What is an ETF?

Given Australia's first Exchange Traded Fund was offered in 2001 the growth is staggering; so, what are they and why are they becoming increasingly prominent in our portfolios?

What is an Exchange Traded Fund?

Exchange Traded Funds are investments available to buy and sell on an exchange.

Examples of an exchange would be the Australian Stock Exchange (ASX) or New York Stock Exchange (NYSE).

Other than this they operate much like a managed fund where investors have their money pooled together by the manager of the Fund to invest according to a specific objective or mandate in return for a defined fee for their service.

What are the types of Exchange Traded Funds?

Investors have access to two types of Exchange Traded Funds; Passive or Active.

Passive Exchange Traded Funds are designed to track an index and are the most common.

An index can be defined as any grouping of assets based on a set of rules.

Examples of an index would be the ASX 200, which is the largest 200 companies on the Australian Stock Exchange, or the S&P 500 which is the largest 500 companies on the New York Stock Exchange.

Other indices can be sector or asset class specific with a focus on bonds, infrastructure, financials, mining or even cyber security.

Typically, passive strategies offer lower management fees than their active counterparts.

Active Exchange Traded Funds aim to beat an index based on the skill of the investment manager and are far less common.

Examples of an Active Exchange Traded Fund would be:

• Intelligent Investor Growth Fund (ASX:IIGF)
• Intelligent Investor Income Fund (ASX:INIF)
• Intelligent Investor Ethical Fund (ASX:INES)
• Intelligent Investor Select Value Share Fund (ASX: IISV)

What are the benefits of Exchange Traded Funds?

• Diversification

Purchasing a single Exchange Traded Fund can provide exposure to hundreds, even thousands, of different investments in one transaction which is an easy way to spread your money and reduce your risk.

• Low Fees

Passive Exchange Traded Funds traditionally offer much lower management fees as the investment strategy does not require as much intense research. For example, we utilise iShares S&P 500 (ASX:IVV) in our portfolios and that has a fee of just 0.04% per annum.

• Accessibility

Exchange Traded Funds can be purchased through a brokerage account during trading hours and can provide access to assets that may otherwise be difficult to acquire such as bonds or international shares.

• Transparency

Exchange Traded Funds are required to publicly disclose their full list of holdings and allocations to each investment on a regular basis, unlike traditional managed funds who do not provide the same level of detail and commonly only disclose their largest holdings or best-performing holdings.

• Income Generation

Exchange Traded Funds can provide income streams for investors with varying frequencies of payments, and any dividends, interest or capital gains accrued (including franking credits) are passed on.

What risks to consider when choosing an Exchange Traded Fund?

• Liquidity

While the majority of Exchange Traded Funds have guaranteed liquidity by employing third party organisations called market makers, some may not, which can make trading more difficult at times.

• Currency

Exchange Traded Funds can provide a simple way to gain exposure to overseas investment opportunities, but this can also open the possibility that changes in the value of the Australian Dollar or other overseas currencies can impact performance both positively and negatively.

Investors can avoid this risk by selecting Exchange Traded Funds that hedge against currency fluctuations, but this usually results in higher fees to cover the costs involved.

• Market Risk

All investments have an associated level of risk, and Exchange Traded Funds are subject to these risks. If the index falls, then the Exchange Traded Fund will fall.

If you invest in an Active Exchange Traded Fund, the ability of the investment manager can also add risk, in addition to general market conditions.

How we build diversified portfolios using Exchange Traded Funds

InvestSMART Funds Management offers 10 Exchange Traded Fund Portfolios through our Professionally Managed Account (PMA) Platform. Currently we are managing accounts for over 2,500 investors and exceed $500 million under management across our full suite of products.

Our Investment Committee designs and oversees the progress of our Exchange Traded Fund Portfolios. Currently, this team includes Paul Clitheroe, Effie Zahos, Alan Kohler, Alastair Davidson and Ron Hodge.

Within our range of 10 Exchange Traded Fund Portfolios there are 5 Diversified Portfolios and 5 Single Asset Class Portfolios. Our Diversified Portfolios include:

• InvestSMART High Growth
• InvestSMART Growth
• InvestSMART Ethical Growth
• InvestSMART Balanced
• InvestSMART Conservative

Our first step in building these portfolios involves reviewing each of the 250 Exchange Traded Funds available on the Australian Stock Exchange. As previously mentioned, it is important to consider management fees and liquidity but there are other elements involved in our research.

• Buy/Sell Spread

This is the difference between the bid and the offer price on market, expressed as a percentage. As an Exchange Traded Fund is designed to trade closely to the value of its assets, called a Net Asset Value or NAV, the spread represents a cost to the investor.

• Tracking Score

Exchange Traded Funds are designed to replicate the performance of their stated index. Tracking score shows how closely the Exchange Traded Fund performance aligns to this index. Like the spread, tracking error represents a cost to the investor.

• Size

Size refers to Funds Under Management. Size can be important, as smaller funds are at risk of being closed when it is not economical for the Fund Manager to run them.

• Tax Domicile

Domicile refers to where an Exchange Traded Fund is registered for tax purposes. If you invest in an Exchange Traded Fund that is registered overseas, it can result in additional, complex paperwork and unexpected tax consequences.

After reviewing all Exchange Traded Funds and establishing the best available option to track a chosen index we then move on to what indexes we need and the investment allocation to create our portfolios.

Our investment philosophy involves tracking a benchmark for the lowest possible fee with the aim of outperforming our peer average. Benchmarks are a standard that the performance of a security, managed fund, or investment manager can be measured against.

We utilise the data from these selected benchmarks to see what proportion of investment should be allocated to each major asset class. These are:

• Australian Shares
• International Shares
• Property & Infrastructure
• Bonds & Fixed Interest
• Cash

We then align each asset class with the best available Exchange Traded Fund and purchase an appropriate allocation to build a completed portfolio.

Our Investment Committee continues to review new Exchange Traded Funds that come to market along with any changes to benchmarks, while also considering any apparent trends from our peers. Periodically we make trades to realign the portfolio based on these reviews, which is called rebalancing.

Over the long term, this strategy has proved to be fruitful, with our four founding portfolios (established in 2014) achieving their aim as reflected in the performance table below, as at 31st March 2024.

If you feel that Exchange Traded Funds can help you reach your investment goals but you don't have the confidence, time or desire to research and monitor them effectively, then please consider investing with us.

Our Portfolio Services Team are happy to provide more information or answer your questions, contact them at invest@investsmart.com.au or by calling 1300 880 160.