CPD: A checklist when considering ETFs

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What are the advantages and benefits when recommending ETFs to your clients?

In the past 12-18 months we have seen an increase in popularity of Exchange Traded Funds (ETFs) in the Australian financial services market.  According to the 2020 Stockspot ETF report, in 2019 the ETF market grew 24%, with expected FUM in Australia to reach $100b by 2022. This increased interest has been driven by a combination of factors such as:

  • Australians having an increased focus on fees and transparency of their investments;
  • A move out of underperforming active fund managers;
  • Regulatory change pushing advisers to act in the best interest of their clients;
  • Product innovation; and
  • Increased financial awareness of the benefits of diversification.

Let’s take a look at what an ETF is, the advantages and benefits, and what to consider when recommending ETFs to your clients.

What is an ETF?

An ETF is similar to a managed fund except that it’s bought and sold on the stock exchange just like shares such as Commonwealth Bank and BHP. ETFs allow investors to hold a range of assets such as bonds, shares or commodities in one trade.

ETFs can invest in one type of asset class or various industries. They can also provide access to a particular strategy like fixed income, dividend income, or ESG. ETFs seek to provide the return of an index or return of an asset class minus any fees.

How do ETFs work?

Buying and selling ETFs is just like shares, so you can buy and sell during the Australian Stock Exchange (ASX) trading day. There is usually no requirement of a minimum investment. It can be done in two easy steps:

  1. Set up your brokerage account;
  2. Use the ASX ticker to buy or sell.

Consider how ETFs can be used in your clients’ investment strategy and what will be suitable for them. ETFs can be used as a core/satellite strategy, meaning your clients can build a core diversified portfolio of indices or asset classes.

What benefits do they offer investors?

ETFs offer investors simplicity, liquidity, transparency, and value for money.

Transparency: At any time, the underlying portfolio holdings of an ETF can be viewed online via the ETF Provider.

Liquidity: ETFs are traded on the ASX so can be bought or sold at any time throughout the trading day.

Diversification: Investors can gain investment exposure to a range of investment strategies, geographies, and asset classes through the purchase of a listed ETF. They are an effective way to diversify a portfolio in an easy and simple manner.

Value for money: ETFs track the performance of an index or asset class. In some instances, they apply a rules-based methodology which can mean no active management fees for investors.

For advisers looking to recommend ETFs to their clients, below is a checklist of things to consider for your clients.

Your five point ETF checklist

1. The index

A core element of investing in an ETF is understanding what index and/or asset class the ETF is tracking.  Ensure you have in-depth knowledge of the ETF before investing. Is the index or asset class the ETF is tracking something you can easily communicate to your client and will they easily understand it?

2. Fund rating and research report

Has the ETF been rated by a rating house? When reviewing funds most rating houses interview portfolio managers, review investment processes and the index the ETF is tracking, analyse risks, capability and expertise of the fund managers, and the product structure.  The research and rating of the ETF will provide additional insight to you and your clients on the qualitative and quantitative capabilities of the ETF manager.

3. Price – The Goldilocks principle: just right

It’s critical to understand what your clients are willing to pay for an underlying investment fund. Often the cheapest doesn’t always provide a client with what they may need in their investment strategy. On the flip side, the most expensive may also not be appropriate.  Finding a happy medium when it comes to price is important.

4. Track record

Is the ETF issuer a reputable and long-term participant in the market? Do they have a proven track record backed by experience? For example, a global solutions provider like Russell Investments has been managing ETFs in the Australian market for over 10 years.

5. Watch the gap

What is the ETF’s tracking error? Does it closely match the underlying index returns? Watch out for historical high tracking error as the ETF may not be able to capture the performance of its underlying index.

Before you invest in ETFs it’s important to do your due diligence. This checklist is a guide to helping you select the ETF needed to meet your clients’ investment goals. Selected and managed wisely, ETFs can be a great investment strategy for investors.

Let’s take a look at how these principles can be applied when looking at ETFs

ETF case study 1

Dan and Lily Phong, both aged in their late thirties, recently sold their investment property, a 1 bedroom unit in Sydney’s inner city suburb of Waterloo for $730,000.  After discharging their mortgage of $400,000 they had $330,000 left to invest.

Dan and Lily spoke to their financial adviser about investing their funds into a product that is aligned to their environmental and socially responsible values.  They also wanted a product that aligned to their risk profile that was, transparent, liquid, diversified and had a long-term track record.

Dan and Lily’s financial adviser Tony, reviewed his approved product list and identified a range of ETFs for Dan and Lily to invest in.

Tony was able to provide Dan and Lily with the following:

  1. Full transparency of the underlying holdings – all the holdings of the ETF could be viewed from the fund manager on their website.
  2. Liquidity – the investments can be bought and sold on the Australian Stock Exchange
  3. Diversification – the environmental and socially responsible fund recommended to Dan and Lily includes a range of holdings ranging from utilities through to REITs
  4. Track record – the ETF recommended by Tony for Dan and Lily is the Russell Investments Responsible Investing ETF (RARI) which has a five year track record

Tony as the financial adviser for Dan and Lily ran the five point check list over the fund, let’s see how it stacks up.

1. The index

The Index for RARI is the Russell Australia High Dividend Index and is constructed based on the outline below:

Index construction overview

  • Specify the parent index and remove non ASX listed securities
  • Eliminate companies failing Responsible Investment Committee criteria
  • Calculate an ESG score for each eligible security
  • Calculate an active weight and a portfolio weight based on the ESG score using the NLP
  • Calculate an income score for securities that have a portfolio weight greater than 0 from the previous step
  • Calculate an active weight and a portfolio weight based on the income score using the NLP • Remove securities with weight less than 5 basis points and reduce number of securities to 100

Using this criteria, it’s clear how the index constituents are determined, and the weights applied to each security in the portfolio.  Tony as the financial adviser downloaded a copy of the index methodology from Russell Investments’ website and stepped through it with Dan and Lily.

2. Rating

RARI has been rated by Lonsec and Zenith. The research report outlines the fund overview, the features, advantages, and benefits of the investment product along with the inherent risks. As a financial adviser, Tony’s licensee subscribes to Lonsec research and he has attached a copy of the Lonsec report on RARI to the statement of advice for Dan and Lily

3. Price

The price of RARI is not the cheapest in the market but at 0.45% it is also not the most expensive and is reasonably priced based on the index methodology and capabilities of the Russell Investments team

4. Track record

The ETF Tony has recommended to Dan and Lily has been in place for over five years and is managed by large international fund manager with local and global expertise.

5. Performance against the index

The ETF Tony has recommended has remained true to label in tracking the index over time

Of course, all investors are different and whilst this checklist and individual objectives are aligned to Dan and Lily’s goals, there may be other factors to include when considering ETFS.

For example, let’s take a look at another case study.

ETF case study 2

Josh and Ella Simpson have a self-managed super fund with a balance of $750,000.  Josh and Ella are in their early sixties and want to preserve some of the capital gains they have made recently on the Australian Share Market, as they plan and prepare to retire in the next three years.  The Simpsons are also keen to reduce portfolio volatility with the portion of capital gains they are looking to preserve.

The Simpsons speak to their financial adviser and given their ages and their goal to retire within the next three years, their adviser recommend they diversify $300k of their portfolio and invest it into Russell Investments Australia Bond ETF. This investment is seen as an alternative to cash given their desire to preserve capital and have access to their funds should they require it.

In looking at the checklist, the Simpsons’ adviser includes some other factors in considering their product recommendation.

  1. The Australian Bond ETF has a Zenith and Lonsec Rating. In the case of the Simpsons their adviser uses Zenith research for their product research
  2. The Australian Bond ETF has a long-term record in the Australian market along with long-term consistency against the index

As clients have different needs, the above checklist may be an ideal starting point to commence your ETF review as part of matching the appropriate product to your client need.

ETFs as an investment structure can offer clients the benefit of liquidity and diversification at a reasonable price.  With a range of products in the market understanding and communicating the index, research, price, track record and tracking error as an initial checklist along with the guidelines and accreditations from your licensee they may be a worthwhile solution for your clients.

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