What are ETF’s?

ETF’s have become the latest big investment trend on the ASX and the growth looks set to continue. Over the past 9 years the ETF market in Australia has increased in value from around $500 million to over $4 billion. In the US the market is far greater having grown by 34% pa over the past 10 years to the current level of $1.5 trillion.

But What is an ETF?

ETF’s (or Exchange Traded Funds) are managed funds quoted for trading on a securities exchange. Generally ETFs are constructed as indexed portfolios of shares, bonds or real estate securities. This is done through purchasing all, or a representative sample of the individual shares in the index. While the majority of ETFs track market indices, other ETFs may track a narrow sector of a market or even be based on stocks with particular characteristics, such as their dividend yield. ETFs which track securities with particular characteristics such as dividends can be thought of as listed quantitative managed funds.

ETFs can be bought and sold through share trading accounts and investment platforms in the same way as shares at any time during exchange hours at intraday prices, rather than end of day prices as with unlisted managed funds.

Advantages of ETFs

Low costs

The management fees for index-based ETFs are usually significantly less than investing in the same exposure of individually purchased securities. ETFs are also more cost efficient than actively managed funds and are often priced lower than comparable unlisted indexed managed funds.

Diversification

Index funds invest in all or a representative sample of securities in an index and provide a highly diversified investment.

Potential for tax efficiency

The low turnover of an indexing approach minimises the capital gains distribution impact. This improves after-tax performance and tax efficiency over the longer term. ETFs also offer other potential tax benefits in comparison to managed funds as a result of the different process for redemptions.

Liquidity

Unlike unlisted managed funds, investors are able to trade ETFs during ASX trading hours and at a price quoted on the ASX. The authorised participant’s ability to create and redeem ETF securities on a regular basis ensures an underlying depth of liquidity.

Transparency

The issuer of the ETF provides daily information to the market including the ETF basket and the Net Asset Value (NAV) of the ETF, making ETFs a highly transparent investment option.

Disadvantages of ETFs

Below Market Returns

ETFs, like indexed unlisted managed funds, don’t offer the potential for above-market returns, in contrast to actively managed funds. Even the most efficient ETF will only ever be able to provide investors with the return of the relevant ETF less its management fees and transactional costs.

Tracking a market index also means that ETFs don’t have the potential to minimise the effects of market downturns. Most active managers have an allowance under their mandates to allocated funds to cash in periods of heightened risk and volatility.

Liquidity

While liquidity in terms of the ability easily transact and settle ETFs via an exchange is one of the purported benefits of ETFs, the structure of the ETF market creates potential disadvantages in terms of liquidity. Here the ability to execute a transaction at an appropriate price is the important issue. ETF liquidity is largely determined by the liquidity and volatility of the underlying market being tracked but market supply and demand and sentiment conditions also play a part. If an ETF or underlying market is not widely traded then the buy/sell spreads can move wider, however the activity of the Authorised Participants is designed to mitigate this and liquidity has not been seen to be a real problem for ETFs traded to date.

 

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