ETFs are not a risk-free shortcut to investing

Australian investors' love affair with exchange-traded funds (ETFs) continues to deepen.

While the first Australian ETF, State Street's STW, celebrated its 20th anniversary in August this year, it was in 2020 that ETFs exploded in popularity.

Funds under management grew from $61.5 billion at the beginning of the year to $94.4 billion by its finish - a surge of more than 50%. At the end of September 2021, that number had risen to an astounding $123 billion.

And there were 227 ETFs listed on the ASX at the end of September 2021, providing investors with many options to invest via ETFs to help keep fees low and improve diversification.

With hundreds of thousands of people planning to invest in ETFs for the first time this year, it's fair to say that ETFs are becoming a mainstay of Australia's investing landscape.

But this also brings additional complexities - with hundreds of options available, how do you select the ETFs that are right for you?

What's an ETF?

An ETF is a managed fund that combines the simplicity and benefits of a listed stock on the ASX (liquidity and transparency of holdings) with the benefits of a managed fund in terms of investment diversification at a low cost. ETFs typically track an index that aligns with a basket of stocks (like the ASX 200 or the S&P 500 in the US) or bonds, as well as other assets. Using ETFs is typically called passive investing, as the funds track an index, versus actively trying to pick certain stocks.

An investor can use multiple ETFs to construct a globally diversified portfolio including different asset classes, such as shares, bonds, infrastructure and cash yield. The combination of different asset classes - known as your asset allocation - can be a very powerful way to manage your investment risk and performance over time.

The main risk with ETFs is that investment performance will track the underlying index, so, for example, if the ASX 200 is down 10% in a given year, an ETF that tracks the ASX 200 will also go down about 10%.

Not all ETFs are created equal

As the number of ETFs has grown, so has their complexity. Instead of tracking relatively well understood, transparent indexes like the ASX 200, there are now what are called active and thematic ETFs that apply more complex rules to the indexes they track, for example, a specific industry like biotechnology, or companies with high dividend yields.

The premise of such ETFs is that investors may have a better chance of outperforming broader market performance. You can see how such ETFs start to move into the realm of active investing in terms of making more targeted bets on sectors of themes.

What to look out for

While historical performance is an important consideration, it's not always a reliable guide to future performance, particularly for newer, more complex ETFs with a limited track record. Here are some other factors to consider when you're sizing up options for your portfolio:

1. What is it made up of?

The more complex, or speculative, the index an ETF tracks, the more risk of that strategy under-performing versus broader share markets. Do your homework on the ETF index.

Find out what it's tracking and ask yourself: "Do I understand the strategy, and does it make sense?". For example, a high-yield ETF may look attractive on paper, but the yield may mask poor stock price performance of the index, so overall returns may be relatively weak.

2. How much does it cost?

Issuers have to disclose the MER (management expense ratio) on each ETF. This is not a fee that you'll be billed, but it's reflected in the unit price you pay. In addition to the MER, ETFs are also required to separately disclose their net transactional and operational costs.

These are the costs incurred by the funds for things like brokerage charges (for buying and selling the assets held by the ETF) and foreign exchange associated with the trading activities of the funds. It's worth checking these out as part of any analysis.

However, the fact that an ETF is the cheapest doesn't always mean it's the best - like performance, cost is only one part of the equation.

3. How easily can you sell it?

It's important to understand the assets you'll be buying in an ETF and how liquid they are, that is, how easily can the ETF be quickly bought or sold at a price that closely reflects its intrinsic value. Liquidity influences performance as well as risk.

As an example, emerging market equities have been a strong historical performer, but at the end of the day it is a more risky asset class with lots of currency and country risks. One of the reasons for this is that the markets where these ETFs have exposures will often be closed when you're buying so that can affect the price as well as the risks.

The more unusual the asset class, the more difficult it's likely to be for market makers to price the asset - less liquid assets don't trade as often so the price you may be able to sell at may be quite different to the last traded price. ETFs are straightforward in some ways and complicated in others.

4. How is the fund structured?

ETFs that are structured as locally domiciled trusts minimise the administrative burden for investors who otherwise might have to file various overseas tax documents.

Some ETFs also lend out their underlying securities to institutional investors who might be seeking to short-sell a stock, i.e. borrowing a stock to sell it in the hope of buying it back cheaper in the future.

Securities lending can modestly enhance an ETF's return by bringing in extra fees, but it does introduce an element of additional risk which you need to be mindful of.

5. Does it have a strong track record?

Most of Australia's ETF issuers are large and well established, have decent processes in place and have products that are commercially viable and acceptable.

If everything else was equal, I'd suggest going with an issuer with a track record of running ETFs the way they should be run.

As a general rule, larger ETFs are probably preferable because once a fund reaches critical mass, there is less risk of them increasing their fees to cover costs or potentially even closing down and returning investor funds.

But generally, the mainstream ETFs are large, and are run by a handful of professional well-known providers. It's the selection process that's hard.

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