How to get the best out of ETFs
There’s much to know – and never set and forget.
Exchange-traded funds (ETFs) are traded on ASX just like ordinary shares. They have ASX codes such as STW, IOZ and NDQ, and are bought and sold in the same way you would buy and sell Commonwealth Bank, BHP Billiton or Telstra.
ETFs are created by issuers such as Vanguard, BetaShares and iShares, who create funds based on themes such as indexes, sectors, yield, ethical investing, etc.
They are becoming more and more popular with investors around the world as they prove to be just as profitable as share portfolios, but with much higher diversification and lower volatility. This means they have the same benefit with less risk and without the need for individual stock selection and supposedly its associated level of active management.
The commonly adopted approach is to hold, say, a basket of three or four ETFs as a core portfolio while still having other portfolios and holdings, which are deemed satellite investments.
Here’s the simple logic that underpins this tactic: if you were to own just a handful of shares that are beating the broader market and the rest of your capital is tracking the index, then you will outperform the market. But there is a lot more to understanding ETFs than just this simple logic and they certainly are not a product to be treated as set and forget.
First, I classify their investment mandates in terms of risk, this being a qualitative assessment. I think ETFs that track indexes are safer than actively managed ETFs and safer than sector-based ETFs. Hence an index ETF, by its very nature, is more diversified.
There is also the question of local versus foreign ETFs, where the latter have the added complication of currency exchange. Some use currency hedging and some don’t. Then there is the size of the fund, its volatility and its length of trading history. I classify all ETFs with a risk rating between 1 and 10, taking all these factors into consideration.
The task of quantitative comparison needs to be done by considering capital growth, distributions and any franking credits. It may surprise some people to know that index ETFs commonly have distributions, and even franking credits. It also may be a surprise that in our local ASX 200 index, ETFs closely match US ETFs in terms of overall performance. The US markets are rising faster but our ETFs, based on local shares, pay higher distributions.
To compare apples with apples I have created an indicator that considers capital growth, distributions and franking credits, and gives a total rate of return (TROR).
Applying that indicator to both iShares’ SP-500 tracking ETF, IHVV, and SPDR’s ASX 200 tracking ETF, STW, I conclude IHVV is a slightly better option, at 14.14 per cent per annum versus 12.57 per cent per annum for STW.
But returning to their investment mandates, I think our market represents less risk than the US and so it wins by a very small margin. Hence, I would own both ETFs for local and international diversification, but STW would have the slightly larger weighting.
We are standing on shifting sands here because if the US markets were to accelerate, IHVV’s performance would overpower the safety of STW. Furthermore, when the current global rally ends, income ETFs like BetaShare’s HVST (dividend harvester) will be a better option than any index ETFs. Hence, ETFs need to be actively managed.
I will raise a warning flag with regards to ETFs that focus on income. These most definitely need to be actively managed.
If you invest long term in the four big banks for income, you are investing in their underlying businesses, and I can declare with a high degree of certainty that they will still be around in 20 years. So, I can confidently ignore their share price volatility, focusing almost entirely on yield.
But I certainly can’t say the same for income-focused ETFs because in most cases they are being actively managed. Hence, there is little point in assessing the underlying businesses that I’m buying into as they can change. And is the fund manager optimising yield, value investing and/or seeking high-quality businesses?
In some cases, income ETFs have even employed options-writing strategies to enhance returns. This is all very good and by all means consider these products, some of which have excellent performance.
But do not think for one second that you can set and forget. Income ETFs fall into the category of actively managed income investments and should never be put in the bottom draw and forgotten.
A final comment
The world’s major sharemarkets have been enjoying a bull run since 2009 and Australia’s has risen with them. But unlike the US, where the rally has been broad based, ours has been rising far more sedately in a narrow advance. It makes complete sense that Australian investors should be seeking to invest in the index rather than individual shares, while also diversifying into outperforming overseas markets.
ETFs facilitate both functions, among others, and they are attracting a lot of investors, who are rightly employing ETFs as a core component of their portfolios but managing them passively. This is because they do not understand the true nature of these products and why they need to seek independent educational services and support.
The Exchange Traded Funds and Exchange Traded Product course is a great way to learn about the features, benefits and risks of these products. This free, online course has eight modules.