The ins and outs of index investing - Pt II

The myths

Part I of this series introduced the concept of index investing. Here, we’re going to examine the world of exchange traded funds (ETFs)—simply listed index funds—and expose some of the myths and misconceptions about them. Even if you have a predilection for unlisted funds you’ll find this useful—most have an unlisted equivalent.

The motives

Fund managers—and advisers that enjoy their trailing commissions—don’t much like ETFs, or index investing generally. It threatens the gravy train on which they like to travel. Every dollar invested in an ETF is a dollar lost to the pool of potential funds from which they earn a cut.

This gives rise to one important implication. You will often see articles or reports talking about the problems of ETFs. Frequently, this is an expression of self-interest more than anything else. Some ETFs do have problems but they tend to be limited to a particular fund or category. As a concept, ETFs are sound and have many attractions.

Equity index ETFs

An ETF that tracks major equity indices is no different in structure to a typical long-only equities fund, except that investment decisions are ‘pre-set’ rather than determined by a fund manager. The fund owns shares and makes periodic distributions of dividends received on the shares it owns (with associated franking credits or foreign tax credits), together with any capital gains arising on disposals.

Equity index ETFs may invest in ‘broad’ indexes like the ASX 200 or ASX 300, or particular sectors or industries. The ASX Small Ordinaries Index or the ASX 200 A-REITs (property trusts) indicies both being examples. You will also find Australian and foreign equity index ETFs listed on the ASX. The iShares US S&P 500 fund, for example, invests in the shares that constitute the US S&P 500 index.

Although Australia is still a developing ETF market, there are plenty of choices, as Table 1 shows. Each can be purchased through your share trading account.

Equity index ETFs avoid some of the problems of the more exotic ETFs (more on this later) but you do need to understand the nature of the index your fund is tracking.

With broad based ETFs, the main difference is that some track the S&P indices while others follow the MSCI versions. The MSCI Australia 200 sounds the same as the S&P/ASX 200 but, while it's certainly similar, it’s not identical. The MSCI index doesn’t include Australian-listed foreign shares, for example.

As for sector and strategy based ETFs, all is not what it first appears. For example, the S&P/ASX 200 Financials index includes a bunch of property trusts (A-REITs). If the SPDR S&P/ASX 200 Listed Property Fund (SLF) takes your fancy, understand that the two Westfield entities constitute 40% of the index. As for those interested in high dividend yielding stocks, you have four options—one each from S&P, MSCI, FTSE and Russell.

The good news is that, so long as you are aware of the issue, working out what’s in or out of each index is not difficult. It's merely a matter of reading through the details and taking note of the differences.

Fixed income ETFs

As their name suggests, fixed income ETFs track established fixed interest indices. They’re popular overseas but have only just arrived in Australia. The fixed income (or bond) ETFs currently listed on the ASX are shown in Table 2.

Some of the conventional arguments for fixed interest ETFs are that they offer diversification for smaller investors (since direct bonds aren’t easily accessed), are quite liquid and can be purchased in small amounts. These arguments aren’t compelling, especially in an Australian context.

Most such ETFs hold Government bonds. Even the Corporate bond ETFs hold mainly Australian banks. How this achieves much diversification for the average Australian investor is difficult to see. As for liquidity, this is only achieved at the expense of having to take market risk. And the ‘small amount’ argument is weak given the accessibility of term deposits, listed bonds and some Government bonds.

Fixed interest ETFs listed overseas have their share of problems, too. Occasionally, they’ve traded well below net asset value (NAV), increasing the trading costs to investors.

During the GFC some fixed interest funds traded at a significant discount to NAV as liquidity in the underlying bonds dried up (the ETF market relies on institutions arbitraging away any NAV discount by exchanging bonds for ETF units). Some of the international bond indices are also difficult to replicate precisely, increasing the risk of tracking error.

Aside from these more technical issues, it’s difficult to get past the fact that fixed income ETFs don’t have a fixed term. Investors have no choice but to trade the market when they need the cash, forcing them to take gains or losses depending on movements in underlying interest rates and credit margins.

To us, fixed interest should be about certainty; You pick your term, credit risk and interest rate. There may be situations where you need to exit early (and so take a gain or loss) but that should be the exception rather than the rule. You don’t get as much certainty with fixed interest ETFs.

We don’t want to overstate these problems. If you’re simply looking to reduce overall portfolio volatility, by all means consider fixed interest ETFs. But if you have a bit more to invest, direct bond investing is a better route. If you’re a small investor, ETFs don’t add a great deal to what you’re probably already doing.

Cash and currency ETFs

This is a small segment of the Australian market, currently only catered for by Betashares. The list of cash and currency ETFs is shown in Table 3.

The Betashares Australian High Interest Cash ETF is more akin to a fixed interest ETF—its investments are loans to banks (bank deposits). The average investor probably doesn’t need an ETF to get bank deposit exposure.

The remaining currency ETFs offer investors a position on Euro, British Pounds or USD relative to the Australian dollar. These have more appeal since it isn’t that easy to open up a foreign bank account. The main market risk (currency movements) is actually what investors are seeking exposure to.

Are these the best way for investors to get exposure to foreign currency?

It depends. If you are looking to hedge other foreign exchange exposures, there aren’t many options available—a CFD account may be more useful and cheaper. Currency ETFs also can’t be used to buy foreign assets or pay the costs of an overseas holiday. If you need to spend the foreign currency, you still need to sell the ETF, receive the local dollars and convert it. In this case, the effort of establishing a foreign bank account may be worth it.

Commodity ETFs

Where Australia does shine is in commodity ETFs. There are 20 commodity ETFs (including seven precious metal ETFs) currently listed on the ASX (see Table 4).

Let’s first look at the non-precious metal ETFs, covering commodities like corn, natural gas, oil and grains.

The truth is that none of them actually invest in commodities. Every single one of the 13 non-precious metal commodity ETFs is a ‘synthetic’ exposure obtained via futures contracts.

What does this mean to potential investors? First, you need to establish whether you want exposure to an index or a commodity itself. These ETFs might have natural gas or oil in their titles but they don’t invest directly in them. Instead, they invest in futures and hope to track an index of futures prices (ETFS Natural Gas tracks the Dow Jones-UBS Natural Gas Subindex).

This means the performance of these ETFs won’t necessarily track the price of the commodity. The spot price of natural gas may rise over the next year but your investment in ETFS Natural Gas may not.

Equity index ETFs hold the underlying shares so their performance will closely track that of the share prices. But synthetic ETFs are buying futures, which often trade at a premium to the spot price of the commodity and need to be regularly rolled (exchanged for new contracts) due to their short term maturities.

Let’s assume for a moment the spot price of natural gas doesn’t move and the premium on futures prices is consistent. If the synthetic ETF makes a small loss every time it rolls into a longer dated futures contract, it will make a loss over the course of a year and underperform the natural gas price.

Why don’t synthetic ETFs avoid this problem by buying the commodity? The answer is simple—storage. Unlike shares and bonds, storing natural gas, oil and corn is difficult and expensive. Futures contracts might avoid the actual storage but they come with their own cost.

The one class of commodities ETFs that doesn’t trade synthetically (at least in Australia) is precious metals. Gold, silver, platinum and palladium are much simpler to store than natural gas and oil.

So, if you invest in the Betashares Gold Bullion ETF the fund takes your money and buys gold bullion, which it then stores in JP Morgan’s London vault. This means the price of the ETF should track the price of gold (pre-fees).

But there is still a catch. Compare the Betashares ETF with Perth Mint Gold. While Perth Mint Gold is technically not an ETF—it’s legally structured as a call option—your exposure is still to the spot price of gold.

The more important difference is what can happen with the underlying physical gold bullion. Whereas Betashares has gold bullion registered in its name in a London vault, Gold Corporation (a WA government entity which issues Perth Mint Gold) is entitled to hold the bullion in unallocated form (this enables them to lend it out for a fee).

This brings in what is known as counterparty risk. Yes, it’s the Western Australian government—hardly a poor credit risk—but it is an extra link in the chain connecting you to your investment.

This leads us to the second catch with precious metal ETFs—one more relevant to those investing in gold as a hedge against banking system or fiat currency failure. Gold (and, to a lesser extent, other precious metals) is an interesting asset due to its dual role as a commodity and currency. Some investors view it as the ultimate safe haven—protection when paper (or digital) money fails.

Whether or not this is true of the physical asset, there is every chance it is not true of an ETF—regardless of what is in the London vault. There is simply no way of knowing how an ETF is going to perform in the event of a systemic crisis.

If you’re looking for gold price exposure through an ETF, fine. But if you want shelter in a crisis—some gold to go with the guns and whisky—look to the physical metals and secure storage.

Other ETFs

Overseas ETF options are more exotic than the menu served up here. Thrill-seekers will find leveraged ETFs (where your index exposure is multiplied), short ETFs (which give negative exposure to an index) and leveraged short ETFs, which have caused problems due to the need for them to be rebalanced daily—over time they tend not to track the index in the manner expected. Unless you are punting or seeking single day exposure, all should be avoided.

Yet to arrive on Australian shores are ‘active’ ETFs that behave like the traditional managed fund but are listed on an exchange. This provides another option for those that prefer their investments listed.

Mythbusted?

The world of index funds and ETFs isn’t full of traps and pitfalls. There is something on offer to those looking to use a core-satellite approach, or for a simple low-cost investment. There are issues to watch out for—synthetic ETFs, in particular, probably aren’t going to have a place in the average investor’s portfolio—but don’t let that stop you exploring.

As always, send us your questions, and keep an eye out for future Product Sleuth reviews of some of the more popular ETF products.