Exchange Traded Funds (ETFs) have been around for 25 years and as a product with the characteristics investors are often seeking – access to diversification and liquidity – they have been met with extraordinary demand. ETF holdings in Australia have grown by nearly one third in the last financial year alone and on-exchange investments overtook cash and property as the most popular choice for Australian investors in 2017.
Until the first Active ETFs were launched in 2015, the choice to invest in an ETF was a decision to invest in a passive investment solution, but this is no longer the case. Investors now have the choice to buy both active and passive strategies on exchange.
While more choice can only be a good thing, helping investors to understand the benefits and limitations of the different structures will be important in helping them to meet their investment objectives.
What are Active ETFs?
While traditional, passive ETFs track an index to provide investors with low-cost exposure to a particular asset class, country/region or sector, Active ETFs, as the name suggests, are an actively managed portfolio of stocks constructed with the aim of outperforming the index which they are benchmarked against.
Like their passive counterparts, Active ETFs are quoted on the ASX and traded just like shares. Unlike regular managed funds, where an investor generally will not know the price per unit they have invested at until after the transaction, ETFs are traded at live market prices on an exchange. An iNAV price may be displayed by the respective fund manager (typically on the fund’s website) and updated throughout the day to provide an indication to investors what the underlying value of the ETF may be.
Each fund will have a different number of holdings depending on the investment approach and style. The key is to ensure the fund is diversified. A well-diversified portfolio reduces risk (the variability of return) without sacrificing long term returns. The key to efficient, effective diversification is combining asset classes or securities that have low correlations. Adding securities that are highly correlated with those already in the portfolio achieves little benefit and adds to costs.
What are its advantages?
The benefits of investing in an Active ETF are many and varied, with the simplicity and ease of buying and no minimum investment amount obvious drawcards.
To begin investing, or to sell ETF holdings, it just takes one trade on the ASX. With every unit purchased, investors get exposure to multiple assets without the trading costs it would take for direct investment in each one.
By delivering exposure to a basket of individual assets within a class, sector or region, ETFs can offer the diversification that can be effective in smoothing out returns and spreading risk. By choosing asset classes that are lowly correlated, if one or two investments are performing poorly, these can be offset by the returns you may receive on other investments within the portfolio.
Unlike regular managed funds, where an investor generally will not immediately know the price per unit they have invested at, ETFs are traded at live market prices on an exchange. This means an investors basket of holdings is available to view daily, giving investors timely visibility of their exposure to securities, markets, countries and sectors.
Some ETFs offer exposure to overseas markets, companies and asset classes that may be hard to access, research and monitor – such as emerging markets and industries. For investors seeking to avoid concentration risk that can come from weighting a portfolio towards blue-chip Australian equities, for example, trading global ETFs on the ASX can provide an easy, low-cost way to gain exposure to equities in other regions and sectors.
This is important because of the concentration of risk that currently exists in many investors’ portfolios. For example, a common example might be an investor who owns their own house, has investment properties and may also own shares (invariably bank shares because of the excellent dividends that Australian banks have delivered).
While they may think they have diversified their assets from property through to stocks and possibly funds, their exposure is still to Australian housing. That represents a risk. In making it easier to invest, Active ETFs are another way to help investors diversify their holdings and reduce this risk.
Traditional or Active ETF?
While the debate over active vs passive continues to rage in Australia, in reality active plus passive can be a great combination. At different points in the investment cycle, such as during increased volatility, a higher allocation to active may be more appropriate, while when all markets have fallen precipitously, a higher allocation to passive should achieve good returns for a lower cost.
When it comes to the benefits of passive investing, the period post the global financial crisis in 2008 is a good case in point. While the stock market had taken a hit, the Australian economy was largely untouched and market falls were largely sentiment based. Investing in a passive fund at this point would have been rewarding for an investor.
On the other hand, active management offers the opportunity to achieve excess returns over the index but very importantly can offer a degree of downside protection which is particularly important if the aim is to provide investors with a smoother ride during periods of volatility.
Investors can decide which strategies suit their objectives best, be they active or passive, and combine these options easily to help them achieve the outcomes they are seeking, whether than be low cost access to markets, to outperform the index or to defend their portfolio against downside risk in periods of volatility.
With an increasing number of Active ETFs now available from a range of providers, buying an actively managed fund has never been easier. As Australian investors increasingly understand the benefits of this vehicle, especially in enhancing diversification of investments and also in providing risk adjusted returns, their popularity can only grow.
Alva Devoy is managing director of Fidelity International.