ETFs are a $50 billion industry and new funds are listing on the ASX every month. Are they worth a look?

In the second article in our Investing Basics series on exchange-traded funds, we examine the pros and cons of ETFs compared to traditional unlisted managed funds so you can decide if they're a good fit for your portfolio.

More in this series: What is an ETF?

Advantages of ETFs

  • Low cost
  • Diversification
  • Low minimum investment
  • Transparency
  • Ease of access
  • Low-turnover
  • Fully-invested

Low cost

ETFs have ultra-low ongoing fees compared to traditional unlisted managed funds. They are generally cheaper than their active counterparts because they don't require an investment manager to be involved in analysis and picking stocks. Investors also don't have to factor in performance fees, which are charged by some funds for outperforming their benchmark.

Costs associated with managing an ETF include the purchase and licencing of the index, custodian fees, accounting fees and audit fees. As an investor, to buy (or sell) an ETF you'll be charged a brokerage fee, the same as you would trading stocks. Brokerage fees typically cost between $10 to $20.

That's not to say that all ETFs are low fee. You can use the Morningstar ETF screener to weed out the more expensive ones.

It's almost impossible to stress how important low fees are in driving superior performance. To illustrate, here's a simple example of the difference over 10 years assuming an initial investment of $10,000 and a return of 5 per cent annually in two funds. Fund A charged management fees of 0.10 per cent annually, while Fund B charged 0.80 per cent annually. The difference in fees paid over 10 years between Fund A and B is stark - $1087. 

Diversification

Another benefit of ETFs is the ease with which they enable you to gain exposure to a market segment, country, or region. If, for instance, you already have a diversified world share fund in your portfolio which invests primarily in the developed markets of North America and Europe, then purchasing an emerging markets ETF would enable you to quickly and cheaply add exposure to the developing world as well.

Low minimum investment amounts

Unlisted managed funds for retail investors often have minimum investment amounts of $5000 or more. This can be a minimum amount for the first time you invest in the fund, or every subsequent investment. ETFs, on the other hand, have no minimum investment amounts, so you could invest as little as $5.

However, there's one caveat. Online brokers may have minimum purchase amounts. CommSec, for example, has an initial purchase amount of $500.

Transparency

ETFs are also highly transparent investment vehicles compared to traditional unlisted managed funds. It's easy to see through to the ETF's underlying stockholdings and price. By contrast, many Australian fund managers are reluctant to disclose regular, comprehensive portfolio holdings for their funds, which means it can be difficult to know and understand exactly where your money's invested.

transparency

Ease of access

For a retail investor without a financial adviser or access to an investment platform, buying units in an unlisted managed fund has historically been difficult. Download a paper application form, print it, fill it in, sign it and send it via snail mail. The forms too are a headache. The Bennelong Funds Management application form, for instance, is 27 pages long - and this is not unique to them. The ASX's mFund service now makes it easier for individuals to buy and sell unlisted managed fund through their broker. However, not all funds and brokers have signed up.

However, because ETFs are listed on the exchange, investors can buy and sell them as they would a normal share.

Low-turnover

Another advantage ETFs possess is that they're low-turnover investments, especially in comparison to many actively managed domestic share funds. The basket of stocks the ETF tracks only changes when companies are added to or removed from the underlying index, unlike actively managed funds, where the fund manager may buy and sells stocks regularly. This low turnover means that an ETF is less likely to generate high levels of realised capital gains.

Fully invested

Unlike traditional managed funds, which generally have to keep a small amount invested in liquid assets such as cash to fund investor redemptions, ETFs as exchange-traded products have no need to hold cash and can therefore be fully invested. In the same way, ETFs have the advantage of not having to sell assets to pay out redemptions, unlike managed funds, where forced sales of assets in falling markets can reduce the value of an investment in the fund.

Disadvantages of ETFs

Although as we've seen ETFs have a lot going for them, there are some issues to watch out for.

  • Outperformance
  • Narrow focus
  • Trading issues
  • Brokerage and drip feeding

Outperformance

Like index managed funds, ETFs don't offer the potential for above-market value-add that comes with investing in an actively-managed fund. Tracking a market index also means that ETFs don't have the potential to minimise the effects of market downturns.

Outperformance is not guaranteed; sometimes an ETF can do better than its index, but sometimes it can do worse. Almost nine in 10 actively managed mainstream Australian equity funds failed to beat the market last year, according to the latest figures from S&P Dow Jones Indices, as reported in the Australian Financial Review.

However, Morningstar analysts have applied Bronze ratings across all providers of ASX 200 tracking ETFs as their preferred (Gold, Silver) active managers have been able to outperform Australian equity benchmarks over the long run, even after accounting for their higher cost.

In contrast, a handful of S&P 500-tracking ETFs carry a Gold rating, as well as several Vanguard multi-asset ETFs. Domestic small-cap active managers have demonstrated their ability to beat the S&P/ASX Small Ordinaries benchmark (over a long period), according to Morningstar associate director, manager research, Michael Malseed.

Morningstar fund analysts assign the ratings on a five-tier scale with three positive ratings of Gold, Silver, and Bronze; a Neutral rating; and a Negative rating. The Analyst Rating is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term.

Money

Narrow focus

An ETF to tap into the robotics revolution. Another for getting exposure to rapid urbanisation. Since ETFs first launched in Australia in the early 2000s, the focus has narrowed as the industry evolves, and new products come to market. A narrowly focused ETF that for example tracks a single-sector segment such as healthcare or technology stocks increases the risks to your portfolio, particularly if that sector underperforms. These products also tend to be more expensive than your garden variety low-cost, broad market ETFs.

All this means that if you're going to invest in a country- or region-specific ETF, you should consider combining this with a diversified global share fund or ETF which gives you exposure to a wider opportunity set of regions, industries, and individual companies. It's also worth scrutinising at the individual stocks an ETF tracks before deciding whether or not to buy. If you already have an unlisted global share fund, you may already have exposure to many of the same stocks.

The caveat “don’t buy what you don’t understand” is always worth remembering.

For more see Thematic ETFs are hot, until they're not

Trading issues

ETFs sometimes trade with wider than normal bid/ask spreads, or deviate substantially from their net asset value, which can jack up the cost to investors. Reasons for this can range from market volatility, illiquid or closed underlying markets, thin market-making activity, or operational errors.

Morningstar analysts have seen extreme spreads and discounts in US-listed ETFs at times, and to a lesser but still substantial degree, in Australia too. By being aware of a few simple rules, investors can avoid most of these issues.

For more see 10 tips for more effective ETF investing

 

Brokerage and drip feeding

Each time you want to buy or sell shares in an ETF, you'll have to pay brokerage, let's say between $15 per trade. If you were to make regular investments of $500 a month, this means you'd be paying 3 per cent of the amount you're investing each time you added to your investment. Over a year - 12 monthly contributions of $500at $15 brokerage for each contribution - this means you'd be surrendering $180 of your $6000 total investment in transaction costs. For this reason, ETFs are less suitable if you're an investor who wants to top up your investment by trading regularly in small parcels. A more cost-effective method would be to buy ETF shares on a quarterly, six-monthly, or annual basis.

The Verdict

ETFs are a cheap and efficient way to gain market exposure. Nevertheless, look carefully before you leap. Keep in mind that many of the ETFs currently available invest in narrow and potentially volatile areas of world sharemarkets. And do your homework about how much investing in an ETF is really going to cost you, as the advantage you gain from low ongoing costs can be offset by brokerage fees on small transactions. Hopefully, though, the arrival of real competition in the cost area will lead Australian investors to pay greater attention to what they're paying and put pressure on fund managers to reassess what they're charging, increasing the possibility of lower costs for ETFs and unlisted managed fund investors alike.

A version of this article originally on Morningstar.com.au in 2009 by former Morningstar communications manager Phillip Gray.