Exchange Traded Funds (or ETF’s) have become very popular, particularly over the past 5 years. In fact, the amounts invested in ETF’s has doubled over this time. Last year (2020), Australians invested over $20 billion in ETFs.
It is true that there are some advantages to investing in ETF’s. However, of course, not all ETF’s make good investments and there are some common pitfalls you must be aware of.
What is an ETF?
An ETF is simply a managed fund that is owned in a company structure and that company is listed on the Australian Stock Exchange. The only assets the company holds are the underlying investments. For example, for an ASX200 ETF (such as A200 or IOZ), the company would own the top 200 listed stocks proportionally according to their market capitalisation (value).
You can invest in an ETF using an online share brokage account, such as Commsec.
What are the advantages of ETF’s
Prior to ETF’s, the only way to invest in a managed (or index) fund was directly with the investment manager e.g. Vanguard.
This required you to fill out an application form each time you wanted to make a new investment. The managed fund would charge you a fee each time you invested and/or divested (this is called a buy/sell spread). And some of the lower cost ‘wholesale’ funds were only available to people if they invested a minimum of $500,000.
ETF’s provide a good solution as they allow you to invest in a wholesale managed fund for the cost of a share trade (which can be as low as $10) and no paperwork is required.
ETF’s and LIC’s are different
Importantly, ETF’s tend to utilise rules-based investment methodologies (commonly referred to as index funds). These products tend to have two common characteristics. Firstly, they are very low-cost. Investment management fees are typically below 0.40% p.a. (some as low as 0.04% p.a.) Secondly, they tend to be very well diversified. You can find a list of all ETF products here.
However, Listed Investment Companies (or LIC’s) are distinctly different as they tend to employ active funds management (remember that few active funds outperform their indexes in the long run). This means these funds can be more concentrated (less diversification) and tend to charge higher investment fees.
Beware that they are designed for retail investors
ETF’s are mainly used by retail investors (DIY investors), but a growing number of financial advisors have started to use them. In the US, substantially more institutional investors (such as large super funds) use ETF’s, but this trend has now occurred in Australia. This creates a few notable consequences.
Firstly, ETF providers will promote products that align with ‘popular’ themes such as investing in technology. Popular investments attract more investors and the more money an ETF attracts, the more fees the ETF provider generates. However, we all know that what is popular doesn’t always make a sound investment. In fact, it is proven (empirical data) that investors that chase trends tend to achieve poor investment performance.
Secondly, because ETF’s are mainly targeted towards unsophisticated (DIY) investors, the investment methodology and thematic must be easy to understand and communicate (i.e. marketing). If the methodology has some complexity, albeit fundamentally sound, it is less likely to attract enough interest. This means that some otherwise very sound (and attractive) methodologies will never be offered in an ETF format. As such, if you are limited to investing in ETF’s only, you are missing out on some sound and attractive investment opportunities.
If they are not popular, they won’t survive
If an ETF product does not attract enough money, at some point an ETF provider will likely wind the product up. You need to take this into account if you identify an ETF that you would like to use but may be less popular. There is no point taking a medium to long term investment position if the product/investment isn’t going to operate long enough for your investment strategy/thesis to play out.
Make sure it does what it says on the tin
The ETF provider’s goal is to get you to invest. Therefore, they will name and describe the product to make it seem as attractive as possible. But you should never allow yourself to be fooled by this marketing. It is imperative that you conduct thorough research (for example, our firm spends a lot of money on such research, because its critical).
By way of example, there is a “Battery Tech & Lithium” ETF with the ticker code ACDC. You might think that investing in companies in the battery space makes sense given electric vehicles are becoming more popular. However, when you look some of the companies this ETF invests in, some give you exposure to other sectors e.g. it invests in Renault and Nissan. I’d argue that is more of an automotive exposure, than battery, and may not be desirable. This ETF also has a significant concentration in one geographical market (27% in Japan). The index it uses is relatively new and unproven. And, as you would expect, it invests in US darling stock, Tesla, which is trading on a PE ratio of over 1,300 times (anything over 20 is relatively high)!
I’m not necessarily suggesting this ETF is a poor investment, although I do have some reservations and I have not recommended it to any of my clients. But my main point is that you must undertake thorough due diligence prior to making any investment. Our research provider looks at the investment team’s experience, investment approach, transparency, liquidity, fees, performance and risks.
Other considerations
There are a few other important factors to consider:
- Is the ETF trading close to its Net Tangible Asset (NTA) valuation. NTA is how much the underlying investments are worth. Sometimes an ETF can trade as a discount or premium to NTA value. Admittedly, this is more common with LIC’s.
- Is there enough liquidity? That is, should you want to sell your ETF shares, will there be someone that will buy them from you? ‘Market makers’ will provide liquidity if required, so make sure they use a reputable one.
- Some ETF products are synthetic. That is, they do not hold the physical underlying assets/securities. Instead, they use financial derivatives (such as swaps) to achieve the desired exposure. This is more common for mineral/resource ETF e.g. a gold ETF. Typically, I would recommend avoiding synthetic ETF’s as they lack transparency, which makes it more difficult to assess risk.
Proceed with caution
ETF’s offer some great advantages.
If you are a DIY investor, I would suggest you only invest in the ETF’s that provide broad-based (i.e. proven indexes) exposure to one or multiple geographical markets. For example, Vanguard offers some really good, diversified ETF’s – see here.
However, if you have a lot of money to invest, it would be wiser to use a combination of ETF’s and managed funds and invest in obtaining independent financial advice.
