Exchange-traded products also come with a measure of investment risk, including hidden costs and intra-day trading complexities, but there are ways to minimise this.

Australia’s exchange-traded product sector has hit another record high for funds under management as new money continues flooding in. However, while the structural tailwinds of convenience, low cost and transparency continue to drive investment, there are trading traps for the unwary, according to Morningstar analysts.

The continued popularity of ETFs was shown in the latest data produced by BetaShares. After reaching a record high of $39.2 billion in FUM in the first six months of 2018, up 9 per cent, the sector broke through the $40 billion barrier in August to reach another new record of $41.5 billion. Just six years ago, FUM totalled barely $5 billion.

Australian investors also have increased choice among these vehicles, with 231 ETPs currently available. These span various asset classes, including fixed income and international equities, commodities and property. Multiple strategic approaches are also represented, including short-selling, strategic beta and others.

Significantly, in the wake of the financial services royal commission, fees have also continued to fall as competition within the space has ramped up.

Morningstar’s associate director, manager research, Alex Prineas points to Australian ETFs priced as low as four basis points, the iShares S&P 500 ETF (IVV) and the Vanguard US Total Market Shares ETF (VTS), “both US equity ETFs with very large strategies”.

In contrast, “the most expensive on our database is the K2 Global Equities Fund (KII), which has a 2.05 per cent management fee. This is an active hedge fund, so it’s engaged in short-selling and other strategies,” he says.

“It just emphasises that even though there an increasing number of products, you can’t always assume that ETPs are a low cost, low turnover, passive option. There’s a huge variety and complexity so you need to make sure you understand the investment strategy and what you’re buying."

Trading traps

While ETPs offer a range of benefits, there are some common trading errors that can result in "a big reduction on return," according to Morningstar senior analyst, Matthew Wilkinson.

trading

Market volatility and trading errors can eat into potential returns from ETF investing

Research and analysis of ETPs can help investors select the right product. Yet even then, there are still pitfalls, warns Wilkinson. These include:

  • Misleading intraday net asset value (iNAV) – the more market volatility, the greater the likelihood the iNAV will be “meaningfully different” from the end-of-day NAV;
  • Premium and discount risk: A well-known issue for closed-end listed investment companies, occasionally ETPs can also trade at significant premiums or discounts to NAV;
  • Investor biases: Continuous trading has the potential to bring out investors’ worst biases, such as a short-term mindset and overtrading, “potentially making only the brokers happy”;
  • Hidden costs of bid-ask spreads: Paying a wide bid-ask spread when buying or selling can “severely dent” returns. Spreads can be skewed around an iNAV, or liquidity can dry up on occasion, making trading “extremely expensive”.

“For these reasons, Morningstar maintains lower ratings on active ETPs than for equivalent unlisted unit trusts,” Wilkinson says.

He points to data showing 424 ETP price spikes over 239 days between November 2008 and February 2018, amounting to a traded value of around $5.5 million excluding institutional-size orders.

“This is a meaningful number of retail investors being caught out by these products, and this may not even represent all spikes,” he says.

Trading during the first 15 minutes is “especially fraught” with price aberrations, “particularly in new and less-liquid ETPs,” Wilkinson says.

Spreads can widen during periods of market volatility due to uncertainty over the accuracy of a NAV, such as during the US election in November 2016. However, spreads can widen in calm markets too, such as when market makers are establishing processes for new products or if there are interruptions to ASX trading.

Nevertheless, such price spikes are “certainly not the norm,” Wilkinson says.

“Most of the time, ETPs trade with reasonable spreads, especially for traditional passive ETFs tracking mainstream benchmarks”.

Wilkinson suggests the trading traps can be avoided by using limit orders wherever possible; checking the manager’s website for the iNAV; checking spread and market depth and avoiding trading during the open, close and auction period; not using stop-losses; and only using such products with a “longer-term mindset” to avoid excessive trading.

“There’s nothing wrong with taking a long view, being patient and not trading, or contacting the ETP provider to assist with executing a trade. If you don’t trade, you can’t do a bad trade,” Morningstar’s Prineas says.

Asked to predict the outlook, Prineas says a market correction could result in outflows from ETFs in the short run. Yet in the long run, “the structural tailwinds supporting ETPs should generate further growth in FUM”.

“Ultimately it’s about what assets you’re invested in and what’s your timeframe. If you’re invested for the long run, you can ride through short-term market corrections and even top up”.

 

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Anthony Fensom is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. The author does not have an interest in the securities disclosed in this report.

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