Investment Road Test: S&P/ASX 200 Resource Sector ETF

PORTFOLIO POINT: Sector-specific ETFs make it easy for investors to get exposure to their indices.

US quantitative easing, combined with good earnings growth in quality Australian stocks is driving our sharemarket higher. While the RBA rate increase last week reinforced the view that the current upswing in commodities will continue, expectations for the financial sector are subdued following the emerging stoush between the government and the banks.

From a strategic perspective, this would suggest building a position that is underweight financials and overweight resource stocks – a strategy that can now be more easily implemented through a range of sector specific ETFs from Australian Index Investments (Aii).

Sector ETFs abound in the US, where the thousands of listed stocks make it difficult for stock pickers to accurately target the most efficient stocks without holding an overly large portfolio.

Studies by the likes of Robert Haggstrom and the Journal of Finance show that the optimal number of shares to be held in a direct share portfolio would be no more than 15, with investors that hold more stocks than this failing to offer any further significant prospect of beating the index. The analysis suggests that the costs and risks of holding more stocks outweigh the additional performance benefits.

But when specific sectors are contributing above their relative share of GDP growth – and where it is expected that this will continue – it is normal to seek additional exposure to those sectors. The obvious caveat being to make sure that valuations are not excessive in the first place.

The ASX maintains and publishes data for a range of sub-sectors within its broad market indices. A full list and explanation of these sectoral indices is available here.

The S&P/ASX 200 Resources sector index (RSR) comprises the S&P/ASX 200 Energy index and the S&P/ASX 200 Metals and Mining index. The Energy index (ASX code: XEJ) includes all stocks within the S&P/ASX 200 that have the majority of their activity in the construction or provision of oil rigs, drilling equipment and other energy related service and equipment, including seismic data collection; or, companies engaged in the exploration, production, marketing, refining and/or transportation of oil and gas products, coal and other consumable fuels. The Metals and Mining index (ASX code XMM) covers all stocks within the S&P/ASX 200 that produce aluminium, gold, steel, precious metals and minerals and also diversified metals and minerals.

The Aii sector ETFs use traditional “passive” index ETF technology to deliver clean and straightforward exposure to these indices. ETFs are rapidly becoming popular to “self-directed” investors because they remove the need to pick individual stocks and typically involve fees and costs which are well below the norm for traditional managed funds.

The Aii ETFs involve a management charge 0.43% pa and since this includes the cost of the underlying trustee and custodian, as well as management and reporting expenses, this is a cost which is well within acceptable levels.

One of the commonly expressed concerns about index ETFs is that they include allocations to their component stocks based on the market capitalisation of the stocks within the index. This means that the larger the stock’s capitalisation (the combination of the number of shares on issue and the price at which those shares are trading), the more it will dominate that index.

Sceptics suggest a stock that is trading at a high price may not be an ideal stock to buy, and argue for an “enhanced” approach to index construction that under-weights or excludes stocks that are “overpriced”.

This is a rational concern but is met by two observations. First, the cost and high turnover of traditional stock picking managed funds (benchmarked typically to an index anyway) often produces disappointing performance. Second, since the components of the indices and sectors within normal index ETFs (including those issued by Aii) are visible, an investor can easily do a reality check of the valuations which the component stocks are trading at – and avoid the sector ETF if it seems to be expensive.

The S&P/ASX 200 Resources sector has risen by 20% since June this year. Its price/earnings multiple as a whole is higher than that applying to the broad S&P/ASX 200 index – but this is to be expected based on the high growth/low earnings of this sector. The Aii website contains useful research on their ETFs, which canvas a range of valuation metrics and should be read by interested investors.

The top 10 holdings in the Aii Resource ETF are:

• Newcrest Mining Limited 9.06%
• Woodside Petroleum 6.51%
• BHP Billiton Limited 41.99%
• Origin Energy Limited 4.01%
• Santos Limited 3.03%
• Fortescue Metals Group 2.34%
• Oil Search Limited 2.04%
• Rio Tinto Limited 10.98%
• Alumina Limited 1.51%
• Oz Minerals Limited 1.48%

ETFs should track the exact performance of the underlying index (which has been a common criticism of the commodity-focused ETFs). Without careful market making this can be challenging, if supply or demand in the ETF is different to that for the component stocks.

Aii works with two market makers (Deutsche Bank and Susquehanna Funds management) to ensure that the value of the ETFs they provide are highly correlated with the net asset value of the components. Although Aii is a new boutique provider with a small staff, its external service providers should ensure that the sector ETFs it offers are true to label and provide good value for investors seeking this type of exposure.

The score: 3 stars
0.5 Ease of understanding/transparency
1.0 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
0.5 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.