My interest in Exchange Traded Funds has grown since I first wrote about asset allocation a few months ago. As you may recall from that post, I like the strategy as a way of diversifying away from Australian shares and as a way of making the investment process more objective and systematic. Anyway, this line of reasoning caused me to search for a cost effective and relatively simple way of implementing a fairly basic asset allocation - and the humble ETF fits the bill.
What Are Exchange Traded Funds?
An ETF is an open ended fund which trades on the stock exchange (open-ended means that the fund can issue or redeem shares at any time). Most of the ETFs I've looked at are designed to track the price of a particular index. They are similar to shares in that you can buy and sell them through your normal stock broker. The only cost you need to pay is brokerage. Another way in which they are like shares is that they pay distributions in a similar way to which shares pay dividends.
The funds' underlying investment is in the shares that make up a particular index. So an ETF designed to track the performance of the ASX 50 will aim to hold each of the components of the ASX 50. This is why the price of an ETF will track the price of the index. There are some mechanisms in place to ensure this is the case and that the share price does not vary too much from the underlying index. Basically there are market makers (also known as authorized participants) who buy or sell depending on demand in order to ensure an orderly market.
Why Use An ETF?
If you're looking for a way to gain exposure to shares in a particular region or market segment but don't want to have worry about choosing shares to buy yourself, then I think Exchange Traded Funds have a number of benefits.
As I mentioned earlier, you can buy or sell shares in an ETF on the Australian Stock Exchange just like you would any other shares. This makes them quite a convenient investment vehicle. For the cost of brokerage, you can buy a stake in the S&P 500 (one of the popular US large cap stock indexes) or maybe the S&P Europe 350 (an index comprised of 350 European stocks).
As well as being cheap to buy compared to managed funds or buying international shares directly, they also have low management fees compared to managed funds. This is because they take a passive approach to their investments by just buying the index resulting in lower transaction costs and there is no need to employ highly paid active investment managers.
Exchange Traded Funds may also offer some tax advantages over more actively managed funds. Because they mostly buy and hold (except for portfolio re-balancing) there is less capital gains tax payable because the underlying share are not frequently bought and sold.
Where I find ETFs to be most useful is in gaining exposure to international shares. I manage my own portfolio of Australian shares but I don't have the time or the expertise to invest internationally. ETFs give me that diversification at a low cost and with the convenience of being able to buy and sell directly on the Australian Stock Exchange.
Most of the international exchange traded funds which are listed on the ASX are issued by Barclays Global Investors, although they trade and are marketed under the name iShares. There are also a couple of Vanguard funds. Vanguard have built quite a reputation as an index fund manager. They also offer some unlisted funds, although I believe the management costs are higher.
The Australian ETFs are issued by State Street Global Advisers and Vanguard. The State Street products trade under the name Streettracks.
Exchange Traded Fund List
There are many to choose from. Here is a list of some of them.
- SPDR S&P/ASX 50 Fund (ASX:SFY) - tracks the performance of Australia's largest 50 companies.
- SPDR S&P/ASX 200 Fund (ASX:STW) - tracks the performance of Australia's largest 200 companies.
- Vanguard Australian Shares Index - tracks the performance of Australia's largest 300 companies.
- SPDR S&P/ASX 200 Listed Property Fund - tracks the performance of the S&P/ASX 200 A-REIT Index
There are many products available to give investors access to a broad range of international shares. As you would expect, American shares are well represented. iShares offer US Large-Cap, Mid-Cap and Small-Cap products tracking various S&P indices and the Russell 2000 index as well. Vanguard also offer a fund which tracks the overall performance of the US market.
In Asia, iShares offers products tracking the MSCI index for Hong Kong, Singapore, Taiwan, Japan, or South Korea or the FTSE/Xinhua 25 index in China.
There is a iShares product for Europe which tracks the S&P Europe 350.
Then there's a number of products with broader scope. There's an iShares Emerging Markets Exchange Traded Fund which I guess you could say is more theme-based, rather than region based. Or the BRIC index (representing Brazil, Russia, India and China) is available as well if you're a believer in the economic growth story of these parts of the world.
Or you can zoom out even further and invest in the S&P Global 100 index, made up of 100 large-cap companies from around the world.
Exchange Traded Commodities
For investors who want to invest in commodities, ETCs (Exchange Traded Commodities) could be an option. These products are similar to ETF's except instead of buying shares, I believe the funds actually buy and hold the actual commodity. As I wrote about in my post about investing in gold, there is a gold ETC available. Or you can choose from platinum, silver and palladium. I need to research these a little better. Once I do, I'll write more about them.
Just to wrap things up, I should point out that to the best of my knowledge, none of the International ETF's employ any sort of currency hedging strategy. This means that for the duration of your investment in the fund, you are exposed to currency fluctuations of the Australian dollar against other currencies.
So for example, if you bought into one of the US funds, and the $A increased in value against the $US, then the value of your investment in Australian dollar terms will have fallen even before taking into account the performance of the underlying investment.
This is not the end of the world. But it is something to be aware of when buying international Exchange Traded Funds.