This article appeared in the January 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Use these 'passive' index products actively, to outperform the market.

Photo of David Bassanese By David Bassanese, Pennywise

Exchange-traded funds (ETFs) are a small but rapidly growing part of the Australian securities market, and if your financial planner is not getting you exposed to these cheap and easy-to-use investments, ask why.

(Editor's note: to learn more about the features, benefits and risks of ETFs, do the free online ASX ETF course. Also, watch David's presentation at the ASX Investor Hour.)

ETFs are listed indexed investment funds that passively track the performance of selected share, bond or commodity indices, such as the S&P/ASX 200, the S&P 500 in the United States, others covering China and other countries and regions, and the MSCI emerging markets equity index.

Australian investors can gain access to the broad Australian markets, sectors such as financials or resources, high-dividend ETFs, and a range of commodities such as oil, gold and agricultural prices.

By November 2011 there were 58 ETFs, including exchange-traded commodities (ETCs), listed on ASX, accounting for $5 billion in funds under management. This remains small compared to the volume of funds in traditional managed funds, but represents a very strong increase in recent years. There was only $48 million invested in ETFs in 1998.

ETFs can be bought and sold on the market just like an ordinary share, and as with ordinary shares, ETFs offer dividends - in line with the yield of the benchmark index they cover.

They offer diversification benefits and minimal paperwork, the flexibility and liquidity of a listed share, and cost savings, simplicity and transparency.

One ETF alone (for example, the SPDR S&P/ASX 200 fund) offers the immediate diversification benefits of a managed fund. Investors get exposure to Australia's top 200 companies in one transaction, without having to juggle investments and the paperwork.

Investment strategies

There are many ways to use ETFs, ranging from very active day-trading to passive "buy and hold" long-term investments.

With ETFs, investors can place very short-term bets on the whole market or certain sectors, using the typical array of technical and fundamental tools. ETFs easily allow investors to express a view without having to take on board the added volatility and risk associated with investing in individual company shares.

Investment research regularly finds that most of the movement in individual shares over a few days to a few months is largely driven by the overall market, and to a lesser extent the performance of the particular sector. It could be said that investors might as well just trade the market or sector ETFs, and avoid the extra research effort required for individual companies, given the often relatively low extra marginal return this provides.

From a technical and fundamental perspective, moreover, trading ETFs may be easier in that there is less "noise" in price performance over time, and future earnings growth for broad equity markets or sectors should be more stable and predictable compared to individual companies.

However, an extra complication with ETFs is buy-sell spreads, which can still be uncomfortably wide for some of the more exotic ETFs covering emerging markets. ETFs that cover the Australian market should have relatively small buy-sell spreads and are better suited to short-term trading.

Monthly ASX reports

ASX produces a monthly ETF report that gives details of the range of ETFs available in Australia, including management fees, funds under management, and liquidity indicators such as average bid-offer spreads over the previous month.

It should be noted that ETFs that track international equity markets, such as the S&P 500 in the US, are still all valued in $A terms, which means investors take on currency risk when investing in these offshore markets. If the $A rises, it will reduce returns from offshore markets.

Day-trading, of course, is not for everyone. It requires a lot of time and skill, and at the end of the day many active investors may find their returns are not worth the trouble.

Similarly, long-term "buy and hold" investing makes sense for investors with limited time and/or feel they do not have the skills or temperament to trade more actively.

The beauty of using ETFs in long-term investment portfolios is that they are likely to provide as good a return as an actively managed fund, if not better, for a significantly lower annual management fee.

For example, Vanguard's Australian shares ETF (VAS) tracks the S&P/ASX 300 index and has an annual fee, or management expense ratio (MER), of only 0.15 per cent. If you owned an actively managed fund that charged 10 times more at 1.5 per cent per year, yet achieved the same gross return over time, you would lose just over 1 per cent net return per year. Over the long term, say 30 years, the result would be an investment nest-egg at least one-third smaller than if you simply used the ETF.

The problem with long-term investing is that returns can suffer for extended periods of time when the market is in a downturn. That is especially true if globally there is a long-term secular bear market, as many professionals fear has been the case since the start of this decade.

Three core strategies

PennyWise Investment uses three core strategies to achieve a good balance between active and passive investment approaches.

The first is called the Active Balanced approach and is designed for investors who want long-term market exposure and do not want to trade too actively. We start with a cheap diversified portfolio of ETFs, covering the Australian and global equity markets and gold, and a benchmark portfolio weighting for those with a moderate risk appetite.

Each month the investor is told whether each ETF is trending up or down, and whether they are cheap or expensive, as a guide to adjusting portfolio allocation at the margin.

Based on these trending and valuation indicators, a "positive", "neutral" or "negative" rating is given for each ETF, and a suggested asset allocation is based on the rating.

The Global Rotation strategy aims to place funds in those areas of the global market that are likely to produce the strongest returns over the short to medium term.

This strategy is based on momentum, because repeated investment studies show markets that have tended to produce the strongest returns in the previous few months are generally likely to keep producing solid returns in the next few months.

The choices are made from a select group of six ETFs covering the broad Australian market, developed markets, emerging markets, the local resources and financial sectors, and (hedged) gold.

At the end of each month, each ETF is ranked, based on our proprietary index of historic relative price performance and we also determine whether their medium-term price trend is up or down. We allocate 50 per cent of funds to the top two ranked ETFs that are also deemed to be in an uptrend.

Finally, the PennyWise ASX Market Timer strategy aims to outperform the S&P/ASX 200 total return index over time and with less downside risk, using specially developed trend-following and market-timing trading algorithms.

The model holds a core position in a broad Australian equity market exchange-traded fund (such as STW, which tracks the S&P/ASX 200 index). It overlays this with an opportunistic long or short position in the ASX-listed contracts for difference, CFD (ASX code: IQ), to either leverage up or hedge the underlying portfolio based on end-of-week market signals.

About the author

David Bassanese is one of Australia's leading economic and financial market commentators. For more information and a review of past investment returns from the strategies outlined in this article, visit PennyWise investment.

From ASX

Visit ETF/ETC on the ASX website for more information on ASX-listed ETFs.

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