SMSFundamentals: Are ETFs A Game Changer?

SMSFundamentals | Oct 13 2022

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Are ETFs the Game Changer for Investors?

Exchange Traded Products (ETPs) are one of the major investment options for investors on the ASX that offer exposure to numerous asset classes and investment styles.

The Australian ETF market has experienced significant growth in recent years
Historically, Australian ETFs provided competitive returns to investors
ETFs are optimized investment vehicles, but like any other investment, they have risks

By Anuj Sharma

Exchange Traded Products (ETPs) are one of the major investment options for investors on the ASX that offer exposure to numerous asset classes and investment styles. Investing in Exchange Traded Funds (ETFs) and other ETPs resembles investing in shares listed on the Australian Securities Exchange (ASX) in terms of trading, clearing, and settlement. ETPs are also impacted by demand and supply and trade at (or near) their Net Asset Value (NAV).

The Emerging Australian Exchange Traded Funds (ETFs) Market

Macroeconomic conditions in the first half of 2022 injected volatility and uncertainty into the market that adversely impacted the growth momentum in ETF investing. The interest rate enhancements by the US Federal Reserve are the primary factor affecting investor sentiment globally. Market declines in the advanced economies tested the Australian ETF industry in 2022, resulting in the industry’s market capitalisation falling compared to 2021. 

After enduring turbulence in the global and local economies, Australia’s ETFs held a market capitalisation of $126.94 billion as of August 2022, signifying an enhancement of 3.4% year-over-year. Whereas in December 2021, Australia’s ETFs market capitalisation reached $134.12 billion, with a sharpest annual enhancement of 42% from A$94.44 billion (December 2020). Regarding annual growth, Australia’s ETF space has outperformed the global ETF (28.5% in 2021) and the US ETF (31.9% in 2021) industries, as per ETFGI data.

Fund managers such as Vanguard, BlackRock, Magellan, State Street, VanEck, and BetaShares are among the most prominent players in Australia’s ETF market, absorbing most of the net new flows.

Should Investors Consider Investing in ETFs?

Investors can consider investing in ETFs based on the numerous benefits derived from ETFs and other ETPs. A single trade in ETFs provides an investment portfolio with direct exposure to an extensive range of asset classes, geographies, industries, and specific market sectors, leading to greater diversification with ease. ETFs are fabricated, issued, and managed by professional fund managers with intensive technology, methodology, information, and research to harness better returns on reduced risk on capital invested.

ETFs can be easily transacted (buy-sell) during ASX trading hours, like equities, with lower operating costs and management fees than other managed investment vehicles. The change in the value of ETFs perfectly correlates to the change in the market value of underlying assets that provides the benefit of fair valuation. Investors benefit from price growth and distributions on ETFs based on the performance of asset classes or the benchmark.

An Analysis of the Performance of ETFs

A comparative analysis of the performance of the major ASX-listed ETFs focusing on equities with the performance of local and global benchmark indices will provide a clear perspective on the efficiency of ETFs and the advantages they have delivered to investors historically.

The analysis signifies the Australian equity-focused ETFs (VAS, STW, and IOZ) match the performance of the benchmark (S&P/ASX200) being tracked. Similarly, US equity-focused ETFs (IVV and NDQ) are in line with returns generated by the benchmark indexes (S&P500 and Nasdaq 100). Further exploration highlighted that the ETFs (IVV and NDQ) had outperformed the benchmarks in terms of holding period returns.

The Risks Associated with Investing in ETFs

Before going into ETFs, investors must comprehend the risks attached to investing in ETFs, like any other investment. ETFs integrate specific risks related to the underlying asset class or benchmark index, style or theme of investing, and technology applied. 

Regulatory risk can be associated with investing in ETFs as the regulator can introduce significant statutory changes (such as tax treatment of distributions from an ETF) that can lead to a deterioration in the value of ETF units (by affecting the value of specific securities configured in the ETF). Market risk can emerge from market conditions (such as the level of liquidity in volatile markets) and can breed adversities in buying or selling ETFs. Market dynamics can make an ETF inefficient in generating returns to match the returns of the benchmark being tracked.

Foreign Investment risk becomes applicable when investing in ETFs when a specific country or region is influenced by excessive market volatility, economic adversities, and political instability. It also negatively affects a security's value (embedded in ETFs). Currency risk is a significant issue in ETFs inclined toward global investments. A decline in the Australian dollar will enhance the value of investments in non-Australian dollars. Similarly, an enhancement in the Australian dollar's strength will cause a deterioration in the investments held in non-Australian dollars, ignoring other factors.

Specific ETFs may become subject to liquidity risk if they perfectly correlate with the market liquidity specific to the underlying asset. If the market specific to the underlying becomes illiquid, it can cause an ETF product to become illiquid with it. In certain circumstances, investing in ETFs is also subject to derivative risk. For example, ETFs composed of over-the-counter (OTC) derivatives that replicate a benchmark index are subject to higher levels of counterparty risk in the absence of central counterparty clearing arrangements.

ETFs are also subject to fund-specific risks derived from the investment strategy they implement or assets carrying additional risk (in which they invest). For example, if the ETF applies leverage in the investment process, interest rate movements can add an extra layer of risk. Fund-specific risks can be analysed through product disclosure statements.

Investment in ETFs is gaining vitality after the global financial crisis of 2008, providing versatile benefits to investors, including cost-effectiveness, transparency, liquidity, extensive diversification, benchmark capital growth, and regular income.

The efficiency of investment in ETFs also depends on any alignment with the individual investor's goals and risk tolerance level.

Investing in ETFs enriches investors' portfolios with the potential to generate competitive returns.

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