Exchange Traded Funds
Exchange Traded Funds
As ADF members you deal with risk every day. It’s impossible to avoid all risks when you invest. Higher potential returns usually come with higher risks. The important thing is to understand the risks and then keep within a level you are comfortable with.
Exchange Traded Funds (ETFs) have recently become popular with investors and they’re increasingly being recommended by financial advisers. They’re often promoted as an easy way to diversify your investments, usually with lower fees than traditional managed funds. However, some ETFs are complex and risky investments.
What are ETFs?
ETFs are promoted as a low-cost way to get investment returns similar to a share index or another underlying asset. They are a type of managed investment that can be bought and sold like shares, through your stockbroker or online trading account. The ETF usually tries to match changes in the value of an equities index, but ETFs are also available that offer exposure to assets such as international shares, foreign currencies and even precious metals.
Two types of ETFs
Most ETFs buy the shares and other investments that they are trying to match – they’re known as standard or ‘physical ETFs’. While you won’t personally own the shares that the ETF buys, you will usually own units or shares in the ETF. Your main investment risk is the performance of the ETF’s underlying shares and other assets, though other risks are discussed below.
Another type of ETF, known as a ‘synthetic ETF’, may or may not directly own the underlying shares or other assets and uses complex products called derivatives and swap agreements to track their performance, before fees. In Australia, only a handful of synthetic ETFs are currently available. They’re required to include the word ‘Synthetic’ in their title, so you can easily identify them, and other rules have been introduced to reduce some of their risks (see Counterparty risks, below).
Synthetic ETFs may be used by investors when it’s impossible or expensive to buy, hold and sell the underlying investment in another way. Synthetic ETFs’ prices should closely match changes in the value of their underlying investments with minimal ‘tracking error’, before fees and taxes.
Risks to consider
ETFs may appear simple and transparent, but they can be complex investments. Below are some of the complex features, which can apply to physical ETFs, synthetic ETFs and sometimes both.
- Tracking errors: Physical ETF prices will not exactly follow the price of the index or investments they are designed to track. This ‘tracking error’ may be caused by fees, taxes, and other factors. The extent of any tracking error with a synthetic ETF depends on its specific features. For example, the prices of some types of synthetic ETFs available overseas, such as ‘inverse’ and ‘leveraged’ ETFs, will diverge from their benchmarks when held for longer than a day. These types of synthetic ETFs are not currently available in Australia.
- Pricing errors (‘gapping’): ASIC has found examples of ETF prices quoted by online stockbrokers that are significantly above or below the value of the assets that the ETF holds. The risk is that you might pay far more than the ETF’s assets are worth, or sell ETFs at a price far below the value of their assets. Before placing an ETF order, check the price you’re quoted matches what the ETF issuer says its assets are worth (the ‘net asset value’, or NAV). Some ETF issuers’ websites regularly update their estimated NAVs.
- Overseas investing: If the ETF tracks international shares or other investments, there may be currency, tax and pricing risks
- Costs: While ETFs have become known for low costs, management fees vary and there are other costs to consider. For example, some ETFs’ management fees may be higher than the fees for an equivalent (unlisted) index fund. ETFs’ ‘buy-sell spread’ (the respective prices that you can buy and sell ETF units at) vary. You should also consider what fees you’ll pay your stockbroker or online trading account (usually at least $20-$30 per trade) to buy or sell ETF units.
- Counterparty risks: Synthetic ETFs enter into contracts with third parties, or counterparties. Your returns are dependent on the counterparty being able to honour its commitment to the ETF. For synthetic ETFs currently available in Australia, the counterparty must be an Authorised Deposit-taking institution or a foreign equivalent (or an entity with an irrevocable guarantee from an ADI or equivalent).
- Securities lending: Physical and synthetic ETFs may use ‘securities lending’, transferring some of their assets (such as shares) to other companies for a fee. The risk is the borrower will not return the securities as promised. While some ‘loan’ security (collateral) is usually provided, risks remain.
- Some are not really ETFs: Some structured investment products may ‘look and feel’ like ETFs, as they also track share indexes or other investments. They may have names such as Exchange Traded Commodities, Notes, Certificates or Securities, but these structured products are not the same as ETFs. The counterparty risks with some structured products may be much higher than with ETFs, because the rules for those products are not the same as the ASX requirements for synthetic ETFs.
Finally, whenever you invest, remember the importance of diversification, or spreading your investments to control your risks. This includes putting money into different types of investments and with a range of financial institutions. If you are investing in ETFs, consider using several different ETF providers.
For a more detailed list of risks to consider before investing, go to www.moneysmart.gov.au and search for ‘ETFs’.
E-mail ASIC with topics that interest you via ADFcolumn@asic.gov.au.
Australian Securities and Investments Commission
Check your mortgage's health
ASIC is encouraging everyone to do the online Mortgage Health Check on the MoneySmart website – www.moneysmart.gov.au.
The Health Check will tell you where you’re at with your mortgage and gives you practical steps to take if you’ve any mortgage issues.
ASIC has a range of other resources in relation to mortgages:
- video clips of real people explaining how they have dealt with mortgage stress – a must watch
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There is also information for family members or friends who know someone that may be struggling with their mortgage. MoneySmart also has sensible advice on how to approach them and help in a practical way.
This is a terrific package of resources and initiatives.
Australian Household Become Thrifty
Fifty years ago Australian households were good savers. Unfortunately this thriftiness disappeared about 25 years ago.
In fact in the early part of this century we spent more on consumer goods and services than we earned after tax from employment, investment income and social security.
Some people believe that financial deregulation which began in the 1980s made it easier to borrow and lower interest rates in the 1990s meant that many people could service much higher debt levels.
In fact household debt reached about 150% of after-tax income.
However in the last financial year households saved about 10% of their income or an average of $3,800 for every person. A lot of this money has gone into term deposits with banks and some of has reduced overall debt levels.
The first part of the Global Financial Crisis was a great reminder of the risks of borrowing too much. Falling asset prices and a stagnant housing market have made people realise that they can’t rely on increasing asset prices to finance their retirement.
Some retailers might complain about higher savings rates but saving more does benefit our domestic economy. It means we would be less vulnerable to the global economy and we could finance additional infrastructure ourselves.
You will never know how much more you can save until you do a personal or family budget. You don’t need to be an accountant to do a budget. The ADF Financial Services Consumer Council has an online budget calculator and we’ve been encouraging ADF Members to use this calculator at all our seminars. We’re pleased to say that an increasing number of ADF Members are using our calculator and so in our own small way we hope we’ve been helping ADF Members to save more.
Our online budget planner is available at our website – www.adfconsumer.gov.au.