A guide to ETFs

Exchange traded funds (ETF) are one of the fastest growing investment tools in the world. This is because they are easy to understand and give investors a convenient way to add diversification to their portfolio.

What is an ETF?

An ETF is a listed security that usually tracks an index, currency, commodity or bond. Unlike managed funds, these trade on market and therefore can be bought or sold just like ordinary shares.

ETF popularity

According to the March 2017 ASX spotlight report, the Australian ETF market has over $27b of investor funds and has increased by approximately 21% in the last 12 months. The table below shows that 39% of funds invested in ETFs are in global equities, with the second highest allocation going to Australian equities at 38%.

Benefits and risks

Benefits of ETFs

Accessibility: given that ETFs are exchange traded, it means investors are able to gain access to markets that they would usually not have access to. Sectors like corporate bonds for example have historically only been available to sophisticated clients with high minimum investment requirements. ETFs overcome this issue and make various asset groups available to investors.

Diversification: By purchasing an ETF, investors can easily gain diversified exposure to the S&P500, specific regions such as Asia, India and Europe, emerging markets or specific sectors such as commodities, bonds, currencies and infrastructure.

Liquidity: ETFs are highly liquid and can be bought and sold on market during trading hours.

Cost effective: ETFs are usually passively managed which means they typically have lower fees compared to traditional managed funds. It is also much more cost effective than paying transaction costs to purchase a number of domestic and international securities.

Transparency: Holdings within an ETF are usually published on the provider’s website, so investors know exactly what they are getting.

Risks of ETFs

Market risk: ETFs will track the value of the underlying market, which may be volatile.

Tracking error: There is a risk that an ETF will not identically track the underlying benchmark. This can be seen when ETFs tracking the same index have different performance.

Currency risk: Unhedged funds with exposure to international assets will be impacted based on exchange rate movement as well as the underlying investment.

Liquidity risk: This often depends on the underlying investment and describes the risk of being able to buy and sell the underlying asset quickly without impacting the price.

Examples of popular ETFs

http://www.asx.com.au/documents/products/asx_funds_monthly_update_mar_17.pdf

In Summary, ETFs are ideal for those that are looking for a convenient way to add diversification, for those who are time poor or would prefer to avoid the challenges of selecting individual shares.

Gearing strategies using ETFs:

Cash extraction for diversification: Investors who hold existing shares but do not want to sell them can use a margin loan to extract cash from their current holding. They can then use those funds to add diversification to their portfolio using an ETF.  For example, if a client is holding CBA shares and does not want to sell them as they do not wish to trigger a CGT event, they can transfer their CBA stock into their margin loan, without triggering a CGT event and then use funds from the loan to purchase a diversified exposure to an index or asset group that will reduce their stock specific risk.

Positive gearing: With low interest rates that can be fixed, investors are able to purchase high yielding ETFs to create a positively geared portfolio.  This creates a diversified portfolio where the dividend is greater than the interest rate and so investors are effectively being paid to borrow to invest. This is an attractive strategy given that it is becoming harder to positively gear in other asset groups such as property.  Of course investors still carry the risk that a dividend may be cut or the market may fall, however holding a diversified exposure through an ETF decreases ‘stock specific’ risk of a dividend cut.

Scalable business: Investing in ETFs allows you to add diversification for your clients in a scalable manner.  For example if a client has an existing portfolio that focuses on domestic resource stocks, you are able to easily add exposure to the broader domestic market, global equities and various asset groups with ease.  For an SMSF, clients may look to use a high yielding ETF to take advantage of the franking credits in a low tax environment. Currency ETFs can be used to hedge against currency movements for relevant clients.  Whatever the strategy, ETFs can be used to reduce the number of separate securities held across your business while still maintaining overall diversification.

To learn more about gearing into ETFs, please contact your Relationship Manager or call Leveraged on 1300 307 807.