Why ETFs could be the answer to market volatility

COVID-19 led us to panic-buy at the supermarket and to panic-sell on the sharemarket. As uncertainty around this global pandemic continues, Australia's economy will remain turbulent.

Watching and acting on daily sharemarket price movements can soon become your worst enemy in uncertain times. What we do know is that expert advice always tells us to stay the course when it comes to investing, unless your financial situation and life circumstances absolutely warrant selling up.

Jonathan Shead, head of investments, Australia, at State Street Global Advisors, says one of the biggest mistakes you can make as a long-term investor is to fall into the trap of trading individual stocks and exchange traded funds (ETFs) daily (that is, trying to time the market).

"ETFs (like all shares) do allow you to trade in the moment. ETFs provide liquidity and are priced right throughout the trading day. That can lead to the temptation for investors to lose sight of their long-term investment goal," he says. "We would encourage investors to focus on the long-term goals when trading ETFs and not to chew up their returns in transaction costs with trying to time the market."

He says too often investors fail to account for the total cost of owning an ETF. They're labelled as low-cost investment products, but not low cost if you're constantly trading them. There's the cost of trading an ETF as a security, as well as the expense ratio of managing the fund.

By their nature ETFs are an investment tool designed for the long term. They're transparent, easy to use and generally low cost and give you broad market exposure. Existing in Australia for more than 25 years, ETFs have weathered volatile times before, says Shead.

Bulls and bears

COVID-19 led to a large market selloff during March and it's upset the portfolios of almost every investor in the country, wiping between five and 10 years of solid bull market gains. However, Australian investors have shown they're a resilient bunch and not everybody was panic-selling.

BetaShares chief executive Alex Vynokur says during the pandemic the majority of investors have asked whether now is the right time to "buy the dips" and pour more money into their investments.

"Retail ETF investors tend to be more disciplined than those that trade often in individual stocks or other instruments," he says. "They have been educated, especially since the GFC, that accumulation is a long-term exercise and probably what's most important is time in the market."

So what ETFs are investors buying in times of market turmoil?

Vynokur says there's been a focus on Australian and global equities ETFs in the first three months of 2020, moving away from last year's strong interest in fixed-income products.

Unsurprisingly, there's also been a flood of money into the ETF provider's three bear funds, which aim to protect investors against declining markets. At the start of the year those bear ETFs were managing about $200 million and at March 30 that had gone up to about $600 million.

On March 31, the BetaShares Australian Equities Strong Bear Hedge Fund (ASX: BBOZ) recorded a trading volume of $160 million. It was larger than Telstra's trading volume for the day. Vynokur says this reflected the final week in March, when investors had again increased their exposure to bear funds despite an uptick in the market in the days prior.

"Several investors didn't feel the bounce in the market is sustainable," he says.

Smoother sailing

In the not-too-distant past, investors didn't have many choices if they feared market downturns or loss of capital - it was either sell the portfolio or attempt to ride the volatility.

Nowadays there are ETFs covering multiple markets and sectors, which mean that when you're putting together a long-term plan with a financial adviser you can be more strategic about your investments.

Vynokur says in BetaShares' managed risk series there are ETFs that reduce exposure to the markets as volatility increases. Citing the Managed Risk Australian Share Fund (AUST) as an example, he says its performance in the month to March 30 was 10% better than that of the ASX 200 (the fund fell 9%, the ASX fell 19%). It essentially cushioned the blow.

Shead says feedback from financial advisers and their clients tells SSGA that investors want ETF products that have high-quality companies with less volatility in day-to-day or month-to-month price movements.

He cites the SPDR MSCI World Quality Mix Fund (QMIX) as an example. SSGA was named Money magazine's best ETF manager for 2020 and QMIX placed second in the best international share exchange traded products for 2020 (see table).

Selecting indexes

Regardless of investment goals, any investor in an ETF wants to be confident that the index the fund follows is well constructed.

Shead says important questions you might want to ask include: how does the index obtain exposure to less expensive stocks, high-quality stocks or lower volatility stocks; and how diversified is the index (think geography and sectors, for example)?

"Those features of an index become particularly important as more and more ETFs become available," he says. "Product disclosure statements and fact sheets are also very useful. Fact sheets are useful to find what sort of countries the ETF invests in; or how many companies does this ETF hold and what are the top 10 holdings."

He says if you're an investor with a strong focus on income, the ETF industry will always present opportunities over and above the short-term volatility seen this year. "Rather than risking your hand with a limited number of higher-yielding equity securities, with one ETF purchase you can get a portfolio of broadly diversified Australian high-dividend-paying companies, or even global high-dividend-paying companies," he says.

He adds that it's critical for investors and their advisers to know the index they're using and how it's constructed. As an example, the SPDR S&P Global Dividend Fund (WDIV) is an income ETF that has a series of tests in place to avoid dividend traps or companies that are unlikely to continue to pay the dividends they've been paying in the past under extreme stress.

One of the traditional approaches to investing is a core-satellite method and selecting the right mix of indexes and/or ETFs becomes crucial. Half your investment pool generally sits in a passive core, while the other half sits in more active, specialised strategies.

Speaking at a S&P Dow Jones Indices ETF Masterclass in Sydney in March, Gary Stone, Share Wealth Systems managing director, says the qualification for using active strategies (as part of the satellite) is that they should collectively perform better than the core - otherwise you're essentially receiving the returns of the indexes in your portfolio with little additional income.

He teaches the core-satellite approach to investors, but with modifications. Instead of allocating your core and satellite to focus on specific asset classes, you could consider allocating to strategies. This potentially lessens your asset class diversification but assists growth.

Stone adds that ease of access is one of the main reasons ETFs are a preferred way to invest for retirement. But this shouldn't stop you from looking further afield for ETFs that aren't commonly in the press.

He says ASX 200 ETFs always get a mention yet Vanguard's ASX 300 (VAS) is one of the longest-standing ETFs in Australia. Globally he also likes an S&P 400 ETF because if you were to reinvest the dividends "you have a higher probability over the long term of getting 2% better per annum [than the S&P 500]. That can make the difference in doubling or tripling people's nest eggs."

Josef Stadler, Bell Partners' head of advice, told the forum there should be no excuses for investors to use actively managed indexes in their portfolios.

Felicity Thomas, Ord Minnett senior private wealth adviser, told the masterclass she also uses the core-satellite approach and will use an ASX 200 ETF to diversify a client's portfolio because they generally already have direct shares in ASX 20 or ASX 50 companies.

"We prefer an active or a direct approach when it comes to small and mid-cap companies or emerging companies, but that may change over the next 10 years in this environment," she says.

"If you look at SMSFs, most have cash, Australian shares and direct property. We like to add in an S&P 500 ETF because it's a cheap, easy way to get access to the US market and it doesn't scare retirees as much, but it will give them that extra growth that they need for the longevity of their portfolio. Obviously Australia is great for an income, but there are also ways to get good income from global markets."

Also speaking at the conference, Nathan Ide, Private Capital Management managing director and adviser, says there's generally two ways he uses ETFs for clients.

For the younger accumulation clients he looks at self-instalment warrants as a way to get a bit of leverage. "The underlying products that I use would be a high-income Aussie [equities] ETF for probably about 50% of the warrant. What happens over time is the dividends pay down the loan within the warrant," he says.

For retirees, one of the goals is matching pension liabilities or drawdowns within a portfolio. "You've got a client around 60 years old, and you'll ask how much income they'll need to draw down each year, starting at 4%. I want to make sure that I've got income coming that makes sure I can meet those liabilities," he says. "So if you look at an Aussie high-yield ETF that's giving 5%-6%, that's the same as the ASX 20 or 50 [prior to March]. There's some really great international ETFs out there that also have high yield."

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