The ETF success story
The benefits of ETFs make ETFs attractive to investors.
The ETFs juggernaut shows no signs of abating, as the quantum of funds, inflows and product innovation continues to boom. This article, proudly sponsored by Russell Investments, explores the intricacies of ETFs.
The twentieth anniversary of the launch of Australia’s first ETF passed quietly, occurring as it did in the middle of the CIVID-19 pandemic in 2021. Much of Australia was in lockdown at the time; many advisers were grappling with running businesses from home and mollifying clients concerned about market volatility. However quietly it passed for most of us, there were those that looked back to the launch of the first Australian ETF in February 2001; at the time this ETF that tracks the S&P/ASX 100 Index was launched, ETFs in the US had amassed funds under management (FUM) of nearly A$100 billion[1].
ETFs by the numbers
Since that first ETF was launched, the statistics are staggering. At 31 December 2022[2] there were 276 exchange traded products (ETPs) available to Australian investors, with a total market capitalisation of A$130.44 billion. An average daily value of $419,853,475 was bought and sold on the ASX during the month, across more than 20,000 daily transactions.
Research[3] released late in 2022 found approximately 1.9 million Australians are invested in ETFs, a six percent year-on-year increase. Interestingly, 32 percent of ETF investors stated that ETFs are used as the core of their portfolios, a significant increase from four percent in 2019. The same report noted that the number of SMSFs holding ETFs reached 400,000 in 2022, up from 370,000 in 2020.
During the past five years, Australian ETFs have grown 38 percent per year. This is faster than the US (24 percent per annum) and Europe (23 percent per annum)[4]. This growth continues to underpin ETFs as one of this century’s investment success stories.
Although figure one shows just six years of data, earlier reports show market growth and activity on a similar trajectory – new ETPs are regularly launched and market growth continues, despite the volatility that has become part of the investment landscape over the past two years.
ETP market activity shows a marked increase over the pandemic years, both in terms of the number of transactions and the value traded.
Historically, Australian and global equities have consistently been the top two asset classes for ETF investors (figure two) both in terms of the spread off assets and by funds flow. However, the most recent data indicates a slowing of fund flows into global equity products, likely due to the uncertainty prevailing in global financial markets thanks to inflation, interest rates, volatility and talk of recession.
Of the 12 ETPs launched onto the ASX in November 2022, 11 were ETFs and of these, six were actively managed ETFs and one a synthetic ETF. A further five were launched in December – a synthetic ETF, two thematic ETFs and two active ETFs.
While early ETFs tended to focus on broad markets, a more recent trend is the focus on thematic products. A thematic ETF is one which provides the opportunity to invest based on a structural trends: responsible investing, climate change, energy transition metals or healthcare. There are approximately 22 thematic ETFs on offer to Australian investors – and with over 300 thematic ETFs available to US investors, it’s a number that’s likely to continue to grow.
Types of ETFs
As already touched upon, there has been considerable product innovation in the ETF space and there are now a number of different types of ETFs available. The upside is it means there is a greater number of options for portfolio construction, whether using ETFs as core or satellite investments. While passive and active ETFs are the most commonly used, other ETFs available to investors also warrant review.
Passive or Index ETFs
The original ETFs, referred to as index or passive ETFs, typically use an indexing approach that tracks a specific market or sector index, such as the S&P/ASX-200 Index or S&P/ASX All Industrials Index.
Such ETFs aim to deliver the same return – before fees and expenses – of the specific index it tracks. This is achieved by investing in the securities that comprise the index, and in the same proportion that each security holds in the index.
The quoted price of units in the ETF will change in accordance with changes in the valuation of the underlying securities. Accordingly, the value of a passive or index ETF moves in line with the index it tracks. Allowing for fees and expenses, the total return received by investors will be slightly lower than the index returns, whether positive or negative.
The popularity of index ETFs can be ascribed to, in part, the benefits they provide: diversification, transparency, low fees, trading flexibility and continuous pricing. It’s important to note, that ETFs are not without risks, such as market risk, currency risk (for global products) or regulatory risk.
Additionally, fixed income ETFs may be subject to interest rate risk and credit risk. Interest rate movements can result in a decline in income generated (falling interest rates) or a decline in the value of its (rising interest rates). With respect to credit risk, the issuer of the underlying fixed income securities may fail to make interest payments and/or repay the principal, or may have its credit rating downgraded, thereby affecting the value of the securities.
Active ETFs
Whether you know them as quoted funds, exchanged traded managed funds or active ETFs, this product class comprises actively managed funds that are listed and traded on the securities exchange in the same way as shares or index ETFs.
Rather than tracking an index, an active ETF follows a specific investment approach and invests in a portfolio of securities selected by a professional fund manager to achieve a stated objective. In most cases, the active ETF has an unlisted managed fund counterpart managed by the same investment team and following the same investment process.
The primary difference between active ETFs and actively managed unlisted funds is that active ETFs can be traded on a stock exchange and are required to disclose portfolio holdings on a periodic basis. However, some actively managed ETFs, notably those with concentrated equity portfolios, are permitted to publish their portfolio holdings less often, such as quarterly rather than daily, to protect their intellectual property and proprietary trading strategies.
Where a portfolio is published less frequently, the manager is required to publish an indicative net asset value (iNAV) that is updated every 15 seconds. This allows investors to gauge the value of the investment throughout the day.
Like their index counterparts, active ETFs are transparent, provide diversification and offer trading flexibility. Active ETFs generally have higher costs than index ETFs, to compensate for the time and resources required from investment managers to manage them.
Thematic ETFs
Following emerging trends and megatrends, or capitalising on structural shifts, thematic ETFs generally invest in a smaller number of securities focused on a specific idea or market niche. Some thematic ETFs may have a broad investment mandate, such as climate or ESG. Others have a narrower focus, such as those focused on robotics, cryptocurrency, specific minerals or artificial intelligence.
As with active ETFs, the fees associated with thematic ETFs are generally higher than traditional index ETFs.
The main positive about thematic ETFs is that they provide exposure to a particular theme or sector that may be otherwise difficult to invest in, thereby providing diversification benefits to your clients’ portfolios. However, because thematic funds typically hold less stocks that traditional ETFs, the broad diversification benefits generally gained from ETF investing are not present.
While a thematic ETF may prevent stock specific risk arising from investing in a stock in an industry or sector of interest to an investor, it does not mitigate theme specific risk. Indeed, this can be an issue for investors. US-based research[4] found that thematic ETFs are often launched near the top of the market, at a time of peak interest in that particular theme, which often precedes a steep fall in returns – and therefore, underperformance of the ETF.
Thematic ETFs may also be more susceptible to liquidity risk – the liquidity of the fund generally correlates to the market liquidity for the underlying assets. If the market for the underlying assets becomes illiquid, the ETF is likely to follow suit.
Synthetic ETFs
Another ETF where the nomenclature can be confusing, as synthetic ETFs are also referred to as structured products. A synthetic ETF invests in derivatives and swaps rather than in actual physical assets such as shares or fixed income securities. Investors in synthetic ETFs typically don’t receive an interest in a portfolio of assets held by the fund, instead relying on rights against the issuer of the fund under the terms of issue[5].
Synthetic ETFs are designed to provide exposure to assets that are hard to access, such as certain commodities. Using copper as an example, instead of owning tonnes of copper or shares in copper miners, a synthetic ETF that is tracking copper will hold a series of copper futures contracts. These agreements are established with a third party, usually an investment bank, who promises to pay back an agreed level of return when copper reaches a certain price.
While synthetic ETFs can often offer higher potential returns than those holding assets such as shares, they also come with greater risk. Because synthetic ETFs use derivatives to achieve their investment objective, investors are subject to the risk that the counterparty to the derivative may fail to meet some or all of their obligations.
Inverse ETFs
There are four inverse ETFs currently available in Australia, designed to allow investors to take a contrarian position. Inverse ETFs generally aim to provide returns negatively correlated to an asset class or index.
An increase in the value of the asset or index will generally result in a decrease in the value of the product; conversely, a decrease in the value of the asset or index will generally result in an increase in the ETF’s value.
There are two main strategies employed in managing an inverse ETF. The first is the use of short selling, which may involve the risk of incurring significant losses over and above the initial investment if the market moves counter to expectations. The second strategy is a synthetic construction using over the counter derivatives to obtain an inverse return. Over the counter derivatives may be subject to significant counterparty risk.
Importantly, taking a view and investing in an inverse ETF is not a set and forget strategy.
Annual surveys[6] have found the number of financial advisers recommending ETFs to clients has more than doubled over the past 10 years. In 2021, sixty percent of advisers were using ETFs in client portfolios, up from 27 percent in 2010.
Twenty one years after ETFs first launched on the ASX, advisers can now construct and maintain an investment portfolio across asset classes and investment styles, entirely with ETFs. The benefits of ETFs – transparency, low cost, trading flexibility, liquidity and buying/selling at fair value – make ETFs attractive to investors. However, ETF investing is not without its risks and some more exotic products carry a greater number of risks than the traditional index ETF. This is where advisers play an important role, ensuring your clients invest in ETFs that are appropriate for their risk profile and situation, and best placed to meet their financial objectives.
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