Passive vehicles like ETFs are an easy way to invest, but it pays to know what you are getting into.

Exchange Traded Funds (ETFs), or passive investment funds, have grown rapidly over recent years. They have also been in the headlines this month, particularly in the United States.

An ETF is an investment vehicle that holds a basket of securities, usually shares, bonds, commodities or currencies. The component securities in an ETF portfolio represent an index or segment of the investment markets.

For example, a United States S&P 500 Index ETF contains all the stocks in the index according to their individual index weightings. The value of an S&P 500 Index ETF goes up and down in line with the overall index and investors can redeem their investments at, or near, net asset value, or sell their ETF shares to other investors.

Thus, if the S&P 500 Index goes up or down by 0.8 per cent, then an ETF which represents this index should go up or down by a similar amount.

The figures in the accompanying table illustrate the phenomenal growth in ETFs over the past decade, from US$357 billion at the end of 2004 to US$5.78 trillion ($8.63 trillion) at present.

Equity ETFs have surged from US$319 billion to US$2.97 trillion, while other ETFs, mainly bonds, commodities and currencies, swelled from US$38 billion to US$2.81 trillion.

Equity ETFs now represent 4.7 per cent of the total value of the world’s sharemarkets, compared with just 0.9 per cent at the end of 2004.

The world’s largest ETF providers are BlackRock’s iShares, with total assets of US$1.1 trillion, Vanguard (US$504 billion) and State Street (US$448 billion).

The world’s largest ETF is State Street’s S&P 500 (ticker code SPY) which has total assets of US$175 billion and an expense ratio of 0.095 per cent, including management fees.

Low fees are attractive but ETFs are only practical in large financial markets, particularly the United States. ETFs, and other passive investment vehicles, are far less popular — and numerous — in smaller financial markets, including New Zealand and Australia. There are two main reasons for this:

1) Large financial markets are relatively efficient, mainly because the huge number of brokers and professional fund managers makes it extremely difficult for investors to “beat the market” as measured by benchmark indices.

For example, after Apple makes its quarterly earnings announcement, brokers and fund managers produce hundreds of research reports analysing the company’s performance.

As Apple, and most large listed US companies, receive extensive analyst and media coverage, it is difficult for investors to “beat the market” and, as a consequence, low-cost ETFs are an efficient way for investors to get exposure to the market.

2) Fund managers will only provide low-cost ETFs in large markets where they can attract substantial investor interest. For example, State Street’s S&P 500 ETF has an expense ratio of 0.095 per cent, giving it total fees and costs of about US$166 million per annum.

By comparison, the NZX’s Smartshares Top 50 ETF, which tracks the S&P/NZX 50 Portfolio Index, has total assets of only $192 million, a management fee of 0.75 per cent and, as a consequence, total annual fees of less than $1.5 million.

Smartshares, which is the largest provider of ETFs in New Zealand, makes the following comments in its investment statement: “Smartshares funds are able to keep costs down because the manager does not make active investment decisions, which may require expensive research, analytical and trading expertise.

“Trading only occurs to rebalance the Smartshares funds’ holding to match the weighting of each entity’s shares in the indices.

“By contrast, actively managed funds, where the manager makes active investment decisions, generally incur higher costs and therefore may charge a higher management fee.”

Nevertheless, our ETFs are relatively less attractive because the management fee on Smartshares Top 50 ETF is 0.75 per cent (0.60 per cent on Smartshares’ NZX Top 10 ETF) compared with 0.095 per cent on State Street’s S&P 500 ETF.

In addition, all 500 companies in State Street’s ETF are extensively covered by the media and analysts while many of the companies in the Smartshares Top 50 ETF receive limited media and analyst attention.

The latter feature should make it easier for active investors to outperform the main NZX indices.

The Australian market is also relatively more attractive to an active, rather than a passive, investment style because the ASX has 1971 listed companies, one of the highest in the world and more than the New York Stock Exchange.

The large number of ASX-listed companies, and limited broker coverage of the vast majority of these, gives investors a greater opportunity to outperform the market.

The 2015 Australian ETF Report, compiled by Stockspot, revealed that ETF funds grew by 66 per cent to A$17.8 billion ($18.95 billion) in the past 12 months. However, most of the growth occurred in global equity ETFs, rather than Australian equity ETFs.

Fees on Australian-based ETFs are as follows:

• From 0.15 to 0.55 per cent, with an average of 0.29 per cent, for broad market ETFs.

• From 0.25 to 0.49 per cent, with an average of 0.37 per cent, for ASX sector ETFs.

• From 0.25 to 1.19 per cent, with an average of 0.60 per cent, for ASX strategies ETFs.

These figures clearly demonstrate that ETFs come with many different strategies and fee structures and investors have to be careful when they are choosing their ETF investments.

ETFs were in the spotlight on Wall Street in the past two weeks because of the huge trading volume and weak share prices of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and SPDR Barclays High Yield Bond ETF (JNK).

HYG has total assets of US$14 billion and an expense ratio of 0.50 per cent, while JNK has total assets of US$9.2 billion and an expense ratio of 0.40 per cent.

HYG has over 1000 individual securities and JNK 770, while the two ETFs have current yields between 7 per cent and 8 per cent. This has made them attractive investment vehicles in a low-interest environment.

Bloomberg reported earlier this week that US$4.3 billion of HYG ETFs traded on December 11, the highest on record by a considerable margin. Few of the transactions were in excess of US$10 million, suggesting most of the trading was by non-institutional investors.

The frenzied activity was in response to the failure of a non-ETF junk bond fund and concerns that the increase in interest rates will cause problems for high-yielding income funds.

In addition, a mind-blowing US$6.5 billion worth of HYG options were traded on the same day.

Bloomberg reported that about US$6 billion worth of junk bond ETFs, which includes HYG and JNK, traded on December 11 and an additional US$11 billion of direct junk bonds for a total of US$17 billion.

Junk bond ETFs made up approximately one-third of total junk bond trading for the day, which is about the same percentage that equity ETFs typically make up of all equity trading.

According to Bloomberg: “It shows that these newer fixed-income ETFs are being leaned on more and more relative to their underlying markets, just as with equity ETFs.”

There is no doubt that ETFs are an attractive consideration for any portfolio and are here to stay but investors need to make sure that they understand the vehicle they are investing in, particularly as many ETFs have relatively high fees.

Leveraged ETFs, which use derivatives and debt, are especially high risk as are those that invest in higher-risk asset classes, as junk bond ETF investors have discovered in recent weeks.


Brian Gaynor

Portfolio Manager

Disclosure of interest:  Milford Asset Management is an active investment manager but has ETF investments in a number of its PIE funds.

Disclaimer: This is intended to provide general information only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should always speak to an Authorised Financial Adviser.