What to know about your ETF

Aside from the performance of the underlying assets, there are other factors that can influence the profitability of your ETF…

Exchange-traded funds (ETFs) can be a healthy addition to an investment portfolio, but they can also work well as a stand-alone investment. Offering diversification in one trade whilst having generally lower fees than managed funds, ETFs seem to be becoming a popular choice with investors. As such, there are many ETFs available on the ASX providing exposure to a range of markets and sectors.

It’s important to note that ETFs are considered by ASIC to be complex financial products. Some are more complex and risky than others. For more information on ETFs and risks associated with them, see ASIC’s Moneysmart website at https://www.moneysmart.gov.au/investing/complex-investments/exchange-traded-products

While the key characterisation of an ETF is the index it tracks, there are a number of other differentiators and influential factors you should be aware of as an investor.

The ‘other things’ influencing your ETF

Fees

As a ‘passively-managed’ investment, ETFs are known for having lower fees than ‘actively-managed’ investments such as managed funds. This is because they don’t need to pay for the services of a strategic fund manager. But ETF costs such as the management-expense-ratio (MER) and the bid-ask spread do still take little bites out of your returns. These costs vary between funds, so you should always take note of how much you’re paying in fees and compare ETF providers to see if you’re getting the best deal. For ETF funds on the Canstar database, the MER ratio ranges from 0.05% up to 1.19%.

Slippage

When you execute a trade, the actual executed price can be different from the price you expected. This difference is known as ‘slippage’. Slippage occurs more during times of high volatility. Like stocks, ETFs are traded on the ASX, so they are also subjected to slippage.

 Liquidity

The liquidity of an ETF is important since lower levels of liquidity can cause greater bid-ask spreads, more slippage and a decreased ability to trade profitably.

Factors influencing ETF liquidity include:

  • what makes up the ETF (composition – e.g property harder to sell than shares)
  • the liquidity of the individual securities within the ETF
  • the trading volume of the ETF
  • the investment environment (if everyone is trying to get into a particular sector, an ETF representing that sector might suffer temporary liquidity issues)

Regarding trading volume, large-cap ETFs can be more liquid than small-cap ETFs. In a similar way, ETFs with fewer actively-traded securities can be less liquid and may have a greater bid-ask spread.

Since ETF issuers can create more units in an ETF pretty easily, liquidity issues tend to be short term. In general, ETFs are considered to be more liquid than managed funds.

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Fund Size

Larger ETFs might be able to offer lower fees, higher liquidity and more protection against major swings in the price of the fund, but this isn’t always the case. When it comes to performance though, size doesn’t really matter. Comparisons have shown no notable differences in performance between larger and smaller ETFs tracking the same index.

 Counterparty risk

Counterparty risk refers to the risk that another party fails to fulfill their financial obligations. Synthetic ETFs more exposed to this risk than physical ETFs, since synthetic ETFs don’t actually hold underlying assets – instead relying upon swap agreements.

 People

Don’t forget about the importance of the people involved in delivering ETFs to investors. They are responsible for ensuring the ETF performs the way it should. Consider the quality, usefulness and experience of the implementation team, market makers and key participants. ETF providers also need to have a good succession plan to ensure it maintains operational efficiency when its investment professionals leave or retire.

 Investment process

ETF providers have a duty to match the benchmark index they track whilst handling the costs of turnover through an efficient investment process. High turnover in a portfolio, where lots of buying and selling is taking place, can lead to higher tax and trading costs. These costs can be passed on to the ETF’s investors. High turnover is okay so long as it creates higher returns. While turnover is usually low for ETFs, high dividend and strategic beta ETFs can have higher turnover due to their rebalancing requirements (e.g. removing a stock with a reduced dividend yield and buying a stock with an increased dividend yield).

For more information on ETFs and risks associated with them, see ASIC’s Moneysmart website at https://www.moneysmart.gov.au/investing/complex-investments/exchange-traded-products.

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