From the introduction of retail unit trusts in the 1980s and the subsequent emergence of master trusts and access to wholesale unit trusts in the 1990s, the underlying theme of this evolution has been one of efficiencies underpinned by cost savings for both product manufacturers and investors. By the early 2000s unlisted index funds, both retail and wholesale, started to garner more presence in advisers’ portfolio recommendations. Roll forward to the second decade of this century and Exchange Traded Funds (ETFs) are now taking an increasing share of the capital deployment route for investors.

So what is it about ETFs which sees them receive a seemingly ever increasing flow of adviser recommendations for clients? AdviserVoice’s Ray Griffin spoke with John Hewison CFP of Hewison Private Wealth (Melbourne), Paul Dunn of Meridian Wealth Management (Melbourne), Tim Mackay CFP of Quantum Financial (Sydney) and Adrian Zoppa CFP of Hood Sweeney (Adelaide) in an effort to identify how advisers are using – or not using – ETFs in their advice to clients. He also then takes a close look at Exchange Traded Australian Government Bonds and how they provide access to government bonds in the retail market.

As the name suggests, ETFs are investments which can be bought and sold on an investment exchange and which can have a variety of underlying asset exposures. Shares both domestic and international, fixed interest (bonds), listed property, currencies and commodities exposure can all be accessed through ETFs. While the first ETF launched in 1989 in the United States was a passive share market passive index exposure, there is an emerging trend for ETF providers to market active funds.

In terms of equity ETFs, perhaps their closest relative is Listed Investment Companies (LICs) in that they are both bought and sold on, in the case of Australia, the Australian Securities Exchange (ASX). However, at that point they traditionally diverged with ETFs typically having been passive index exposure whereas LICs are investing in companies based on research and analysis which complies with the LIC’s investment strategy. Like LICs, ETFs provide low cost access to markets with Management Expense Ratios (MERs) as low as 0.05% p.a.

By early 2014, with the total number of ETFs being traded in Australia approaching one hundred, funds under management had reached circa $10 billion. According to a 2013 survey by BetaShares and Investment Trends, approximately half of the 102,000 ETF investors in Australia were SMSFs.  Globally, ETFs account for around US$2.4 trillion with more than 5,000 funds listed on 59 exchanges. With such numbers, ETFs are anything but the latest ‘fashion of the month’ investment.

ETFs more generally, tick both the efficiency and cost reduction boxes and are increasingly finding favour with both advisers and investors alike.  However one of their drawbacks, some advisers might argue, is that they can deliver exposure to assets which, given a choice, an adviser might not wish to recommend to clients.  In the case of index exposures, it could be argued that an ETF is a quasi-recommendation for all the assets which comprise the index; it’s a case of taking the good with the bad, as the adage goes. For actively managed ETFs it can still be the case that an investor is buying assets which they might otherwise prefer not to be exposed to. It has to be said however that this aspect applies equally to all managed investment products; at any one time a fund of any ilk might hold assets which if addressed in isolation might not carry a ‘Buy’ recommendation from an adviser.

Structure

The emergence of ETFs in the US in the late 1980s saw investment managers transfer components of/their entire share portfolios, heavily weighted to the S & P 500 Index, to fund managers who contracted to track and administer the performance of the holdings over time. The fund manager issued units and there was a relationship between the unit price and the value of the underlying shares.

In effect, rather than administering large numbers of share certificates, which in the US could mean hundreds of share certificates, institutional investors could hold a single asset which was units in a fund. The economics of this delivered lower administrative fees for investment managers.

Source:

http://www.ifa.com/images/articles/etf_concern_diagram2.jpg via http://www.betasharesblog.com.au/etf_creation/

The units are only available to wholesale investment managers; the Authorised Participants. The delineation sees institutions dealing in the wholesale, primary, market and individual retail investors participating in the secondary market.

 ETFs in Australian portfolios

While financial advisers have been using ETFs in Australia for many years, the strategic application in portfolios varies quite markedly.

Melbourne based Hewison Private Wealth specialises in managing and administering portfolios of direct investments.  Founder and Managing Director, John Hewison says his firm has been including ETFs in portfolio recommendations for around eight years. “We have used them for both index exposure to a sector such as REITs for example and for sector exposure such as International Emerging Markets or International Global Top 100 companies. We typically use ETFs in specialist areas where we would find it difficult to get direct access or prefer to utilise an index approach.” He said. “However, our typical allocation is small at around 10% of a portfolio.”

While Hewison Private Wealth will use LICs over ETFs for some sector exposures, Quantum Financial’s Tim Mackay cites the greater propensity for LICs to trade either side of Net Asset Value (NAV) as a reason to rank ETFs ahead of LICs. “We prefer them over LICs as they don’t face the same problem that LICS do of trading at a discount or, less frequently, trading at a premium to NAV.” he pointed out. Quantum Financial utilises ETFs to deploy a so-called thematic investment strategy on a client by client basis with no specific level of portfolio allocation. “We think that ETFs provide the ideal tools to easily and precisely construct portfolios based on asset allocation, enabling us to create efficient portfolios in a modular way as easily as snapping Lego pieces together. And they increasingly cover most asset classes and are cheap, liquid and reliable.”

Meridian Wealth Management’s Paul Dunn however notes that just like LICs there can be occasions when ETFs don’t trade at NAV. “They don’t always trade at NAV like an unlisted fund. Premium and discount factors always need to be considered.” Meridian Wealth’s portfolios can hold up to 20% exposure to ETFs subject to any active tilts in place. “We use them to provide specific exposure towards any strategic theme that we want included within a portfolio like, for example, CTN for microcaps or IOO for large global market caps and the like.” Dunn added. “We like the liquidity and broad based exposure and the biggest advantage is being able to buy and sell directly on the overseas exchanges where a lot more options are available.”

In contrast to the higher and more active use of ETFs at Quantum Financial and Meridian Wealth Management, John Hewison points out that ETFs do not fit Hewison Private Wealth’s investment philosophy. “We generally like to use direct investments so ETFs don’t really fit our broad philosophy of going direct to markets where we can. That said we typically use ETFs in specialist areas where we would find it difficult to get direct access or prefer to utilise an index approach.” He said.

Hood Sweeney’s portfolio allocations are based on a direct approach to assets along with strategic inclusion of managed funds with the usage of both asset types being centred on a value bias. “We’re active portfolio managers but we’re very focused on the long term and fundamental business valuations and we’re keen to understand the likelihood of continuing dividends.” Notes Hood Sweeney’s Adrian Zoppa CFP.  “While we’re yet to make substantial use of ETFs in portfolios, we believe that for some investors there is an argument for low cost, well diversified, equity ETFs that are consistent with the client’s investment strategy.” He added. “The return investors should demand from such ETFs should be at a high risk premium over the risk-free rate and the objective with the equity ETFs in the portfolios is that a 5-10 year time frame is adopted.”

While not all advisory firms are recommending ETFs in portfolios, in 2014 there is no shortage of choice in fund styles. While the original ETF raison d’être had been market cap funds with index or market segment exposures, increasingly so-called smart beta funds are being launched which are structuring funds based on non-market cap factors such as dividend yield and valuations. Put simply, the new breed of ETFs are far less sedentary than traditional market cap funds. 

“We’re closely watching the way this sector is developing and we’re quite interested in the more sector specific ETFs which are coming onto the market.” John Hewison said.

Tim Mackay’s Quantum Financial builds portfolios with as few as eight investments, all of them ETFs. “You can put together a wonderfully simple, diversified, cheap and coherent portfolio based on investment themes such as blue chip shares, broad index shares, high dividend/imputation shares, small cap shares, resources and so on.”

Tactically, Quantum Financial leans toward so-called ‘core and satellite’ construction techniques with cores comprised of diversified low cost ETFs and satellite investments based on high conviction positions in direct shares or funds they see as outperforming. “We see this as the best of both worlds.” Mackay said. “Clients save in fees in the core or passive components and this is complimented with the active satellite positions.”

According to Paul Dunn, Meridian Wealth uses ETFs to complement the firm’s active portfolio management style.  “They provide us with broad based exposure for portfolios as well as themed exposure to complement our active style. They provide very good liquidity especially when gaining exposure to market sectors that are often very thin or limited in size.”

In focus – Exchange Traded Australian Government Bonds (ET AGBs)

One of the more interesting recent developments in the ETF market in Australia was the launch of a facility on the ASX for trade in Australian Government Bonds (AGBs). Up until the mid-1980s, Australians were able to invest in AGBs in amounts as low as $20 via their local bank branch in over the counter transactions (OTC). In some respect, this was a carry-over from the issue of war bonds during the Second World War when citizens lent money to the government to fund the war effort. Some readers might recall the somewhat patriotic, flag waving, television advertisements of the late 70s and early 80s for ‘Aussie Bonds’. For several decades following World War 2, small OTC AGB investments were still possible in bank branches all over the nation.

However, by the 1980s the high cost of administering many tens of thousands of individual investments and the cumbersome, unreliable, nature of raising capital via that method, saw Treasury withdraw back to dealing only with large, authorised, institutions to fund the government’s Bond (medium to long term) and Treasury Note (short term) requirements.  As a consequence, direct access to investing (lending money to the government) in AGBs for the vast majority of investors disappeared. While most Australians had indirect access to AGBs via superannuation funds, life insurance policy statutory funds (i.e. so-called Capital Guaranteed funds) and managed (unit trust) bond funds, the primary market participants were only the very large authorised institutions.

Retail trade in bonds

In late 2012, as a first step in developing a broad and liquid corporate bond market under the Competitive and Sustainable Banking System (2010) policy, legislation was passed to facilitate retail trade in Federal Government Securities. The rationale for the change was to reduce the government’s reliance on foreign funding and a goal of reducing the prominence of equity and property allocations in superannuation funds which can be vulnerable to sharp market value declines with a corresponding sudden lapse of confidence in that form of savings retirement vehicle.

While the ‘paper’ or physical bonds are not traded on the ASX, the rights to the physical bonds are traded electronically as with any other security on that exchange. Austraclear is a subsidiary of the ASX and is the wholesale securities depositary which holds legal title to the AGBs. The holder of an Exchange Traded AGB holds the right to receive all interest (coupons) and principal payments applicable to the underlying bond; the beneficial ownership. This ownership takes the form of a CHESS Depositary Interest (CDI) and it is the CDIs which in effect link the wholesale bond market (institutions) with the retail market.

Types of Exchange Traded AGBs

The two types of ET AGBs are Treasury Bonds (eTBs) and Treasury Indexed Bonds (eTIBs) with each having a minimum one unit which is equivalent to $100 Face Value of the bond over which they are issued.

As with any interest bearing security being traded on an open market, the market price of Exchange Traded Australian Government Bonds (ET AGBs) is driven by its yield to maturity and it is also impacted by the prevailing inflation and interest rate expectations. The market price of the securities move above/below face value in accordance with such expectations.

Making a market

The Commonwealth Bank of Australia, JP Morgan and UBS are the three market makers appointed by the ASX to access liquidity in the wholesale bond market. These participants are also required to provide continuous Bid and Offer prices on all ET AGBs. The market makers must quote a minimum volume of ET AGBs and quote a maximum spread between the bid and offer price which is concomitant with the spread in the wholesale market. At present their obligations include quoting a minimum 50,000 Treasury Bonds and Treasury Indexed Bonds which equates to around $5 million (50,000 x $100) on the bid and offer.

Risk and reward?

The price for the perceived greater security of investing in a government borrowing with a high credit rating comes, in part, in the form of a yield which is low relative to some other types of securities. Governments with high international credit ratings can borrow at lower rates than those with lower ratings. For investors in AGBs this means that while the yield is low the risk of capital loss is low and it is these characteristics which see roles in portfolios for clients with lower tolerance for portfolio volatility.

The above comments about risk notwithstanding, it’s instructive to note that the GFC put an end to the view that government debt is risk free debt.

An ET AGB versus an Index Bond ETF?

As mentioned earlier, the purchase of any fund of investments bring with the possibility that some of the fund assets are, at a point in time, sub-optimal. In the case of an Index Bond ETF, understanding the average terms to maturity and yields are essential to gaining insight into how the market price might perform over time under various scenarios. In the case of an ET AGB, an investor is buying rights to a single bond not multiples of them. There is a single yield to maturity and but one term to maturity. The risk, it could be argued, is easier to identify when compared to a fund which has a bundle of bonds at various coupon rates and maturity dates. Bond fund managers would rightly point to the spreading of risk which a fund with a range of maturities and yields can provide.

In the case of a Global Index Bond Fund there is of course the issue of currency risks – a buoyant AUD and an unhedged fund does not bode well for capital stability.  In addition a global bond fund will, notwithstanding the principles of diversification and risk management, potentially hold government bonds in economies with less than stellar credit ratings.

These are some of the risk-reward trade-offs to consider when evaluating the two forms of exchange traded investments.

Exchange Traded Investments – Summary

For the time being at least, with a tailwind of relatively robust economic data from around the world, exchange traded investments of various types are gaining increased prominence in Australia investment portfolios. Their role in portfolios varies from passive index exposures for minor portfolio proportions to much larger and more active allocations which advisers will look trade as their outlook for a sector or commodity changes.  ET investments deliver reduced costs and under normal market conditions they provide liquidity.

While not strictly a ‘fund’ as advisers know them to be, Exchange Traded Australian Government Bonds provide retail access to investors for amounts as low as $100 per unit.   ET AGB investors do not have legal title to the underlying bond however they do hold the rights to all coupon and principal payments related to the bond.

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This is the first of two articles on how licensees are coping with the potential impact of the Future of Financial Advice Reforms that have been postponed to 1 July 2013. In this article, three principals of independently owned small-to-medium advice businesses discuss what they’re doing to get FoFA ready. The second article in this series will look at how much larger advice businesses, including a product manufacturer, are getting set for FoFA.

In speaking with the heads of three independently owned financial advice firms about the proposed Future of Financial Advice (FoFA) reforms, one thing is abundantly evident…despite the uncertainty of where FoFA will eventually end up, on the whole, they seem to be just getting on with business.

That’s because there are common aspects of the businesses that are allowing them to cope with FoFA – no in-house products, fee for service and good disclosure systems in place. That said, they all have issues with potential costs associated with an opt-in regime and some see issues getting much needed cost effective advice to clients in areas such as corporate super.

Dr Tony Virtue, of Virtue and Partners Sydney, argues that advice for corporate super and intra-fund advice is where the real problems with FoFA lie.

“There’s not a lot of issue with SMSFs because we bill annually, but corporate super is an area that is still far from settled. How that will work with My Super and intra-fund advice, and whether adviser fees are implicit or explicit and so on? To be frank there is still both uncertainty and different interpretations of the legislation as it stands which is still not through the Reps.”

Virtue and Partners provides advice on a range of financial services but primarily in the areas of risk, retail superannuation (using wraps and SMSFs), a non-super investment service along with a mortgage brokerage. Dr Virtue believes that larger portfolio clients are already paying for services on a FoFA type basis but that it’s the smaller portfolio clients where it’s going to be difficult.

“For the larger clients there is no change where there is an invoiced fee. We already send them an invoice and they pay it. I think the real issue is in the ‘mid-market’ – the twenty to fifty thousand type small accounts where we need to get some scale. That’s the area which we’re finding difficult in how to reorganise ourselves in a way that is still relevant to the public.”

Melbourne-based Hewison Private Wealth CEO John Hewison is a little more at ease about what FoFA could mean for his firm. With several hundred million dollars under management via direct investment portfolios, Hewison is very comfortable where the firm sits for an eventual FoFA implementation:

“Really it doesn’t worry us at all. We’re fee-based and we’re transparent. The clients know what they pay because we already issue them with an invoice and for us to send have to send them an annual statement [opt-in] – well, it’s annoying but it’s not a big deal.”

Similarly Orange-based Roan Financial Group head Peter Roan is also ready for FoFA.

“We’ve always adopted the approach that you have to be providing service for clients and a value proposition, and your client needs to be able to connect with you on that and vice versa. So for us, regardless of whichever way FoFA ends up, it’s always going to revolve around a value proposition; the client knowing what they’re paying for – what they’re paying and where it [the payment] is coming from, and did it represent true value for what the work being carried out?”

All three principals are agreed that if an opt-in requirement were to be put back into the Bill, it would add costs to their operations. Tony Virtue argues:

“A lot will depend on if there is any retrospective annual fee disclosure. If ASIC will accept fee disclosure via the quarterly statements that clients receive on a wrap account, for example, then that won’t have an impact, but if we have to write separately to clients historically on my letterhead as opposed to the wrap account, then really that’s just pure duplication for duplication sake. The point is there is no need for there to be a separate piece of paper to what is currently being provided [for fee disclosure].”

Looking more broadly at financial advice businesses, John Hewison claims:

“The real issue is when not if FoFA will actually go through. The big question is how on earth can a product manufacturer comply with fiduciary duty?”

We’ll look at that issue in the next FoFA article.

There are key aspects of these businesses which can well serve licensees looking to set their businesses for an eventual FoFA regime. Each of the businesses has:

• dedicated client service systems already in place
• fee for service charged in a way that ensures clients know how much they’re paying and what for
• strong ongoing relationships with their clients.

Regardless of FoFA, these attributes are already serving these businesses well.

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