InvestSMART Australian Exchange-Traded Product Quarterly Report - September 2018

Introduction

About this report

Welcome to InvestSMART’s September Quarter 2018 Exchange Traded Products (ETP) update.

ETPs form the basis of InvestSMARTs form the basis of a range of InvestSMART’s Professionally Managed Accounts (PMAs). The purpose of this report is to provide our clients with an easy to digest wrap of market activity as well as provide a greater level of insight into how and why we’ve built our SMA portfolios the way we have. 

ETPs are a low-cost, hassle-free way for investors to achieve their investment objectives. Whether your aim is to diversify your portfolio or to obtain exposure to a particular investment theme, the ability to buy ETPs directly on market, their transparency and relatively low cost has seen the popularity of these securities amongst investors grow rapidly. 

We have categorised the ETP market by asset class to allow clients to quickly identify suitable securities to fill any investment gaps in their portfolio and remain aligned to their specific investment objectives.

Figure 1: Asset Classes

We also categorise ETPs throughout the report by their structure. This is an important consideration as each carries its own set of risks. ASIC has sought to clarify the naming conventions in its Information Sheet 230: Exchange traded products. 

In conjunction with this report, clients have access to our ETP filter which can be used to quickly identify securities of interest.

Diversified

A diversified portfolio for those looking for a better return than cash or saving for the short-term.

Balanced

A diversified portfolio for investors seeking a conservative investment solution.

Core Growth

A diversified portfolio suitable if you’re looking to build your wealth over the medium-term.

High Growth

A diversified portfolio that aims to reward your patience and grow your wealth over the longer term.

About InvestSMART

InvestSMART Star Rating

Exchange Traded Products (ETPs) are a wonderful way for retail investors to obtain greater control of their wealth and build a fully diversified portfolio themselves at a low cost. As the Australian ETP market grows and more investment options become available, the InvestSMART rating system has been developed to assist investors objectively compare products.

It should be noted that the InvestSMART Star Rating is a quantitative measure and it does not take one’s investment objectives into account. The InvestSMART Star ratings do not constitute recommendations. Additionally, we do not rate Actively Managed Funds (MF) or Structured products (SP). This is because these products carry a different set of risk/ return metrics that are not easily quantifiable. 

Finally, our ratings are designed for comparing ETFs with a similar objective. It is not appropriate for example to use the star rating to compare a highly liquid and low-cost S&P ASX 200 fund to one designed to track emerging markets.

There are five key criteria we use:

Highlights this quarter

How do ETFs track an index?

Exchange Traded Funds (ETFs) were developed to allow investors the ability to invest in an index. As we have discussed previously, how well an issuer is doing this is captured in the tracking error. We speak about this in our March 2018 Report. Given the wide range of geographies and asset classes that investors can now invest in via ETFs, it is important to understand that not all ETFs are constructed equally, and each carry varying forms of risk. 

Replication Methods

The ways in which issuers elect to manage their fund can be categorised under two broad headings, namely ‘physical’ and ‘synthetic’ replication.

Physical

As the name implies, this method involves physically holding the securities in the index. However, the degree to which the issuer holds underlying securities can vary.

• Full Replication

If an ETF is fully replicating, the issuer will hold securities in the portfolio on a 1:1 basis to the index. This is often the choice for managing ETFs that track liquid, easily accessed indices such as the ASX200 or Dow Jones.

If an ETF is fully replicating, the issuer will hold securities in the portfolio on a 1:1 basis to the index. This is often the choice for managing ETFs that track liquid, easily accessed indices such as the ASX200 or Dow Jones.

• Partial Replication

Partial replication, often referred to as optimisation or sampling, is used where the underlying index is comprised of a large number of securities (sometimes into the thousands) or those designed to track less liquid securities where the transaction costs of holding every security outweighs the benefits of full replication.

Partial replication strategies carry an increased tracking error risk, or the risk that your fund will not perform in line with the benchmark as closely as a fully replicating fund, however issuers are constantly working to ensure minimal tracking error.

Synthetic

Synthetic replication involves the use of derivatives, such as swaps, to deliver index returns. The most common reasons as to why an issuer may choose to adopt a synthetic structure includes: 

• Physical holdings are impractical: Often the case for commodities such as oil and agricultural products
• Complex Strategies: Leveraged & inverse strategies require derivatives to deliver desired outcomes.
• Market Restrictions: For example, the China A-Shares market does not allow for foreign investment

Synthetic strategies carry an additional layer of risk in the form of counter party risk.

Ways to use Exchange Traded Products

At a basic level, ETPs allow an investor to get exposure to, and maintain a portfolio of securities in a couple of clicks. However, ETPs are more than just market trackers used by lazy investors. They offer a way for retail investors to manage their money like financial professionals, at a fraction of the cost.

Diversification (strategic asset allocation)

ETPs are a great way for investors to manage portfolio diversification themselves as they allow you to invest in asset classes which you may not be familiar with, such as bonds or hybrids or have access to, such as international equities or infrastructure assets. In constructing our diversified portfolios, we use the following ETPs to access various asset classes. 

Acting as a stop gap

Great investment ideas aren’t always easy to find, however sitting in cash for too long can be detrimental to long term performance outcomes. During such times, ETPs offer a way in which to remain exposed to the market. The great thing being that when you need to liquidate you can sell immediately with no additional paperwork or exit fee penalties.

Trading positions

As ETPs are priced intraday and can be bought or sold rapidly during market hours, they offer a way for investors to position themselves based on a view in real time without the need for specialised product knowledge (eg, options or CFDs). For example, those seeking to profit from a falling US market may look to purchase units in BBUS (BetaShares US Equities Strong Bear Hedged). Or, if you have a strong view on the future positive performance of the Australia equity market, you could invest in GEAR (BetaShares Geared Australian Equity (Hedged).

Exposure to a sector or theme (tactical asset allocation)

As the local market matures, there is an increasing number of ETPs being listed that are designed to provide exposure to particular sectors or themes. Some examples are listed below. 

Sectors 

There are a number of ETPs now that are designed to provide exposure to a particular sub-sector, for example banks, resources & healthcare. These products provide an ideal way to quickly invest in an undervalued sector in one trade.

Themes

Aside from investing in the performance of broad exposures such as domestic small cap or European shares, there is a growing number of ETPs designed to capture the performance of particular macro thematics. For example, 

We caught up with ETF Securities head Kris Walesby recently to chat about ACDC. You can watch here.

Portfolio Strategy

There are several key thematics that are beginning to impact markets and will likely be key to markets over the coming 12 months. These are:

1. Rising bond yields
2. Tighter financial conditions
3. Equity risk premiums topping out

We have already started to see the final quarter being impacted by these thematics with October seeing an equity correction, US bonds yields climbing to five-year highs and the cost of capital increasing further due to another rise in the US Federal Funds rate. The cost of capital will rise further, with the US Federal Reserve forecasting ‘gradual rate raises’ all the way to December 2019.

We point out that these thematics are being created by good economics: US growth is booming, inflation is finally materialising, and not just in the US, employment is powering ahead, which is creating confidence, and corporate earnings are expanding strongly on a year-on-year basis. However, this kind of data does tend to occur in the latter part of a growth cycle and explains why central banks will begin to tighten policy to avoid overheating.

These thematics form the basis for our strategy for the coming 12 months, which is a slow rotation out of ‘Growth’ and a stretched equity market and towards ‘Value’ and ‘Defensive’ indices and sectors.

Market Overview

Source: ASX and Morningstar

Funds under management (FUM)

We also saw 2 funds closing, ETF Securities Physical Singapore Gold ETF (ZGOL) and ETF Securities Physical Renminbi ETF (ZNCH) taking the total number of products on the ASX to 181.

At the end of September, the amount of capital in Australian-listed ETPs exceeded those in Listed Investment Companies (LICs) for the first time.

Flows 

Like last quarter, ‘Equity Large Blend’ again saw standout inflows suggesting continuing interest in overseas investment. At the other end, ‘Equity Australia other’ saw the largest outflows, mainly due to large outflows in resource related securities VanEck Vectors Australian Resources ETF (MVR) & the BetaShares S&P/ASX200 Resources Sector ETF (QRE).

Looking ahead and flows have begun to rotate, October has seen large outflows from Developed Market funds, particularly the US. Over US$15.2 billion left US ETP funds in the second week of October while Europe and Global funds saw US$4.8 billion and US$4.0 billion of outflows respectively. Interestingly, large inflows where seen in Emerging Markets, particularly into China funds, which saw US$2.4 billion of inflow in the same week. This would fit with our view that ‘Value’ is likely to be rotated into.

Globally, ETPs are on track for their second-best year of capital inflows in the past 16 years. On a year-to-date basis global ETPs have seen US$200 billion of inflows with a quarter to go. Last year was the biggest year, with over US$420 billion of inflows* 

* Morgan Stanley – 17/10/2018.

Figure 8: Quarterly Flows

Source: ASX and Morningstar

Figure 9: Cumulative FUM Flows ($M)

Source: ASX and Morningstar

Figure 10: FUM Flows ($M) by Asset Class

Source: ASX and Morningstar

Performance

While international equities in general saw strong performance this quarter, global tech was the standout performer on average. The best performing security in the category being Betashares Cyber Security ETF (HACK). It was a fairly poor quarter for commodity related funds though, with 4 of the 5 worst performing all leveraged to that sector.

Figure 15: Returns 3 and 12 months

Source: ASX and Morningstar

3 Month
12 Month

Source: ASX and Morningstar

Figure 16: Sub-category volatility

In finance, volatility implies risk. That is the higher the volatility, the higher the risk. Per below, you can see that the categories to the left of the chart, or more volatile, generally include leveraged, equity and commodity focused securities. To the right we find cash & bonds focused securities. 

We are strong supporters of the benefits of diversification, that is spreading your portfolio across various asset classes for the purposes of reducing risk, and it is interesting to note that despite having allocations to equities, the diversified funds lie toward the low risk end of the spectrum, highlighting the benefit of diversification for risk averse investors.

Securities Overview - Commodities

Securities designed to provide exposure to the performance of various commodities and natural resources. We do not hold any commodity focused ETPs in our PMA Portfolios.

With volatility increasing and global fixed income markets under pressure flows have been seen into precious metals with gold up over 5% to start October. If global risk continues it likely precious metal ETPs’ will see further inflows in the coming months.

Industrial metals have suffered at the hands of US-China trade relations and weak industrial production from China. However, China has recently announced that it will ‘provide unwavering support for its private sector’ which has seen a copper and aluminium starting October in a more positive fashion. 

Energy markets are moving into the traditionally ‘high demand’ season with the North Hemisphere moving into winter. The high demand period is coupled with supply concerns from the new Iranian trade sanctions and geopolitical tensions with Saudi Arabia. However, the US has reported that it has doubled its inventories to start October and US rig counts are at 2015 high which is likely to see oil moderate over the medium term. 

Figure 17: Funds Under Management ($m)	Figure 18: Geographic Exposure
Figure 19: Flows ($m)
Figure 20: Average Yield
Figure 21: Total Costs
Figure 22: Performance
Figure 23: Average Annual Volatility

Securities Overview - Currency

Securities designed to track the performance of the Australian dollar relative to various currencies. We do not hold any currency focused ETPs in our PMA Portfolios. 

The AUD is facing further headwinds in the coming months being a ‘risk’ currency exposed to emerging markets. This coupled with the head winds of higher US interest rates is likely to mean the AUD will be at or below currently levels to finish 2018.

Figure 25: Funds Under Management ($m)	Figure 26: Geographic Exposure
Figure 27: Flows ($m)
Figure 28: Average Yield
Figure 27: Total Costs
Figure 28: Performance
Figure 29: Average Annual Volatility

Securities Overview - Property & Infrastructure

Securities designed to track various domestic and global property & infrastructure indices. We hold positions in VAP, IFRA & DJRE in our PMA Portfolios. 

We have seen downward pressure in infrastructure products due to the ‘bond-proxy’ nature. With interest rates forecasted to increase over the coming year it is likely this pressure will continue into 2019. Listed property however has managed to perform well in 2018 as rental yields from industrial property remains robust. We would also point out that although residential housing in Australia is falling, listed property is more commercially exposure which is weathering the down turn well.

Figure 31: Funds Under Management ($m)	Figure 32: Geographic Exposure
Figure 33: Flows ($m)
Figure 34: Average Yield
Figure 35: Total Costs
Figure 36: Performance
Figure 37: Average Annual Volatility

Securities Overview - Fixed Income & Cash

Securities designed to provide investors access to domestic and global fixed income & cash markets. We hold positions in AAA, FLOT, QPON, VBND, IAF, VACF, VGB & IGB in our PMA Portfolios.

Global fixed income is facing longer-term weakness as the economic picture, particularly in the US, remains robust which will likely see higher cash rates in 2019. The prospect of higher interest rates from the US Federal Reserve will push yields higher and will cause bond capital to decline. Australian fixed income on the other hand remains stoic; the Reserve Bank currently has no plans to shift rates in either direction, while there are no foreseeable changes to Australia’s sovereign rating on the horizon. This is likely to make Australian fixed interest a stable capital investment for the income investors. 

Figure 39: Funds Under Management ($m)	Figure 40: Geographic Exposure
Figure 41: Flows ($m)
Figure 42: Average Yield
Figure 43: Total Costs
Figure 44: Performance
Figure 45: Average Annual Volatility

Securities Overview - Diversified

Securities designed to provide investors with diversified multi sector asset allocation. We manage a range of diversified PMA Portfolios.

Figure 47: Funds Under Management ($m)	Figure 48: Geographic Exposure
Figure 49: Flows ($m)
Figure 50: Average Yield
Figure 51: Total Costs
Figure 52: Performance
Figure 53: Average Annual Volatility

Securities Overview - Equities

This group of securities provides the investor with broad-based as well as specific sector exposure across domestic and international equity markets. We hold positions in IAA, IVV, VEQ, UMAX, VGS & IOZ in our PMA Portfolios. 

The US equity markets just had its best quarter since 2013 and saw IVV for example adding over 10% in the September quarter as it also benefited from the falling AUD. Looking ahead, US equity markets have begun to find sellers and the fact Value is becoming more attractive may see rotations to differing equity markets in the coming year. For example: Asian equities which have fallen over 30% in the past six months and sectors with a value thematic such as staples are likely to see rotation flows as markets reposition into 2019.

Figure 55: Funds Under Management ($m)
Figure 56: Geographic Exposure
Figure 57: Flows ($m)
Figure 58: Average Yield
Figure 59: Total Costs
Figure 60: Performance
Figure 61: Average Annual Volatility

Glossary