Why every stock picker should know about ETFs

If there is an investment product that is benefiting from the turbulent times, it is exchange-traded funds (ETFs), which are burgeoning in number, and capitalisation. From $1 billion in market size in 1995, ETFs have grown to a $760 billion market around the world, with about 1500 ETFs trading worldwide.

An ETF is a stock that represents an index, portfolio or commodity. Like equity funds, ETFs offer an individual investor a simple means of gaining exposure to a broader portfolio: they are structured to provide single-stock exposure to the ‘beta’ (market performance) of the stock portfolio. 

But ETFs are much cheaper, with no entry and exit fees, an annual fee that can be as low as nine basis points (0.09 per cent) a year, and investors only pay normal Australian Securities Exchange (ASX) brokerage when buying and selling the ETFs.  

“An ETF gives an investor of a diversified basket of securities, and they’re very cheap and low-fee,” says Danny Goldberg, director and senior adviser at independent investment advisory firm Select Equities.

“They give investors very good correlation to the index they want to invest in, in a single stock. Our institutional clients use them as well as our retail clients, because they can buy the index and hold exposure to the market if they think the market is good value. 

“They’re not running the risk of an active manager getting it wrong, because they understand now that most active managers do worse than the index, over the long term,” says Goldberg.

The first ETF, the “Spider”, or SPDRs (Standard & Poor’s Depositary Receipts), an ETF based on the S&P 500 index, was launched by the American Stock Exchange in 1993. The Spider has been hugely successful: it has become one of the most-traded stocks in the US, regularly turning over US$40 billion a day. Another heavily traded ETF is the QQQ tracker stock, which tracks the Nasdaq 100 index. In total, ETFs account for more than one-third of US trading value. 

In Australia, ETFs have grown in size from $48 million in June 1998 to more than $28.4 billion at October 2008. The first ETFs arrived in Australia in 2001-02, when State Street Global Advisors listed three funds tracking the S&P/ASX 50 index, the S&P/ASX 200 index and the S&P/ASX 200 Listed Property Trust index. But the major impetus to the local ETF market has come in the last two years, as Barclays Global Investors (BGI) launched its series of 16 iShares ETFs, tracking a range of international market indices.

The iShares track the S&P 500 index (ASX code: IVV), the S&P Global 100 companies index (IOO), the S&P Europe 350 index (IEU), the S&P US MidCap 400 index (IJH), the S&P SmallCap 600 index (IJR), the Russell 2000 (IRU) US small-cap index, the S&P Asia 50 index (IAA) the MSCI EAFE (European, Australasian, and Far Eastern markets) index (IVE), the MSCI Emerging Markets Index (IEM), the MSCI BRIC (Brazil, Russia, India, China) Index (IBK), the MSCI Japan Index (IJP), the MSCI South Korean Index (IKO), the MSCI Singapore Index (ISG), the MSCI Taiwan (ITW), the MSCI Hong Kong Index (IHK) and the FTSE Xinhua China 25 Index (IZZ). The iShares are unhedged: investors are exposed to currency fluctuations.

Tim Bradbury, co-head of iShares at BGI, says the beauty of the iShares for individual investors, lies in their cheapness, and their flexibility. “It’s the cheapest exposure you’re going to get. The S&P Global 100 iShare, for example, costs 0.40 per cent a year compared to the average of about 1.9 per cent for an actively managed international equities fund,” he says. (The S&P 500 iShare is the cheapest iShare, costing just 0.09 per cent a year.) 

There are two main ways in which investors use ETFs, he says. 

“You may just want to build a very cost-effective core equity portfolio, and ETFs allow you to do that for 10-20 basis points. You can do a couple of trades that give you effective underlying exposure to hundreds of stocks, in your domestic and international equities allocation. 

“You don’t have to worry about the manager choosing wrongly, you don’t get portfolio overweights that you don’t like, and you don’t get ‘style drift’. You get your exposures cost-effectively, and that sits there as your core equities allocation. Then, if you believe that there are active managers that can beat the index, you can use them as ‘satellite’ holdings around the core – rolling the dice a bit, to chase some ‘alpha’ (performance above the market return, or ‘beta’).” 

The other major use, he says, is as a tactical tool: using a passive investment (that is, one that delivers index performance) to make an active play. “Say you want to make a tilt to your portfolio to the broad US market, the S&P 500, on the grounds that it’s been bashed around so heavily. You can overweight to that using the S&P 500 iShare. 

“Or, you may want to put an allocation into Asia-Pacific, easily and cost-effectively. You may want to go long China, but short Hong Kong. The iShares work neatly for these kinds of tactical plays. They are simple instruments but they provide very effective diversification benefits. 

“ETFs are an extremely efficient way to allocate assets and to get in or get out of a market rapidly with a small cost profile. And unlike managed funds or structured products, they are very transparent: every day, you know exactly what is in the portfolio, and what its price is,” says Bradbury. 

In the US, this calendar year, he says, about $71 billion has flowed out of mutual funds, while about $86 billion has poured into ETFs. “We think that’s a very telling statistic. These are obviously pretty ordinary times for investment, but we believe people are challenging what they’ve been doing for the last five or ten years – they’re thinking about a few different ideas, to put into portfolios going forward, and ETFs are benefiting from that.” 

Chris Lavers, investment consultant to managed accounts administrator Direct Portfolios, says the attraction of international ETFs is the ability they give to make a highly specific, targeted investment. “Only four years ago, the ETFs were very broadly-based: there were US, European and world ETFs. Now, they are quite exotic: you can go into individual-country ETFs; you can go into an across-the-board commodities ETF or target just gold or zinc stocks; you can go long or short – the ability to make specific investments very cheaply using ETFs is quite phenomenal.” 

Australia also has two listed exchange-traded commodities (ETCs). The Gold Bullion Securities (ASX code: GOLD), launched in March 2003, was the world’s first ETC, allowing retail investors to buy securitised ownership of gold, without having to own actual bullion. 

Each GOLD security gives the investor ownership of one-tenth of an ounce of gold bullion, held in the London vaults of custodian bank, HSBC Bank USA. The price of the GOLDs is one-tenth of the $A gold price. 

In May 2003, the GOLDs were joined on the ASX by the Perth Mint Gold Quoted Product (PMG), which gives the investor the right to buy one-hundredth of an ounce of gold on or before 31 December 2013. The PMGs trade under the ASX code of ZAUWBA: at any time, their price is simply one-hundredth of the $A gold price. 

Investors find the ‘trackers’ more simple to use than bullion and less risky than gold company stocks: there are no company-specific factors like mine life, resource security or hedging activity to complicate matters. The stocks simply track the A$ gold price very closely, and may be sold at any time on the ASX. There is normal brokerage on the purchase or sale, and the management expense ratio (MER) of the investment is 40 basis points (0.40 per cent) a year. 

Next week, four new ETCs will be listed on the ASX by ETF Securities, issuer of the GOLDs. ETF Securities will launch ETCs over physical silver, platinum, palladium and a basket of the three, plus gold. 

The silver, platinum and palladium and basket ETCs have an MER of 50 basis points, reflecting the higher cost of storing the other metals, and no entry or exit fee. As with gold, the platinum and palladium ETCs give the right to own one-tenth of an ounce: the silver ETC covers an ounce. 

Hector McNeil, managing partner at ETF Securities, says the attraction to investors of the ETCs is the same as for ETFs – they offer cheap, simple, transparent access to an investment exposure. 

“In these sort of times, a lot of investors want to diversify their portfolios into precious metals, because they’re not correlated with the equity or bond markets. Diversification always reduces the risk, and particularly diversification into precious metals: gold, for example, still has its age-old attributes as a safe haven, a store of value, a hedge against inflation and a method of exchange. Precious metals are in limited supply, whereas governments are printing money like mad.” 

McNeill says metal ETCs offer investors a real asset, with “zero” credit and counterparty risk. “These products are backed by allocated bullion – there are dedicated gold bars in the vault. They’re perfect for investors who want the attributes of physical metal in their portfolio, but with one very simple and cheap investment, that is easily bought and sold. 

“With all the trouble that managed funds and hedge funds have had with redemptions and having lock-ups – having a product that is totally open-ended on a daily basis is extremely important for investors. Having an investment backed by allocated bullion is as secure as it gets,” he says.