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Buy the market in one transaction

With all the talk on the impact of management fees on investment returns, many investors are now turning to low cost index products such as ETFs to get broad equities exposure – while keeping a lid on costs. Ongoing research on manager performance also shows that smaller investors are struggling to get above benchmark returns from active managers, once the impact of tax and retail fees are taken into account.

This article is about ETFs and how they can be used in a portfolio in order to achieve efficient exposure to equities markets.

ETFs are listed index tracking funds that invest in a portfolio (or basket) of underlying securities, such as the S&P/ASX 50, the S&P/ASX 200 or the S&P/ASX 200 Listed Property Index.  Put simply, by investing in an ETF you are able to gain exposure to the Top 50 or Top 200 companies listed on ASX in one transaction.

ETFs offer all the benefits of a managed fund, with additional key features such as they are very low cost (with MERs between 0.28 and 0.40 per cent) as well as important tax advantages.

ETFs aren’t new – in fact they are widely used by investors globally, and are one of the world's fastest-growing investment products. According to Citigroup, ETF assets in the US have increased by 53 per cent from 2003 to 2005 alone, with Americans investing nearly US$240 billion in ETFs today. When this amount is converted to Australian Dollars we find the US ETF market is around one third of the size of the Australian market!

Following the launch of the State Street Global Advisors’ streetTRACKS series of local ETFs in 2001, more Australian investors than ever are embracing the benefits offered by ETFs.

Core and Satellite approach

A major trend driving the increasing use of ETFs is the adoption of the ‘core and satellite’ approach to portfolio construction by smaller investors.  This approach is based on the principle of separating ‘beta’ returns (ie the general performance of the underlying investment market) from ‘alpha’ returns (ie the excess returns above benchmark gained due to your fund manager’s skill).

It’s an approach that larger investors have used for some time to gain better overall portfolio returns for lower overall fees.  Some developments over the past 5 years that have reinforced the rationale behind this approach are that:

  • Some investment managers are tending to hug the index, rather than trying to substantially outperform it.  Unfortunately, this means investors are paying active management fees, but only getting index performance.
  • Traditional asset classes have become far more positively correlated (ie move up and down in line with each other) – therefore the benefits of diversification are being reduced.
  • Past performance data is increasingly being shown as a poor investment guide – and what’s more, many investment managers fail to outperform on a ‘persistent’ basis.  This is making it increasingly hard for investors to pick ‘winning’ active managers.
  • We have entered a period of lower market returns – making it harder for fund managers using ‘traditional’ investment strategies to deliver the high returns investors have become used to.  With lower overall returns on offer, the impact of fees also becomes more critical in terms of eating away at investors’ net return.

For these and other reasons, more investors are deciding to hold a ‘core’ portion of their portfolio in a low cost index strategy which will capture the ‘beta’ or market returns, and to combine that with active ‘bets’ using more aggressive active managers that are better positioned to capture ‘alpha’.

For more information on ETFs visit the ETF page on the ASX Website or visit www.streettracks.com.au.

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