The five secrets of successful ETF investing

ETFs (Exchange Traded Funds) in Australia are less than 15 years old, yet now account for many billions of dollars of investments. A new survey from UBS Asset Management estimates that already 20 per cent of all SMSF investors hold interests in ETFs and another 10 per cent plan to invest in ETFs in the near future.

As you probably know ETFs are investment vehicles, which represent a basket of shares; it might be shares on Wall Street, blue chips or Australian small caps or gold. The one thing ETFs have in common is that the vehicle itself is listed on the stock market. ETFs are a spin off from the original idea of index funds, which were also baskets of shares, but index funds were not listed.

This week alone has seen two new Vanguard international fixed interest ETFs start trading on the ASX. ETFs have three important characteristics for investors:

• First, they are traded on the ASX stock exchange, meaning that they can be traded any time that the exchange is open.  

• Second, they seek to perfectly replicate the performance of some underlying investment group – for example, they might look to provide the same return (less costs) of the S&P/ASX200 index.  

• Third, they are open ended, which means the number of units can increase or decrease in response to the demand by investors. This is an important difference to Listed Investment Companies (LICs), where the number of shares generally does not change from day to day.  Increasing or decreasing the number of units in an ETF helps the share price to closely track the value of the assets in the ETF.  With an LIC the share price might trade at a premium or discount to the value of the assets. (To read more on LICs see recent coverage by Mitchell Sneddon, click here.)

Being a relatively new addition to the investment landscape – albeit one that has been tested by, and survived the GFC – we have to keep looking to increase our understanding of the best way to trade ETFs.

Here's the five secrets for successful trading in ETFs:

1. You can optimise the time of your trade

The traditional managed investment of choice in Australia is the managed fund – possibly because the trailing commissions from managed funds supported the majority of the financial planning industry.  Most managed funds only allow trading at the end of each day – once the final value for the assets of the fund have been calculated at the end of the day.

Because they trade on the stock exchange (ASX), ETFs allow investors to trade throughout the day as the value of the ETF's assets change.  This provides investors the chance to take advantage of any intra-day volatility that is potentially favourable to them.

2.  You must avoid the first and last hour of trading  

In Australia, there is a staggered open and close to the trading day.  During this period of time, not all shares in an underlying ETF are trading – leading to some uncertainty about the underlying value of the ETF. See also: How to choose an ETF, July 8.

This uncertainty presents itself in larger than usual ‘bid-ask spreads', the difference between the price market participants are prepared to buy or sell shares at. Because of this, it is important to be careful when trading at the market open. Likewise in the hour before the market closes as market makers begin to limit their risk resulting in wider bid/ask spreads in the last hour or so.

3. Be prepared to use ‘At Limit' orders

With brokerage being an increasingly small cost of a trade, an important cost in trading will be how efficiently a trade is priced.  Rather than just placing an order “At Market”, and letting the market price the trade, it is worth looking at market depth (the price that other market participants are willing to buy or sell at) and controlling the price the trade goes through at with an ‘At Limit' order. This article provides some more thoughts on that process: Seven dos and don'ts of ETF trading.

4. Be aware of the underlying assets of the ETF

Many ETFs in Australia simply hold the assets that they invest in.  For example, an ASX200 ETF might actually hold the 200 shares that make up the ASX200 index.  

The other option, that some investors are not comfortable with, is "synthetic" ETFs, which use derivatives and other trading strategies to replicate the performance of an index.  There is further discussion around the issue of physical vs synthetic ETFs in this article from ASIC on its Moneysmart website: Synthetic exchange traded products.

The other issue with ETFs is that they have increasingly become very narrow in the assets that they look to track.  Vanguard's founder John Bogle, one of the pioneers of whole of market investing, warns that many of these individual sector and country funds are probably "too narrow for most". 

Bogle is also scathing of the leveraged and "inverse" ETFs, where investors benefit when a market falls in value. 

The important point – investors need to be aware of what they are investing in, and be comfortable with that exposure in their portfolio.

5. Understand how they do index calculations for international assets

Index funds may not perfectly match their underlying indices, especially when it comes to international indices. Over the six months to the end of October 2015, the Vanguard MSCI Index International Share Fund has provided a return (after fees) of 7.59 per cent, against an index return of 7.5 per cent.  

Equally the BetaShares FTSE RAFI US 1000 ETF (QUS) is outperforming its index, after fees, over one, three and six months.

It is unusual to see an index style fund outperforming its underlying index.  However, with international funds, this is largely due to the complication around tax calculations for international shares.  For example, issues of stamp duty and withholding taxes vary from country to country.  Generally international indices are calculated using the lowest likely return from international investments – meaning that actual returns are often a little higher. 

At a practical level for investors, this means that international returns from investing in an ETF might differ from the quoted index a little more than they might see from Australian investments – however there is a feasible underlying reason for this, which can be in your favour.

Conclusion

By most measures, ETFs are recent additions to the investment landscape in Australia.  That said, the take up of them – now with more than $20 billion of assets invested with them – suggests that both institutional and individual investors see them as valuable investment instruments.  As ETFs evolve, we as investors can learn more about them and become more thoughtful in how we use and trade them in portfolios.

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.