MORE ETF COMPETITION IS POSITIVE, BUT CHOOSE CAREFULLY
Always assess the issuer, the expertise and, of course, the ETF’s structure. >Read more

MORE ETF COMPETITION IS POSITIVE, BUT CHOOSE CAREFULLY
Always assess the issuer, the expertise and, of course, the ETF’s structure.

Competition is rapidly increasing in the global market for exchange traded funds (ETFs), with 109 firms issuing them, according to BlackRock. In Australia, two new local issuers, Vanguard Investments Australia and Australian Index Investments, have launched ETFs in the past 12 months. Other issuers are expected to enter this market this year.

This is good news for investors and financial advisers as more competition creates greater product choice and helps the ETF market to grow. But it also means investors must look closer at not just the ETF, but who is issuing it. Many investors mistakenly believe all ETFs are the same because they replicate an index. But similar ETFs can have important differences, and the performance of the issuer is crucial.

Market share – the leaders and the rest
The top three global issuers (iShares, State Street Global Advisors and Vanguard) have a combined 71.9 per cent share of the total ETF market, BlackRock research shows. The leader, iShares, has market share of 47.4 per cent globally, more than triple its nearest competitor. Another 106 issuers are fighting for a 28.1 per cent share. Many are launching ETFs for the first time.

Australia is in a different situation, with only four ETF issuers at present. As more emerge, investors will have to think carefully about who is providing the ETF. The most important considerations are: What is the issuer’s track record? Does the issuer have extensive experience in managing index investments? Is the issuer dedicated to providing support, education and other resources for investors, financial intermediaries and market participants?

The economies of scale
Scale is vital. iShares had 413 ETFs listed worldwide and managed US$489 billion of assets at December 2009. State Street Global Advisors had 107 ETFs and Vanguard had 47. Local issuers that can leverage off their parent’s global product suites are better placed to offer lower management costs for investors in ASX-listed ETFs.

Scale can also lead to tighter bid/ask spreads for an ETF’s market price. New ETF issuers may experience lower liquidity if they are not well known or if their products cover unfamiliar indices. Lower liquidity could lead to a wider bid/ask spread, thus higher trading costs. Always assess the expected liquidity of a new ETF before investing.

Scale provides another key benefit: more expertise within the ETF issuer, to accurately capture a particular market or asset class through sound ETF construction and management; and lower tracking errors – the degree to which an ETF deviates from an underlying index. Large, persistent tracking errors mean an ETF is not doing its job of tracking the performance of its index, and reduces investor confidence in the ETF and the issuer’s skills.

What else should I consider?
Other important considerations are: Is the index well known to local investors? Are the securities in the underlying index liquid? Are there clear benchmarks to compare index performance? What is behind the index – do a handful of securities dominate? Do securities with the highest weightings replicate direct investments in your portfolio?

There may be good reasons to buy an ETF from an unknown ETF issuer. Just make sure you closely assess the ETF and the firm behind it. If satisfied, you can take advantage of the benefits offered by more competition and product choice.

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ADVISER Q&A: ETF INTEREST GROWING
iShares
ETFinvestor spoke to Mike Hawkins, Chief Investment Officer at Evans & Partners, about the growth of ETFs.

ETFinvestor
Mike, why do you think interest in ETFs is growing?

Mike Hawkins
Many private investors are disenchanted with the structure of unit trusts, or active managed funds. Tax issues are a problem. New entrants in unit trusts can incur embedded tax liabilities from previous investment decisions in the fund. There are also issues of liquidity and transparency with the unit trust structure, and the inability of investors to predict the income flow from the structure year after year. By law, a trust must pay out all capital gains and income to investors, but capital losses can distort the ability to pay out a distribution in a managed fund. Simply put, the unit trust structure does not deliver for retirees or other private investors who seek a more predictable income flow.

There is also the perception of relatively high fees in active managed funds compared to other investment alternatives, such as ETFs. Some active managed funds may outperform on a relative basis but still lose money. Private investors have become much more fee-sensitive and are more willing to contemplate alternatives such as ETFs that can achieve the same types of returns with much lower fees. The financial services industry has added layers of fees into certain products over the past decade.

ETFinvestor
How do ETFs overcome problems inherent in the unit trust structure?

Mike Hawkins
ETFs have good liquidity and it is clear what you get when investing in one. Investors also get a more predictable income stream in certain ETFs.

ETFinvestor
How does Evans & Partners use ETFs?

Mike Hawkins
We construct a model portfolio using ETFs that is basically a quasi index fund. Then we take views on developed economies compared with emerging economies, or large stocks compared with small-cap stocks. We are not looking to shoot the lights out with this portfolio – we want competitive returns on an after-fee basis that are more consistent and predictable.

ETFinvestor
We have seen more financial advisers embrace ETFs in recent years. How are stockbrokers such as those at Evans & Partners using ETFs?

Mike Hawkins
It varies by adviser, but we like the idea of clients holding a portfolio of shares and some ETFs as well. If the client gets nervous on a particular market they can sell the ETF, rather than sell a stock they may have held for 20 years and in doing so trigger significant capital gains tax. We find ETFs are a useful asset allocation tool to combine with shares and active managed funds in portfolio construction and maintenance. In past years, an investor may have held eight to 10 active managed funds, only to see some stronger fund performances cancelled out by weaker ones, and an index-type return result – for higher active management fees. Now they can hold a combination of ETFs and active managed funds, and get a better result.

ETFinvestor
What is your view on international equities in 2010?

Mike Hawkins
I am becoming more bullish on developed nations and overseas markets. Compared to Australia, markets such the United States look cheaper and corporate earnings are coming off a lower base, so have further to grow. The US profit recovery looks well established; Europe is patchier. Overall, we like the prospects for global multinational companies. We use the iShares S&P Global 100 and other iShares ETFs over emerging markets, global consumer staples, the US S&P 500 index and the S&P Small Cap 600 index.

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An early obstacle to the growth of exchange traded funds (ETFs) in Australia – their integration into investment platforms used by financial advisers – is rapidly fading. One of the country’s largest and fastest-growing platforms, BT Wrap, reports that funds held in ETFs through its platform have tripled to $300 million in the past year and are growing about $10 million a month.

“We are definitely seeing more interest in ETFs from financial advisers as awareness and understanding of these products grow,” says Craig Lawrenson, national manager of products and strategy at BT Wrap. “Investment products included in BT Wrap are really a function of adviser demand, so as more advisers use ETFs, more ETFs will feature in platforms.”

Financial advisers use ‘wrap accounts’, or ‘master trusts’ – collectively known as platforms – to more easily access products such as active managed funds, listed securities, or insurance; and manage administration and tax reporting for client portfolios. More than $323 billion of funds are now divided over more than 50 platforms, reports Investor Daily.

The platform industry traditionally revolved around active managed funds and ‘funds-of-funds’, with less focus on direct investments. At an indexing roundtable discussion hosted by Asset magazine in late 2008, proponents of unlisted index funds said the relatively lower visibility and functionality of ETFs and other listed securities through platforms created a bigger administration burden for financial advisers, and minimised ETF advantages such as lower costs and more tax certainty compared to active managed funds. There was a view that financial advisers would shun ETFs because they were seen as being too hard to manage ‘off wrap’.

But strong growth in self managed superannuation funds (SMSFs) and more focus on direct investing since the global financial crisis has seen the platform industry generally improve its service for listed securities. More competition among platforms and recent product improvementts are favourable for ETFs, which are becoming more popular in SMSFs. The Financial Standard website recently reported that the ‘(platform) improvements follow adviser and client calls for better trading functionality in regards to equities and exchange traded funds.’

BT Wrap, for example, launched a new multi-client bulk order trading facility in March that enables a financial adviser to buy or sell a single listed security for up to 25 clients in one go – an important development for advisers. The next evolution of its platform, due later this year, will enable advisers to establish model portfolios, and more easily and quickly rebalance allocations within portfolios. “The changes are all about increasing adviser efficiency and helping them better serve their clients,” says BT Wrap’s Lawrenson.

Like other listed securities, ETFs are widely available on investment menus of most platforms. They are also featuring more prominently in platform superannuation menus, which generally have more restricted product offerings. Super menus require a trustee who has fiduciary oversight for funds invested, and products have to be approved before they can be included.

Most iShares ETFs are now available on the investment and super menus of platforms from BT Wrap, ASGARD, Macquarie Wrap, AXA Summit, MLC Masterkey Custom, and Navigator.

ETF growth through platforms is off a low base: the $300 million held in ETFs through BT Wrap still represents less than 1 per cent of the $38 billion in funds invested through that platform. But this should increase over time as more financial advisers embrace ETFs and more platforms respond by making it easier for advisers to buy and sell ETFs, and administer transactions and client reporting.

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TACTICS: STRONG INCREASE IN ETF BORROWING
By Tony Featherstone, Journalist
ETFs play a useful role in gearing strategies through diversification.

More people are borrowing to invest in exchange traded funds (ETFs). One of Australia’s largest margin lenders, Leveraged Equities, reports a noticeable acceleration of monthly growth in ETFs held through its loans since September 2009, and an increase in the number of clients holding ETFs.

Julie McKay, Head of Products at Leveraged Equities, says: “Recent growth of ETFs held under clients’ margin loans has been robust even after stripping out the effect of rising prices. This change is not equal across all ETFs and there appears to be popular investment themes.” Data suggests the iShares S&P500 index and iShares MSCI BRIC are among the more popular ETFs at present.

McKay says this rapid growth, albeit off a low base, suggests ETFs will become a more accepted component of margin loans in the next few years. “Clearly, investors have become more interested in ETFs in the past year, which is being reflected in margin-lending activity.” Individual investors are behind the growth, because margin loans cannot be held in self managed super funds (SMSFs).

Leveraged Equities includes all 19 iShares ETFs in its approved shares list. Its loan-to-value (LVR) ratio – the amount you can borrow against the equity in your security holding – ranges from 70 per cent for some iShares ETFs over emerging market indices, to 75 per cent for iShares ETFs over key indices in developed nations. Blue-chip shares typically have LVRs of 70–75 per cent.

CommSec Margin Lending had 16 iShares ETFs on its accepted equities list in March, and its portfolio LVR for each was 70 per cent.

McKay says three main factors are responsible for the growth in ETFs held in margin loans. “First, people want simple, transparent investment products and simple gearing strategies after the global financial crisis.”

Also, investors are borrowing over ETFs to increase their exposure to recovering global equity markets. “We have seen this trend in direct shares and actively managed funds as well,” McKay says.

McKay says borrowing to invest in iShares ETFs over emerging markets is an example of this strategy. “Obviously, emerging markets are more volatile than developed markets, and borrowing to invest in them can magnify gains and losses. A properly diversified portfolio may only allocate 5 per cent of assets to emerging markets.

“In general, gearing over a diversified portfolio that includes a moderate allocation to emerging markets should not greatly increase overall portfolio volatility, or the risk of margin calls. The potential benefit is more upside to rising emerging markets through borrowing.”

The third factor behind ETF growth in margin loans is more sophisticated portfolio diversification. McKay says: “Investors are generally getting better at asset allocation within their portfolios. For example, they may include an ETF over Australian or international shares in their portfolio core and borrow over those ETFs. Because the ETF invests in a range of securities, there is more diversification, resulting in lower volatility and hence a lower probability of a margin call in relation to the overall portfolio.

“However, investors need to be aware of the lower market depth for some ETFs and have in place a suitable strategy if a margin call were to occur.”

iShares ETFs can play a useful role in gearing strategies by offering greater diversification. But as with any leveraged investment, margin loans require careful consideration or discussion with your financial adviser.

Leveraged Equities does not provide investment advice. Do not read the ideas in this story as a recommendation to buy securities mentioned.

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