its Australian Dividend Harvester Fund in November last year. The fund features monthly income payments which so far have yielded around 1 per cent per month, which if sustained, implies a 12 per cent per annum yield. Of course, when investing for yield, it also makes sense to keep capital growth in mind; the fund’s capital appreciation over six months has been 0.47 per cent during a period when the broader market has rallied. In times of heightened volatility, the fund uses the risk management strategy of selling the ASX200 SPI futures contract to reduce its exposure to the market and reduce the possibility of a significant capital loss as a result of a big event.

Elsewhere, the iShares S&P/ASX Dividend Opportunities ETF has a yield of 12.5 per cent, while the SPDR MSCI Australia Select High Dividend Yield Fund yields 4.8 per cent.

Balancing a portfolio

ETF advocates agree that their products are not the only ones with merit. “There is absolutely room for active managers in the market and indeed the market needs active managers,” Howie says. “The market stays efficient because there are active managers all running around trying to beat each other.”

“An all-ETF approach is an absolutely valid approach,” he says. “We also think that it’s absolutely a valid approach to combine both [ETFs and other strategies].”

Given the many different ETFs on offer, and the control they offer to self-directed investors, there may well be some that are worth investigating further.