One of the challenges with investing is creating a sufficient level of diversification within a portfolio. Investing in small Australian companies has been difficult this financial year, with more than 100 earnings downgrades. You can imagine how taking stock specific risk during this period has been challenging.
Very simply, diversification means not having all of your eggs in one basket. This means investing in Australian shares, international shares, property, bonds etc. Exchange Traded Funds (ETFs) can be a useful risk management tool by providing your investments with additional levels of diversification.
ETFs are primarily passive investments as they replicate indices with no active management value-add. The themed ETFs may be semi-active in that they may apply an independently compiled index but with differing rules on how to define the theme.
They are open-ended (i.e. they can create more units as demand requires) so in that regard they are similar to managed funds but ETFs have the advantage of greater transparency and liquidity through trading on the stock exchange.
ETFs also have an advantage over Listed Investment Companies (LICs) in that they can be bought and sold for close to the value of the underlying asset (i.e. index) and do not suffer the discount/premium that being subject to demand places on LIC share prices. This usually results in the ETF price very closely matching the performance of the asset.
If the ETF’s underlying assets produces income investors will receive regular income distributions. Like managed funds, ETFs pass on this income untaxed and franking credits can also be passed through.
Management Expense Ratios (MERs) are quite low compared to managed funds, ranging from as little as 0.15 to 0.8 per cent for some international shares offerings.
Given the strong growth in ETFs, the range of products on offer has become very wide. New ETF providers entering the market are providing different choices to suit all types of investors. It is important to understand the nature and risks of an ETF product as a result.
Investment strategies using ETFs:
- Access markets that are not easily accessible in Australia and/or are not cost efficient such as international shares (particularly region or theme specific), currencies and commodities.
- Gain diversification across sectors in a cost-efficient manner (i.e. you like the outlook for Energy but don’t have the funds to buy more than one or two companies and don’t want the risk of picking an underperformer).
- Invest small amounts in a broadly diversified basket ETF as a low cost way to get exposure to the Australian share market, or in addition to the Australian share market to enhance diversification.
- Transition funds into the market without having to pick individual company exposure. This may be useful if you have large amounts to invest and want to do this over time and/or if you are uncertain which sectors may perform going forward but still want exposure to the share market.
In summary, ETFs are a useful investment vehicle for:
- Transparency – you know what companies and/or exposure you have through a published index.
- Cost efficiency – low management expense ratios.
- Tax efficiency – passed through dividends and franking credits. Often low turnover usually only based on index changes so that forced capital gains are not a feature of ETFs.
- Liquidity – ETFs trade on a T+2 basis and are required to always have a buy/sell price on screen when the market is trading (achieved through a market maker).
- Diversification – allowing you more options to invest in baskets or specific themes/sectors.
Boh Burima, Financial Adviser | Authorised Representative: 000341081, Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410