SMSFundamentals | Aug 25 2011
SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.
For an introduction and story archive please visit FNArena's SMSFundamentals website.
(This story was originally published on 10th August, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).
By Greg Peel
In Part I of this series on exchange traded funds,(Active, Passive And ETFs) we introduced State Street's SPDR fund on the ASX 200 ((STW)) as a convenient instrument for use in passive investment in Australian listed equities. The STW was first issued in 2001 and at the beginning of this year represented around $2.25bn in funds under management. During the March quarter the STW turned over an average $15 million per day. The STW is the only ASX 200 replicating ETF currently listed on the ASX.
But it is not the only State Street SPDR (“spider”) ETF listed on the ASX. One can also purchase ETFs on the ASX 50 ((SFY)) and the Small Ordinaries ((SSO)).
While stock index ETFs imply a level of “passive” portfolio management, investors can become more active in their approach by becoming sector specific. Two of the largest sectors in the Australian stock market are the banks and the miners, and one of the most popular is the real estate investment trusts (REIT). Listed REITs provide investors with exposure to Australia's property market without the single-asset risk involved in direct “bricks and mortar” property investment, and among the REIT offerings investors can choose those exposed to residential, office or retail properties. However, the investor can take a more diversified, and simplified, approach by investing in a property ETF.
State Street offers the ASX 200 listed property ETF ((SLF)) which provides a price replication of an underlying portfolio of Australian REITs. While the fund does not directly track the ASX REIT index, it does attempt to replicate its returns. All distributions made by the REITs are held as cash and distributed quarterly to ETF unitholders.
State Street's ASX 200 financials ex A-REIT fund ((OZF)) sounds like a mouthful but one might call it a “bank index”. Together Australia's big four banks are the heaviest market cap weighting in the index and the “financials” include smaller banks, investment banks and insurance companies. The ASX's financial sector includes Australian REITs so they need to be removed to provide the specific exposure. State Street's ASX 200 resources ETF ((OZR)) provides exposure to the mining and energy sectors.
By exploiting such ETFs, investors can conveniently weight their portfolios towards “banks” or “miners”, for example, or diversify their equity holdings with property exposure via ASX-listed trusts. The latter two provide exposure to higher yielding investments.
Now that the halcyon days of the noughties stock market boom are over, yield has become much more important for investors, and of particular importance for smurfs (self-managed super fund trustees) who need income as well as growth. Recognising this importance, ETF issuers provide a selection of non index-related portfolio ETFs which invest only in higher yielding listed stocks.
State Street's offering is the MSCI Australia select high dividend yield ETF ((SYI)), which is an ETF over the MSCI (Morgan Stanley Capital International) select high dividend fund benchmark index. Here we move away from the ASX's sector groupings to replicate a portfolio of high yield stocks which may, for example, include banks but not include miners and be more weighted towards defensive stocks such as utilities and less towards cyclical industrials.
State Street's ETF suite can be found at www.spdr.com.au but State Street is not the only issuer of ETFs in Australia. In May this year the Russell Investments high dividend Australian shares ETF ((RDV)) marked its first full year of returns. In its first year the RDV returned 6.2% with a 5.4% dividend yield (or 6.6% grossed up for franking) which outperformed the broad market yield of 4.3% over the same period.
FNArena's 2011 surveys have found investors are holding in excess of 20% cash in their portfolios which is a historically very high weighting but, under the current circumstances, hardly surprising. Particularly popular of late have been bank term deposits which, due to stiff competition between banks, have been offering attractive yields. But Russell Investments has been encouraging investors to look outside term deposits and cash management trusts to income alternatives which can provide capital growth as well as yield, and are also tax effective. There are no franking credits on bank deposits.
Russel Investments has constructed its Australia high dividend index based on a portfolio of high-yielding stocks listed on the ASX. The RDV is actively managed to track that index. High yield can of course often reflect high risk. Investors need be aware that stock yields will grow as entry stock prices fall and those falls might make certain yields look very attractive. But if stock price weakness reflects weakness or risk in earnings growth, that company may need to reduce its dividend payouts. If this occurs, yields are automatically reduced.
High yield ETF offerings from Russell and others contain only “blue-chip” yield stocks which means higher than average yields but not highest possible apparent yields. To be included in the Russell ETF portfolio, companies must have a history of paying higher dividends, dividend growth and consistent earnings.
Of particular interest to smurfs is the tax benefits of ETFs. Equity ETFs can qualify for tax breaks under the CGT (capital gains tax) discount rules meaning any realised gains made after a year may be one-third or one-half tax free to investors. Russell Investments notes an added enhancement is implicit here because the money investors would otherwise had to have sacrificed to pay tax each year can instead remain invested, which adds to growth potential. To learn more about Russell's ETF offerings visit www.russell.com.au.
State Street and Russell Investments join BlackRock (iShares), Vanguard Investments and Australian Index Investments (Aii) as issuers of ETFs on the ASX. There are currently fifty ETFs listed on the exchange but that number is growing each year. Among the Australian equity offerings are index, sector-specific and high yield listings. Australia's ETF market is not that young but it is still immature. Among the sector listings resources dominate, which is hardly surprising given the attraction of the Australian mining and energy sector to offshore investors. If nothing else, Australia's resource sector is a global proxy for investment in China, where foreign investment opportunities are limited. The good news is that this means Australia's ETFs are liquid, but the bad news is that, as yet, Australian ETFs offer little in the way of sector diversity.
Australian equity ETFs are nevertheless not the only ETFs listed on the ASX.
Non Australian-Equity ETFs
While investment in foreign shares has proven disappointing in recent years due to the strength of the Aussie dollar, Australian investors looking to invest in offshore developed or emerging markets have the opportunity to do so through a wealth of local ETF listings.
Vanguard offers a US broad market ETF and and an “all world ex-US” ETF for greater portfolio diversification. Foreign market ETFs are very much the domain of BlackRock however, which under its iShares brand boasts sixteen listings. These include world index, emerging market portfolio, US, European, Chinese and various other Asian market exposures. BlackRock also lists three ETFs which might be considered “global defensive”. They offer international exposure to the healthcare, telco and consumer staples sectors respectively.
Nor are ETFs exclusive to equity market listings. The very first ETF created in the world was created in Australia a decade ago as a unit ownership in physical gold. So far Australian commodity ETF listings (which are labelled by the ASX as “ETCs” or exchange traded commodities) are limited solely to precious metals, with three gold offerings, including one hedged against the AUD, one silver, one platinum, one palladium and one precious metal basket offering.
And finally, BetaShares lists three currency ETFs, on the US dollar, pound and euro.
The Safety And Growth of Australian ETFs
I say finally, but there are two other ETFs listed on the ASX which I have not yet mentioned. They are both offered by BetaShares and are ETFs over the ASX 200 financials and resources sector. Unlike all other ETFs noted so far however, these two are “synthetic” ETFs.
An ETF like State Street's spider on the ASX 200 is simply the equivalent of any index fund, in that the fund manager literally buys the underlying stocks in the index in order to satisfy the replication. You as the buyer of the ETF are buying units in the fund that physically owns the shares. A synthetic ETF also replicates the underlying investment in question, but does so by synthetically replicating stock positions rather than buying stocks. The synthetic fund manager does this by arranging a derivative “asset swap” obligation with a large holder of stock positions, such as a large mutual fund or custodian, which reduces the cost of the fund and thus the cost to the unitholder.
No disrespect to BetaShares, but regulatory authorities across the globe are worried about the rapid growth of synthetic ETFs, and they are worried for two reasons. Firstly, physical ETFs operate in the existing secondary market, buying and selling like any fund would do so. Synthetic ETFs own no more than an obligation, and thus effectively multiply the number of owners of the same stock.
This is not as scary a prospect when considering simple “long” ETFs, but the US and Europe have seen the rapid growth of other ETF variations, including “enhanced” (using derivatives to provide investment leverage) and “inverse” (short) ETFs. Leveraged ETFs bring with them all the issues of leverage in a falling market, while inverse ETFs rely on borrowing someone else's stock to go short. As we found out via Opus Prime in the GFC, ultimate beneficial ownership of borrowed stock becomes an issue even for physical stock, let alone short stock positions based on swap obligations.
The risk is that more than one party can lay claim to ownership of the same share. In many cases the law is unclear, for the simple reason financial innovation always moves much, much faster than the law.
It must nevertheless be appreciated that all ETFs involve a counterparty risk. In other words, were the issuer of the ETF you have purchased to “go under” then it would go under with your money. In the case of derivative-style leveraged and short ETFs, this risk is greater. However, before I scare you away from ETFs completely just when you were considering inclusion in your portfolio, consider that any investment fund can “go under” too. Even the AMP. Although that's a tad unlikely. More likely is a cowboy hedge fund, and many of those are no longer with us.
Australia's developing ETF market is under the auspices of a strict regulatory system. Here I hand over comment to Mark Oliver, head of iShares Australia:
“It is encouraging that ASIC, the RBA and ASX are applying close scrutiny to Australia’s ETF industry, with particular emphasis on transparency and liquidity, as more providers and different types of ETFs enter the market. iShares believes that recent local commentary highlighting possible risks of derivatives-based ETFs are unnecessarily alarmist. The overwhelming majority of ETFs listed on the ASX have no derivative exposure whatsoever.
“Being one of the younger ETF markets, Australia has the benefit of learning from overseas markets in terms of regulation-setting and product structures. ETFs have been trading on the ASX for ten years and almost all are built to the original, tested model. They offer a cost-effective way to gain diversified exposure to various sectors of the Australian and international sharemarkets and give investors a full view of all stocks in their fund and the liquidity to trade at any time that the ASX is open.”
BlackRock's head of ETF Research and Implementation Strategy, Deborah Fuhr, adds:
“Currently ETFs listed in Australia are using the original ETF product model, backed by securities, transparent in their underlying holdings, cost efficient, and providing easy diversification that is matched to benchmarks. They also have the advantage of multiple brokers involved in creation and redemption.”
Fuhr suggests that the Australian ETF industry is on track to follow global trends and increase by 20-30% per annum. In June this year investment in Australian ETFs topped $6 billion, and Fuhr expects that figure to surpass $10 billion by end-2013.
Research in the US notes a rapid increase in the use of ETFs by institutional investment houses. While institutions use ETFs mostly as a bridging tool, meaning for portfolio rebalancing, transition management, turning cash quickly into equity and so forth, rather than ultimate investment assets, institutional involvement both endorses the integrity of ETFs and increases liquidity.
A smurf might ask: If the institutional fund I might otherwise invest with is using ETFs, why don't I just use ETFs myself?
Given rapid growth in ETF listings is expected in Australia, one presumes the aforementioned lack of diversification in sector listings (heavy weighting towards resources) will be addressed. Also missing from the Australian market to date are fixed income ETFs, but market participants are now working with the regulators to enable this asset class to be introduced, which would no doubt prove a popular alternative for Australian investors wary of overweighting to equities, particularly in a retirement portfolio.
Retail interest in ETFs is also expected to receive a boost once regulatory changes with regard to financial advice come into effect in 2012. Under the new regulations, financial advisers will be forced to switch to a “fee for service” model payable by investors rather than the previous trailing commission model paid by financial product providers. Deborah Fuhr believes that under this model, “ETFs will become the ideal solution”.
Fuhr believes self managed super funds investors, who account for 30-40% of Australia’s ETF market, will continue to favour ETFs for their investment strategies over managed funds, embracing ETFs for their lower entry prices, transparency and increased ability to control tax liabilities.
Readers can find a list of all ETF current offerings on the ASX at this ASX link.
Please be advised by FNArena, as is the case with investments of any sort, that it is imperative you seek independent advice from your stockbroker or financial adviser as to the most appropriate ETF selections for your portfolio, and please educate yourself on the workings of EFTs and the implications for risk, reward and tax management.
In the latter case, your enquiry would be welcomed at any of the ETF issuers noted in this article, such as State Street Global Advisers, Russell Investments, BlackRock or Vanguard.
Tell 'em FNArena sent you.
