Exchange traded funds (ETFs) are a hugely popular investment vehicle for many people and for good reason – they are cheap, easily accessible, highly diversified and you don’t need a whole heap of money to invest! For these reasons, I incorporate ETFs in all of my portfolios.
As the popularity of ETFs has increased over the years so have the types of ETFs available. Back in 1993 when ETFs were first created it was simple to explain what an ETF is, an investment which tracks an index, but now days there is so much more to it than that. So let’s first better explain what an ETF actually is.
An ETF is a pool of investments, held in a trust structure, which you can buy into through a stock exchange. Let me simplify it further, an ETF is a bucket and in that bucket there are lots of different assets. Most of the time the assets in the bucket are shares but they can be other assets such as bonds, currency, commodities, etc.
You buy an ETF like you would buy any other company listed on a stock exchange, i.e. with a broker account. When you buy the ETF you add to the bucket and will get exposure to all the underlying assets in the bucket. The amount of exposure depends on the ETFs investment mandate.
So now we know what an ETF is, let’s look at the different management styles of ETFs available. The management style refers to how the assets in the bucket are selected and broadly speaking there are three different ETF types; passive, active and smart beta.
A passive ETF is simple as it tracks an index – plain Jane boring but it gets the job done. So for example, you can get an ETF which tracks the ASX 300. What this means is that by buying the ETF you will get exposure to the top 300 stocks listed on the ASX.
The amount of exposure to each stock is going to depend on market capitalisation (or size) of each stock. As a result, you get the most exposure to the biggest company listed on the ASX (currently CSL), the second most exposure to the second biggest company listed on the ASX (currently CBA) and so on.
Passive ETFs are the more traditional style of ETF and they are a great option for the following reasons:
- Very cheap. All the trading is done by computers with no human intelligence involved in stock selection which keeps the cost down low, real low. The management costs of a passive ETF generally lie between 0.03% and 0.40% per annum.
- Well diversified. You are getting exposure to an entire index through a single holding. This is a great way to get diversification in your investments and we all know, diversification is key!
- Passive investing often outperforms over the long run. A study completed by Morningstar shows that 77% of active fund managers underperform their benchmark over a 10 year period. Even Warren Buffett, one of the greatest active managers of all time, recognises this when he famously made a $1 million bet with Protégé Partners back in 2008 that they wouldn’t outperform the S&P 500 index over a 10 year period. Well he won that million dollar bet and collected in 2018.
So there are a lot of benefits to passive ETFs but, like every investment, there are also downsides which you need to take into consideration. Some of the downsides of passive ETFs are as follows:
- You will only ever get a beta return. A beta return is a return that is 100% correlated with the market. The market goes up 10%, you make 10%. The market goes down 10%, you lose 10%. Many investors like to ‘beat the beta’ and outperform the relevant index.
- Overweight exposure to particular stocks. As the level of exposure is determined by the market capitalisation of the underlying stocks, there is a good chance that you will be overweight in some holdings. So for example, the ASX 300 is dominated by the top 10 holdings which make up roughly 44% of the index. So although your getting exposure to 300 stocks in total, the amount of exposure to those companies outside the top 10 is minimal.
- Inability to target specific portfolio outcomes. Many portfolios are developed with an investment objective in mind. For example, you might need income so you want a dividend producing portfolio which is 100% franked. You can’t do this with a passive ETF as you will generally get a lot of low yielding stocks in the portfolio along with the big cash payers.
So there are a few things to consider there but overall passive ETFs are a great option for many investors. Their ability to give you high diversification at a very low cost with a historically good return means that they earn their spot as the backbone of many portfolios.
As the name suggests, an active ETF has active management going on behind the scenes. So it still the same ‘bucket’ structure but instead of those assets being determine by an index, they are hand selected by portfolio manager or team.
So for example you might have an active ETF which invests only in Australian stocks but their mandate might be to produce a high dividend yield. So they are actively picking high dividend paying stocks to put into the bucket.
The benefits of actively managed ETFs include:
- Exposure to fund managers expertise. Now remember we said that overall statistics show that 77% of fund managers don’t outperform the index over a 10 year period. Well if you select the 23% that does then you are going to get a better return than a passive investor.
- Ability to better target portfolio objectives. So for example I don’t like passive investment in the fixed income space as I like more control over duration and fixed vs floating rates so therefore I tend to only use active management to achieve this. A passive ETF would not suit my needs as its index based mandate is too broad.
- Active managers can hold cash. In a market downturn, like we have seen recently, it is beneficial to have some cash in the portfolio so you can not only reduce your downside risk exposure but also buy more assets when they are cheap. Active managers can make these calls and, provided they get the call right, this can generate good outperformance as a result.
Again, plenty of benefits to active management but they do come with a number of potential downsides as follows:
- Increased cost. Investment decisions are made by people, not computers, so they charge for their time and expertise which is represented in the management fee. The management fee of an active ETF is often well in excess of double that of a passive ETF so the manager needs to outperform by at least their costs to get the same return for investors.
- Active managers often don’t outperform the index. We have looked at the numbers, 77% will likely not outperform the index over 10 years. So don’t expect that alpha return on your money just because you are paying a premium for active management.
- Active ETF managers often don’t disclose their full portfolio holdings. What this means is that you don’t actually know what is in the bucket you are buying into. Often, it is only the top 10 holdings that are disclosed to investors. Now this isn’t the manager being deceptive, it’s them protecting their intellectual property – they don’t want other people copying their ideas! So if you are someone that needs to know everything about an investment, then maybe an active ETF isn’t for you.
So that’s active ETFs and again, I really like active ETFs. I incorporate them into my portfolios regularly, not only to try and get some alpha performance in my portfolios but also to target specific investment objectives.
The last type of ETF I want to look at are smart beta ETFs. These ETFs use a rules based approach to manage what assets go into the ‘bucket’. I guess you could say they are a hybrid between passive and active but essentially they have an automatic screening process which determines what assets to invest in.
So let me give you an example, one type of smart beta ETF is an equal weight ETF. Remember when I said that you can buy a passive ETF in the ASX 300 but it primarily made up of the top 10 companies? Well that’s where you would use an equal weight ETF to overcome this issue.
An equal weight ETF doesn’t care about the market capitalisation (size) of the companies in the index. They use a rules based approach to give you equal exposure to all the companies. So if you compare this to a passive ETF, you will be getting a lot more exposure to those mid cap stocks and proportionally less to the blue chip stocks.
So the benefits of a smart beta ETF include:
- Potential outperformance. As you do with active management, rules based management gives you the potential to outperform the relevant index. Again, this is not guaranteed, but it does give you that portfolio alpha that a lot of investors search for.
- Cheaper than active management. As the manager simply sets the rules and lets the computer do the rest, it is less hands on. This allows fund managers to provide the product at a cheaper cost. Smart beta ETFs usually charge a management fee somewhere in between passive and active management.
- Ability to target portfolio objectives. Like with an active ETF, you can choose a smart beta ETF which has a rules based approach which is in-line with your preferred investment method. So you can target particular portfolio outcomes provided you find the right rules based approach.
As with the other two types of ETFs, smart beta ETFs have some factors to consider before investing. They are as follows:
- Not as cost effective as passive. Although there is not a whole lot of human intelligence involved in this form of ETF, there is still a little. As a result the cost is often slightly higher than that of a passive ETF.
- No guarantee that you will outperform the index. Just because there is a rules based approach behind the scenes doesn’t mean that it is going to outperform. Again, statistics suggest that it is very hard to outperform the index and this applies to rules based investing as well.
So I like smart beta ETFs too and again I use them in my portfolios where required. Really, I am a big fan of all styles of ETFs! They are a great investment vehicle which give you diversification and liquidity at a low cost. In my opinion, ETFs should form the bones of your portfolio with a little extra something sprinkled around them to get the alpha (potentially!).
If you are thinking about investing in ETFs try to stick with the key players in the market which have been around for a while. There are synthetic ETF providers out there which don’t actually own the underlying securities of the portfolio or, in other words, they don’t actually own the assets in the bucket. Instead they use derivatives and swaps to replicate it which comes with extra risks. I will touch on this more in a future blog but for now, happy ETF investing!