Bigger is better when it comes to ETF market

Photo of Damien Sherman By Damien Sherman

min read

If you told many investors a decade ago that buying hundreds of shares in a single trade was possible, they might have dismissed the idea as fanciful, technically difficult or expensive.

Fast forward to today and anyone who can buy Australian shares can now hold every company in the S&P/ASX 300 index with a single trade.

Exchange-traded funds – or ETFs – have particularly grown over the last few years as the range of products on the market has expanded to cover all the key asset classes investors might use to build a diverse base for their investment portfolios.

From Australian shares to global bonds, listed property to developed- and emerging-market equities, less than half-a-dozen trades can build a hugely diversified collection of holdings.

Add to that the fact that ETFs can be accessed for low costs typically reserved for large wholesale investors in traditional managed funds, but with the added bonus of trading units quickly and easily on the market as needed, and it’s not difficult to see why their popularity has surged.

Looking ahead, we can see that the exponential growth rate of ETFs will continue as costs come down, liquidity increases and the range of funds available gives investors greater flexibility when it comes to building their portfolio.

Rapid growth points to great potential
Australia’s ETF sector is still small when compared with the overall market capitalisation and trading volumes of Australian shares. Locally listed ETFs account for around $23 billion in funds today, which is only 0.014 per cent of the S&P/ASX 300’s $1.6 trillion market capitalisation.

But if we focus on the growth rate of the ETF sector, rather than its current size, we can see it’s shaping up to become a common way for investors to tap into different asset-class exposures.

For instance, Australia’s ETF market accounted for $5 billion in funds invested in 2012. Four years later, the sector has grown more than fourfold. If we look to America, where investors have had a little longer to get comfortable with ETFs, listed funds are around 11 per cent of the US market’s total size.

Not only has the size of the ETF investment pool ballooned, but the range of products available to investors has grown rapidly. In 2012, there were 80 ETF products in Australia: today there are 139.

The continued evolution of the ETF product line-up in Australia will significantly influence the future growth rate of the sector locally. Can we foresee a time when ETF funds come to be five or even 10 per cent of the broad market cap, in line with growth in the US? Absolutely.

But it largely depends on investors being comfortable that they can access a broad range of products that can be used to tailor their portfolio to their needs.

How are different investors using ETFs?
It’s not surprising to see that, as different kinds of ETFs have emerged over the last six years, so has the mix of investors using them for very different purposes.

Although institutional investors led the charge with ETFs when they were taking off in the US, individual investors have been the driving force behind Australian ETF growth.

Self-managed super funds – which often prioritise control over their asset allocation and keeping costs low – were the early adopters, but financial advisers have also found they give them a simple, cost-effective tool for building client portfolios. For both advised and self-directed individual investors, broadly diversified and low-cost ETFs are increasingly their go-to for building the core of their portfolios.

On the other hand, Australian institutional investors have just started to embrace ETFs in the last few years. They find ETFs useful as a way of quickly increasing their exposure to broad asset classes depending on how they see markets playing out. The high degree of liquidity with ETFs makes them a favourable solution for holding a significant position in the market for an interim period.

Meanwhile, financial-services professionals like wealth managers, private-client advisers and broker-dealers are using ETFs to give their clients exposure to asset classes that have traditionally been difficult to tap into, like bonds or global shares.

Within more complex investment strategies, boutique fund managers and other sophisticated investors have been using ETFs to construct multi-asset-class portfolios using products like listed real-estate ETFs, as well as using them as risk-management tools by gaining broad exposure to specific asset classes when uncertainty prevails.

Following the funds….
So, where are investors putting their money when they use ETFs?

ETFs have typically been index-based products, which provide exposure to beta – increases and decreases in specific market returns – rather than outperformance of the market.

With many investors focused on keeping costs low instead of chasing outperformance through more expensive active funds, it’s no surprise that broadly diversified, low-cost ETFs continue to attract the lion’s share of cash inflows among exchange-traded products.

An emerging trend among investors is a strong appetite for global shares and bond ETFs. Australian investors have typically been rusted onto a narrow band of locally listed shares, but are now seeking wider growth opportunities overseas. Despite low interest rates, bonds have also become more popular as investors seek to balance their portfolios between risky and defensive exposures.

Although index ETFs have been the traditional go-to for investors, a wave of exchange-traded, actively managed funds are appearing on the market. We expect exchange-traded managed funds to continue to grow as investors seek accessible products that help them to flex their exposure to dynamic investment strategies.

What does the future hold for ETFs?
Although active exchange-traded managed funds will continue to experience healthy growth, we don’t foresee the importance of index-based ETFs diminishing anytime soon.

The continued growth of diversified ETFs will drive greater economies of scale, combined with competition in the ETF market, which will drive down management expense ratios across the industry in the coming years, as we’ve seen in other markets. Lower costs in turn improve liquidity and attract more investors, making for a virtuous cycle of more liquid and better-value ETFs.

This increased liquidity will make trading ETFs more flexible for investors as the sector evolves in coming years, which we are seeing manifest in overseas markets. The effect of this is that ETF units should trade to tighter spreads, meaning smaller premiums and discounts on the net asset value of the underlying ETF units. This will typically mean trades will be executed at prices closer to the underlying unit’s value.

While scale will bring benefits, it will also bring complexity. As more asset managers introduce ETFs, there will likely be a proliferation of products available from which to choose. Although choice and competition are not bad for investors, it will mean they and their advisers will need to be especially diligent when selecting products, especially exchange-traded managed funds, which may bear higher management expenses and turnover within the fund, as well as less transparency of their holdings.

As ever, Vanguard will continue to counsel investors to favour broadly diversified, low-cost, low-turnover funds when it comes to both active exchange-traded managed funds and index-based ETFs. At the end of the day, investors should be wary about investing in any exchange-traded product they don’t understand.

The enduring theme for high-quality ETFs in coming years will continue to be transparency, broad diversification and low costs. ETF trends may come and go over the years, but these three traits will continue to drive the value of them to investors.

About the author

Damien Sherman is Head of ETF Capital Markets at Vanguard Australia
Follow: @vanguard_au

From ASX

If you have overlooked ETFs because you do not understand them, or because they did not offer the exposure you were looking for at the time, now might be a good time to review the ASX online course on ETFs. The course is free and no registration is required. The material is divided into topics so you can skip those you are not interested in and focus on those you are. There are lots of graphics and activities to help you reinforce what you have learned.

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