ETFs pave the road for those seeking diversification

Investors have piled money into exchange-traded funds in recent years for a good reason: they offer investors low-cost exposure to asset classes such as shares and bonds, including those listed on offshore exchanges which were previously inaccessible.

The fact that ETFs track various indexes also makes them a great alternative for investors who have no interest in picking individual stocks, or in paying fees to active managers trying to beat the benchmark when more often than not they don’t.

Reflecting their popularity, funds under management in the Australian exchange traded products (ETP) market jumped 27.4 per cent to $60.7 billion in the year ended April 30, Australian Stock Exchange data shows.

About 90 per cent of this market consists of ETFs. There were 212 ETPs listed on April 30, up 194 a year earlier.

Angela Ashton, founder and director of investment consulting business Evergreen Consultants, says ETFs are popular because they are inexpensive, liquid and generally simple in concept.

“Some investors will use them for simple, cheap long-term exposures to markets. Others will use them to express shorter-term ideas or more specific views, such as holding exposure to healthcare or gold,” she says.

“Investors are also assured that they can buy or sell assets at their current market value.”

Stan Shamu, senior portfolio strategist with Crestone Wealth Management, says the real benefit of ETFs is that they offer investors broad market exposure at relatively low cost.

Several popular ETFs charge management fees of less than 10 basis points, compared with active fund managers who charge an average of 1.5 per cent per annum for Australian equity funds.

“The difference in fees can have a material impact on cumulative returns over the long term,” says Shamu.

Active managers

While in the past active managers have delivered returns in excess of the benchmark, this has been more challenged in recent years, which has pushed investors into ETFs.

The S&P Dow Jones Indices’ SPIVA Australia Scorecard for 2019 has evaluated the returns of over 829 Australian equity funds (large, mid, and small cap, as well as A-REIT), 420 international equity funds, and 115 Australian bond funds.

The scorecard of actively managed funds found that 61.5 per cent of Australian large-cap equity funds did not outperform the benchmark over the one-year period.

Over the five and 10-year periods, active funds performed worse: 80.8 per cent and 83.9 per cent of funds underperformed the S&P/ASX 200, respectively.

Risk-return trade-off

For international investment, in 2019, more than 70 per cent of international equity funds underperformed their benchmark, the S&P Developed Ex-Australia LargeMidCap. Over the five and 10-year periods, 86.6 per cent and 93.5 per cent of funds in this category failed to beat the S&P Developed Ex-Australia LargeMidCap, respectively.

“For investors who aren’t willing to make specific stock calls in this environment, ETFs are a great alternative [to actively managed funds],” Shamu says.

Like any investment vehicle, ETFs involve a trade-off between risk and return.

Evergreen’s Angela Ashton says managed funds can add value in ways that ETFs cannot.

Active fund managers can take part in capital raisings, potentially adding value fairly easily, she says. “ETFs can’t access these opportunities.”

Crestone’s Stan Shamu says one of the major downsides of ETFs which track market capitalisation indices is that they are not always set up to screen out lower quality stocks.

It is, therefore, possible an ETF will include companies that are over-leveraged or have cashflow challenges.

“If these companies fail, they will impact the value of the ETF. An active manager would remove these companies,” he says.

There are also longer-term risks.

As bull markets become extended, investors tend to pile capital into the most successful sectors.

But when the market turns down, these leaders lose value.

For example, Shamu says, the technology sector peaked at 29 per cent of market capitalisation in 1999 before falling to 14 per cent in 2002.

More recently, the financial sector peaked at 22 per cent in 2006 before troughing at 15 per cent in 2008 during the GFC.

“A reversal in markets can create issues for passive investors, as they invariably have full exposure to the largest sectors at the peak,” he says.

For investors who want to blend active and passive investing, there is the new generation of funds known as “smart beta ETFs”.

These ETFs follow an index but use predetermined rules to focus on particular asset classes or assets with particular characteristics, such as valuation, dividend growth or balance-sheet quality.

Smart beta ETFs allow investors access to specific types of companies, such as those with high growth, quality, or value, using various ratios or other methods to classify companies.

“Numerous academic studies have shown that excess returns can accrue to these types of companies (often at different times and sometimes very sporadically) and it is theorised that much of what an active fund manager can add can be captured through smart beta,” says Ashton.