(Article by Peter Denham, ASA Member, first published in Equity October 2017)
In Australia, Exchange Traded Funds (ETFs) have been traded on the ASX since 2002. The assets under management (AUM) in Australia have grown 28% over the last 12 months, illustrating their recent popularity.
ETFs offer a low cost method for investors to receive the same benefits of an equity index. They have since developed into low cost financial vehicles to track a ‘theme’ with examples being Market index, Currency, Region, Commodity, Fixed income, Industry and even Actively managed.
As with all investments, there are advantages, disadvantages and risks with using ETFs. This article addresses some of the risks.
ETF performance will only be as good as the underlying stocks. The ETF returns depend upon the success of your investment strategy, ie value, momentum, growth, etc. Determining an ETF strategy is more suited to top down analysis (eg macroeconomic analysis and momentum) rather than fundamental analysis. However, the average PE for the ETF is usually published.
Strategy and market risk is purely dependent upon the type of investment strategy that suits you and the amount of risk for return you are prepared to take. This is the most important consideration for ETFs but too complex and too hard to consider in an article like this.
Liquidity risk is determined from the amount of ETF units on offer to sell (or buy) compared with the amount you have to buy (or sell). For example, you want to sell 1000 of units at $100 'at market'. The current market has buyers as follows: 500 @ $100 & 1000 @ $99. Your 1000 units are sold at an average of $99.50 (slippage of 0.5%). However if you were selling only 200 shares, you would have achieved your $100 goal with no slippage.
The liquidity risk depends upon the amount you want to sell compared with the amount on offer on the exchange.
Limit orders can control the price for an ETF sold (or bought). However the biggest risk is exiting the investment in a rapidly falling market. A limit order will prevent selling below your desired price, but you will retain the ETFs.
Strategies to minimise ‘liquidity risk’ include:
- Avoid ETFs with an average volume per day < your designed limit. (I use $1M/day)
- Avoid ETFs with an average spread > 0.4%
(The spread is the difference between buy and sell prices)
An ETF unit is comprised of a bundle of shares. A 'value' risk for ETFs can be caused by:
- Excessive premium price: ie, ETF price > the net asset value (NAV) of the underlying value of shares. ETF providers advise that the 'market maker' (company that buys shares on the market to create the ETFs) will meet excess demand. However I have seen an ETF at a 9% premium.
- High management expense ratio (MER): This percentage comes off your bottom line every year. As the main advantage of ETFs is a low MER (compared with LICs), investing in a high MER ETF removes the reason for using an ETF.
Strategies to minimise ‘value risk’ include:
- Avoid ETFs with a price premium > 0.5%. The ETF NAVs are published daily.
- Avoid ETFs with a MER > 0.6%. Note that some large US ETFs have MERs ~ 0.1%.
- Avoid ETFs with a LOW AUM as small funds have higher relative costs (I prefer AUM > $100M). This will likely exclude ETFs with a boutique theme.
Composition and tracking risk
ETFs are designed by fund managers and they make decisions on the weighting and individual shares making up the fund. Some ETF descriptions may differ to what is in the fund, for example a 'Global' ETF comprised of 100% US stocks.
Many index tracking ETFs are made up of a sample of stocks making up the index and have a tracking error.
Strategies to minimise ‘composition and tracking risk’ include:
- Composition: Check the makeup of the underlying stocks against the market in which you want to invest. The ETF data sheets provide this information.
- Tracking: Graph the ETF against the target index tracked to determine if it suits your needs.
Some ETFs are leveraged two or three times. A 2 x leveraged index ETF would be expected to deliver 20% gain for a 10% increase in the index. However it does not always work that way due to timing of entry and exit of the investment. I recommend Buffett's advice on leveraging being along the lines of "Smart investors don't need to use leverage. Dumb ones shouldn't use leverage".
As many investors are turning to ETFs, an index tracking ETF may be flat (index is flat) but have an increasing number of ETFs created, that is net creations of ETFs does not necessarily indicate positive sentiment. I prefer to avoid ETFs that investors are deserting. ETF creations and deletions are reported monthly in announcements.