The growing influence of ETFs

Large APRA regulated superannuation funds have a particularly strong motivation for including Exchange Traded Funds (ETFs) in their member-direct investment options.

Member direct options are largely intended to stem the flow of members with big balances to self-managed superannuation funds, the earliest and strongest supporters of Australian listed ETFs.

In short, no investment option designed as an alternative to self-managed superannuation would seem complete without ETFs.

SMSFs often use a range of low-cost index ETFs covering at least the main asset classes to provide a diversified core to their portfolios, and then use ‘satellites’ of favoured actively-managed funds and direct shares. It is, of course, possible to follow a core-satellite approach using the member-direct options of large super funds.

The impact of SMSFs on the surging popularity of ETFs would be difficult to underestimate. According to Vanguard/Investment Trends, SMSFs made up 90,000 or 41 per cent of 220,000 investors holding Australian-listed ETFs in March this year.

Up until five years ago, SMSFs had made up at least half of the investors in Australian listed ETFs, a percentage that has been reducing as the products have become more mainstream.

Surging growth

The market capitalisation of Australian listed exchange traded products, most being index ETFs, surged by 77 per cent over the past two years to reach almost $24 billion by the end of October. This is from a relatively low base given that Australia is somewhat of a newcomer to ETFs.

The world’s first ETF was launched on the Toronto exchange 26 years ago with the first Australian listed ETF following 11 years later. Much of the growth in the market capitalisation of Australian listed ETFs has been over just the past four years, surging by 318% from just $5.73 billion over that time.

Meanwhile, international ETF researcher ETFGI reports that the market capitalisation of the 6,526 exchange traded products/ETFs listed on 65 global exchanges and offering an almost bewildering array of options, reached a record US$3.408 trillion by the end of September. By contrast, the market in Australian-listed ETFs is relatively straightforward.

Why ETFs are popular

The popularity among Australian investors of market-tracking ETFs is attributable to their:

• Ease of trading: trading on the ASX just like regular equities. In a single trade, an investor can gain exposure, for instance, to every share on the S&P/ASX 300 or the MSCI World Index (ex-Australia).
• Low investment management fees: significantly lower than for actively-managed funds.
• Access to markets not always conveniently accessible to individual investors and SMSFs. These include widely-diversified global equity markets.
• Facility to easily create broadly-diversified base or core for portfolio covering to at least the key asset classes in accordance with an investor’s chosen asset allocation.
• Facility to rapidly and easily rebalance portfolios back to their strategic or target asset allocations.
• Liquidity: investors can simply sell their ETFs on the stock market through a phone or online broker.
• Transparency: investors can readily understand an index ETF that is designed to track a specific market and produce similar returns (after their low management fees).

We anticipate that recognition of the key attributes of ETFs that have contributed to their growth in the past will gather pace.

Emphasis on low costs

A critical factor in the popularity of ETFs has been the determination of many investors to give extra attention to minimising their investment management costs when investment returns are subdued and more uncertain in this low-interest era.

Further, there is growing media attention on the difficulty that the majority of actively managed funds have in at least matching their benchmarks once their higher fees are taken into account.

For ETF providers, explaining the impact of high costs on an investment’s net returns is a relatively straightforward message that most investors would understand.

Factor-based ETFs

The vast majority of Australian listed ETFs track broad market indices. However, factor-based ETFs, also known as smart or active ETFs are beginning to be listed locally, providing an opportunity and a challenge for their providers.

Rather than tracking indices, factor-based ETFs focus on one or more of the investment factors including lower volatility, higher dividends and value (inexpensive relative to company fundamentals).

These products are more difficult for investors to understand than market-tracking ETFs or traditional index funds, presenting an educational challenge for their providers.

Wider influence of ETFS

Despite the growth in their popularity, the total capitalisation of Australian listed ETFs represents only a minute proportion of Australia’s superannuation and non-superannuation market.

Their influence of ETFs is, however, much wider than sheer dollars suggest. ETFs and traditional index funds are making investors more aware of the impact of high investment management costs on their real returns and have contributed to the reduction of investment management fees over recent years.

More individual investors and their advisers, including robo advisers, are likely to use ETFs and traditional index funds to provide a diversified, low-cost base to portfolios. This should provide more time to focus on individual investment selection, on appropriate asset allocations and on efficient wealth management.

Click on chart to enlarge