ETFs: an alternative way to access indexing

The advent and growth of ETFs in Australia has created an alternative method for investors to access indexing, says Vanguard Investments' Robin Bowerman.

Of all the wonder, wit and innovation attributed to Nobel prize-winning physicist Albert Einstein, a favourite quote goes directly to the heart of a key investor education issue today: “If you can’t explain it simply you don’t understand it well enough.”

In other words, the power of simplicity is critical. A rule of inverse proportion applies here — the more complex the subject matter, the more simple the explanation required. Occasionally, though, one comes across a concept so simple that the reverse applies: simple concept, complex explanation.

This, I have to admit, is one of the unfortunate truths about the exchange-traded fund (ETF). Recent commentary surrounding the humble ETF has introduced a raft of unnecessary complexity through various claim and counter claim.

This tells us that some who seek, for example, to portray an ETF as reliant upon complex underlying processes like derivatives trading, don’t understand the ETF well enough.

In the spirit of Einstein, let’s go back to the drawing board. To keep it simple, I have devised three key points: A for Absolute, B for Basic and C for Control.

Absolute

An ETF is simply another way of accessing indexing. Or, put another way, an investment process by which investors gain low cost access to a market or sector of a market as represented by a benchmark such as the S&P/ASX 300 Index.

The primary levers driving the indexing investment rationale are simple — it is extremely difficult to outperform markets over the long-term after all fees are taken into account.

So for investors keeping costs low, diversifying the portfolio and taking a long-term approach will stand them in good stead. The evidence in support of these three drivers is compelling.

Vanguard recently completed a comprehensive research project into the Australian share market and found that 89 per cent of active managers underperformed the index over three years and 78 per cent over five years.

That is not to say there is not a role for active management in a portfolio — it simply reinforces how hard it is to pick strategies that will win in the future.

Let’s turn to costs.

We know over time that costs matter. Really matter.

That is why index funds keep a tight lid on management fees, trading costs and turnover. Actively managed funds typically incur higher management fees and higher transaction costs.

The higher fees often result from costs associated with the research and investment process that an active fund manager conducts.

Higher transaction costs are attributable to the generally higher turnover associated with active management’s attempt to outperform the benchmark.

And diversification? Index funds typically are more diversified than actively managed funds; attractive functions of the way indices are constructed.

The broad range of securities dampens the risk associated with specific securities and removes some return volatility.

Actively managed funds, on the other hand, typically hold fewer securities in more concentrated positions — the result being higher risk.

Basic

Whether on the outside looking in, or on the inside looking out, an ETF is pretty basic in design. As the name implies, an ETF is a fund traded on the securities exchange.

As such, investors receive all the positive attributes of an indexing approach, combined with the benefits of market trading and liquidity.

But what are investors buying underneath the hood? Today there are two different types of ETFs available on the Australian Securities Exchange (ASX). They include domestically listed and cross-listed funds.

The difference between the two is the domestic ETFs are Australian funds listed on their local exchange. Cross-listed ETFs are funds, which hail from overseas exchanges but have a secondary listing on the ASX (or another exchange other than their local exchange).

Sound complicated? It’s not. An ETF is an index fund that trades like a share.

Cross listed funds simply make it possible for everyday investors to access funds which they may not normally have access to on overseas share markets by listing the fund on the local exchange and so it is priced in local currency (e.g. Australian dollars) and sold (in Australia) as CHESS Depository Instruments (CDIs).

A depositary nominee, such as CHESS, holds title of the underlying ETF securities on behalf of the CDI holders.

In order to ensure a good level of liquidity exists in the case of both domestic and cross-listed ETFs, a market maker stands ready to sell to buyers and buy from sellers.

Another level of liquidity exists in the open-ended nature of these funds — in the ability of the issuer to create or redeem units to meet investor demand.

Where a level of complexity does come in is with an ETF’s open-ended structure — which is the mechanism that creates or redeems units and enables the intraday trading price to closely track the underlying value of the assets.

It is this mechanism that some commentators have struggled to come to terms with.

But it is what allows ETFs to trade close to its net asset value (NAV) unlike close-ended structures such as listed investment companies which typically trade at a significant discount or premium to net asset backing.

ETFs have been one of the most successful product categories in the US and Europe in the past decade and as a result have encouraged innovation and complexity in mature ETF markets like the US and Europe where geared or derivative based ETFs are offered.

However, in Australia the ETF market is in its early stages of development and the products are relatively vanilla and ASX rules specifically preclude geared ETFs.

In time, more complex ETFs are likely to be offered and advisers will need to understand what they are recommending to their clients.

But that is no different from understanding the difference between an index fund, an actively managed share fund or a hedge fund.

There is a risk spectrum and advisers will have to assess the underlying security risks as well as the reputation of the manager offering the product.

Control

Since the global financial crisis there has been a noticeable shift in thinking among financial advisers, which has driven a need for simplified solutions to solve the wealth creation needs of clients.

Indexing, whether through a managed fund or an ETF, is simply an effective tool for creating and maintaining control over the asset allocation of a portfolio.

One effective way to use ETFs and/or index-managed funds is to use them as the core component of a core-satellite portfolio.

This is a really practical investment approach that allows for a low cost, well-diversified core holding in the portfolio, which is then combined with active investments if there is a belief they will outperform.

It moves the portfolio construction debate out of the realm of active versus passive into a discussion about what is the right blend of market and manager risk for particular clients.

This is an investment approach that allows businesses to lower overall client investment costs, and potentially improve the advisers’ bottom line, while providing clients with greater transparency and consistency of results.

To wrap up: you don’t need the brain of a physicist to grasp the basics. But investing — like all things in life - is an ongoing learning process. As Einstein also said: “intellectual growth should commence at birth and cease only at death”.

Robin Bowerman is principal and head of retail for Vanguard Investments Australia.