For those who want to build an investment portfolio with exposure to the performance of a diversified group of assets, exchange traded funds (ETFs) are becoming an increasingly popular choice.
ETFs aim to replicate the performance of a particular index or asset by investing in its component parts. A standard S&P ASX 200 index ETF, for example, would effectively give you exposure to the 200 companies that make up the index through a single trade and for a tiny proportion of the cost of investing in them directly.
As an example, a $15,000 initial investment in a balanced range of ETFs could have risen to around $17,600 over the last year, which is growth of 17%, after taking annual management fees into account.
Over three years, between July 1, 2010 and June 30, 2013, the same portfolio would have gone up 25% in total, turning $15,000 into just under $18,800.
Perhaps more interestingly, the portfolio would have grown 22% over the five years to June 30, rising from $15,000 to $18,938.
This growth may sound uninspiring but it came during a period when the ASX 200, the Australian share market’s benchmark index, lost around 8% of its value and listed property investments also went backwards.
An example of a portfolio of ETFs
*Five year figure based on index return as fund has no data available
**Three and five years figures based on index return as fund has no data available
Figures shown in the table are accurate to June 30 2013. The percentage figures show the total returns (capital growth plus dividends) on investments over one year from July 1 2012, three years from July 1 2010 and five years from July 1 2008.
All dollar figures are gross of tax and brokerage fees but net of management fees, show total returns, including capital growth and dividends, and assume that dividends were reinvested.
The funds displayed have been selected for illustrative purposes only and do not represent a recommendation to buy, sell or hold any particular funds. This example does not represent any previous strategy or particular investor.
Past performance is not a reliable indicator of future performance.
The figures in the table show total returns, which combine the capital growth on your investment with dividends earned, and are based on the assumption that the dividends were reinvested.
Over five years, the most profitable investments in the portfolio were US shares, Australian government bonds, gold and then Asian shares, which shows the benefit of spreading your money beyond Australian assets to reduce the risk of losses or slow growth.
This process is known as diversification and involves investing your money across a range of asset classes like shares, bonds and property. It’s impossible to know which asset class will perform best in any particular time period so investing in several of them can help deliver smoother and more consistent returns.
The portfolio shown in the table is just an example of how you could invest in a variety of ETFs to gain access to different asset classes and how the performance of each changes over time.
If you were to look back over a longer time period, 10 or 20 years perhaps, the fluctuations within asset classes would be more pronounced.
Exactly what proportion of your investment you allocate to each asset class would depend on your appetite for risk. Generally the higher the level of risk, the higher the potential returns, with shares being at the riskiest end of the scale and Australian government bonds at the safest.
How do ETFs work?
ETFs pool together the money of investors and use it to buy assets. They differ from other investment funds because they are listed on the stock exchange and can be traded like shares. Most ETFs are passively managed, aiming to replicate the performance of a particular index, rather than beat it.
You can get ETFs that aim to track indexes in different countries and regions, like the ASX 200 or the S&P 500 in the US but also ones that aim to track particular sectors or themes within them, like financials or resources, small cap or high yield.
Other ETFs provide access to corporate and government bonds, property, or commodities like gold, silver or oil. Commodity focused products are often referred to as exchange traded commodities (ETCs)
ETFs can give you diversification but they certainly don’t need to be the only component of a portfolio. You might have a mix of shares and ETFs, for example, or you may have a portfolio of Australian shares but decide you want exposure to the performance of a specific market sector, country or commodity too.
When you invest in an ETF, you have to pay a brokerage fee, just as you do when buying shares. So at around $20 per trade, it would cost $120 to establish the portfolio in the table. You pay the brokerage fee when you sell each investment too.
There is also an annual fee, which is normally expressed as a management expense ratio, or MER, and can be found listed on the fund factsheet through the provider’s website. The management fee is usually included in the unit price and the results shown in the table include the MER to give a net of fees return.
It’s important to check the fees before investing, although generally they tend to be significantly lower than those on managed funds.
How to value ETFs
Another important figure to look out for with an ETF is the Net Asset Value, or NAV, which is the aggregate value of the fund divided by all of the units on issue. When you invest in an ETF, you acquire a certain number of those units and you can use the NAV to gauge what they’re worth.
“It’s an important figure because when you’re buying you don’t want to be overpaying and when you’re selling you don’t want to be missing out on some of the benefits you could be locking in,” says Jonathan Morgan from the ASX.
When buying or selling an ETF, the Australian Securities & Investments Commission (ASIC) recommends only placing orders at least 30 minutes after the share market opens at 10am EST.
“This may help you receive an ETF price that is closer to the value of the ETFs assets,” according to ASIC’s MoneySmart.
You also need to consider what percentage of your investment is spent on a brokerage fee.
“If you’re paying $20, $30, $40 every time you trade and you’re only trading $500 or $1,000 then of course those relative costs can add up over time,” says Morgan.
Aside from low costs and diversification, another benefit of ETFs is their transparency. At any given time, you can see a fund factsheet online, which should have a ‘holdings’ section, where the specific stocks within the fund are listed.
ETFs also enable you to make investments in assets that might otherwise be difficult to access.
“They can give you affordable exposure to both international markets and thematics. For example, you might decide you want to invest in mid-cap companies but if you don’t want single stock exposure then an ETF is a good way to do it,” says Matt Patten, head of CommSec Advisory.
What are the risks?
As with any investment, ETFs come with risks. There’s the risk an ETF doesn’t perform how you’d hoped, for example.
There’s also no guarantee that the ETF will exactly replicate the index it tracks, due to fees, taxes or other factors. With over 90 listed on the ASX, you should research the information available from the ETF issuer before making any decisions about an investment.
If you’re investing in ETFs that are located in another country but are also traded on an Australian market like the ASX, you should check whether you’ll have to pay overseas tax, which can be the case for those domiciled outside of Australia and could mean more onerous tax reporting responsibilities.
Some ETCs are known as structured products, as they use complex investment products to replicate the price movements of a commodity, rather than actually buying the commodity itself, which can be impractical in the case of grain, for example. So it’s important to understand how that works and be comfortable with the risks associated.
Depending on the level of currency hedging, there may also be currency risk when investing in ETFs that track overseas assets because any gains or losses you make would be denominated in another currency. Changes in foreign exchange rates can therefore have a significant impact on investment performance.
According to Patten, the other thing to remember is that while a diversified portfolio of ETFs can help reduce risk, it could also limit your potential gains.
“If you invest in an ETF that tracks an index which grows at 4%, then that’s as much growth as you’ll get but if you choose a group of stocks within that index then you would have a chance of making 20%.
“But you could lose 20% as well, of course.”
This information notes some features of ETFs however is not presented as a summary nor exhaustive statement on any matter. Please consider the product disclosure statement, or equivalent disclosure document, available from the product issuer before making any decision about the relevant ETF.