Why the Popularity of Exchange Traded Funds is on the Rise

If you’re one of the millions of Australians who has superannuation, chances are you’ll have some, if not all, of your money tied up in a managed fund. Even if you’re one of those that look after their own money, like a self-managed super fund (SMSF) for example, managed funds remain a popular investment tool.

For many, though, knowing exactly where their money is invested remains a bit of a mystery. Sure, they might have a vague idea — a split between cash, property (REITs) and shares. Maybe it’s a ‘high growth’ fund, or a more conservative income focused fund. There might be some international exposure as well.

But for many, it’s something they just don’t think a lot about; it’s something that’s ticking over in the background. And, let’s face it, there’s probably a lot more interesting things to worry about.

Managed funds can offer a broad diversity of investment options. However, they are not all the same. For a start, some trade on an exchange — like the ASX — giving investors a quick and easily accessible way to invest.

The convenience of access is just one of the many differences between an exchange traded fund (ETF) and a more traditional fund. But what else has contributed to ETF’s dramatic increase in popularity?

A simpler approach 

A traditional managed fund will invest across a broad range of assets. The amount they allocate to each sector, and the stock picks within that sector, can go through a lengthy process. Typically that involves an investment strategy team, picks by stock analysts, and sometimes the use of external ‘asset consultants’, who come in and advise on the percentages for each sector.

Stocks are then bought and sold, individual holdings added to or reduced, all of which takes a lot of time, not to mention the cost. And none of these people come cheap.

Sure, there will always be managers that outperform the others. For many of the funds, though, you are paying a lot in extra fees for the services of these ‘active’ managers. Yet when you look at the results, they may barely differ from the index. They can even be worse.

The issue for many of the active managers is that they don’t want to take a risk, in case they get it wrong. Get it wrong too often, and you’ll quickly lose funds under management — a key part of their remuneration process. So they construct a portfolio similar to the index, and fine tune it on the edges.

If you think about an Australian equities fund, it would be unusual for it not to hold all the stocks in the ASX 20. Even if they successfully picked stocks well into the ASX 50 and beyond, the size of these smaller companies (and the fund’s allocation in them) might not add much to the total portfolio’s performance.

The downside for an investor is that they might be paying all these extra fees for little gain in performance. And that can add up to a lot if you hold the investment for years.

Instead, a passive ETF replicates the performance of an index by holdings stocks as per their index weighting. So rather than trying to beat the index, they match it…but for a far cheaper cost.

It’s all about the fees

 The next time you get a statement from your super fund provider, there are two things you might want to check out. First, the performance. See what the fund has return and then compare it to the index. And then compare it to cash.

The second is to find out what fees you’ve been charged. If your fund underperformed against the index and it charged you a hefty fee for doing it, then it might be time to look at alternatives.

Apart from their ease of use, one of the great attractions of ETFs is their fees compared to traditional managed funds. Where a managed fund might charge between 1.5–2.0% on your funds, an ETF might be as low as 0.15%. That’s a pretty big difference.

Or look at it another way. If a fund returns 6% for the year, and you pay out a management fee of 1.5%, then that’s a quarter of your return staying with the manager. Add that up over a decade or two and see how much it costs you.

You’ll always know what your investment is worth

Apart from the statements you might get twice a year, it can be difficult to establish day to day what your investment is worth with a typical managed fund. By the time your next statement comes along, it might prove too late to switch into a different strategy.

Another reason for the rise in the popularity of ETFs is that you can find out exactly what your investment is worth whenever the stock market is open. It’s no different to checking the price of a bank stock or a mining company.

Each of the ETFs employ market makers whose job it is to provide a readily tradeable market. That means they bid and offer prices simultaneously so that both buyers and sellers can readily enter or exit their positions.

And that’s another key difference between an ETF and a managed fund — liquidity. In a typical fund, if you want to exit, it can take weeks before you get your money. Some specialised funds — like a hedge fund — might have a three month waiting period.

If you want to exit an ETF, though, it’s the same as any other share transaction. Place your trade, and you’ll receive your funds within two business days, as per the ASX’s new T+2 settlement period. It’s because the liquidity of an ETF is determined by the liquidity of the underlying shares (that form part of the ETF), not the liquidity of the actual ETF itself.

So even if an ETF shows that it has traded very little volume in a trading day, for example, the market maker can still readily provide a market to buyers and sellers based on the underlying stock’s liquidity.

ETFs now account for US$3–4 trillion of assets worldwide. Their popularity continues to grow due to their flexibility, convenience and low fees. And with ever more products coming onto the market, it’s a sector whose growth and popularity looks set to continue.

Regards,

Matt

Money Morning Australia