Exchange Traded Funds (ETFs)

An ETF is an open-ended investment fund that is listed on an exchange. They are one of the fastest growing categories of investment products because they can be traded like a share, offer a low cost alternative to implementing investment strategies, are relatively transparent, and simple to use. ETFs are available for a broad range of assets including equities (Australian and global), fixed income, currency, and commodities.

Most ETFs closely track the performance of a given index or asset class and are referred to as passive ETFs. There are also active ETFs (known as ETMFs or exchange traded hedge funds) that seek to outperform an index, through active management.

ETFs can also be classified into ‘physical’ and ‘synthetic’. A physical ETF will hold all, or a sample of, the underlying securities, whereas synthetic ETFs will employ derivatives (e.g., options, swaps) to try and replicate the performance of the underlying index. Where synthetics are used, the ETF needs to be labelled as such.

The growth in ETF offerings remains robust as providers cover more of the investible universe and address popular investment themes. Globally, assets under management (AUM) in ETF structures have increased to approximately US$4 trillion (figure 1). Equity ETFs are the most common, representing 80% of global ETF AUM, followed by fixed income ETFs at 17% (figure 3). ETFGI, an industry data provider, estimates there are now more than 7,000 ETFs managed by 313 providers globally.

ETFs were pioneered in North America and the region (primarily the US) is the largest ETF market, with ~74% of global AUM. The US-listed ETF industry has grown dramatically over the last two decades, not only in size but also in the diversity of products offered. As of May 2017, there were nearly 2,000 ETFs listed in the US, which held over US$3.01 trillion in assets. As the importance of ETFs in the US market increased, investors started using ETFs as a hedging tool, and ETFs became a leading way to manage risk.

EMEA (Europe, the Middle East and Africa) is the next largest market for ETFs, comprising 17% of global AUM. There are over 3,400 European ETFs, which hold over US$679 billion in assets. ETFs in the region are often listed in multiple countries in order to attract retail investor flows, as many European investors often can only trade on their domestic exchange. The widespread use of multiple exchange listings has led to a fragmentation of liquidity for many European ETFs, as investor flows and market maker quotes disperse.

ETF issuance in the Asia-Pacific region is smaller than in the US and Europe. There are currently over 1,200 listed Asia-Pacific ETFs (including cross-listings from other regions), with over US$353 billion in assets. Japanese ETFs have driven AUM growth in the region, while Hong Kong and Chinese ETFs have risen modestly.

The Australian ETF market has also grown rapidly in recent years, with total assets under management rising to ~$29 billion.

The Australian ETF market, when compared with US, Europe and Asia, is still relatively small. Like its global counterparts however, ETFs offered here are mostly equity ETFs, while fixed income, commodity and currency ETFs account for a relatively smaller share (figure 5). The average ETF trading volume on the ASX is just 1.5% compared with ~25% in the U.S.

In Australia, retail investors have tended to favour ETFs; a survey conducted with local ETF providers, revealed Australian investors use ETFs for two primary reasons: international exposure and high-yield exposure.

ETFs can be bought and sold on an exchange like ordinary shares. Investors can purchase or sell them through their brokers during trading hours. Unlike shares, however, they do not list on the exchange via an initial public offering. Rather, ETFs rely on a creation/redemption mechanism. Understanding how this mechanism works is the key to understanding the benefits and potential risks of ETFs.

The ETF market has three primary participants

1. ETF issuers – Fund manager which manages the ETF and its underlying securities.
2. Authorised participants (AP) - Institutions authorised to create and redeem ETFs.
3. Market makers – Providers of liquidity by facilitating trades on the secondary market.

To purchase an ETF, a buy order can be placed into the market through a broker. This buy order can be executed by matching it against a sell order, much like the way ordinary shares are traded on the market. These trades will be facilitated by market makers who provide quotes throughout the day.

At this point, the ETF issuer is not involved in the transaction at all. The ETF issuer does not know that you have bought the units, nor does it receive any funds to invest. Units simply transfer in the secondary market from one investor (the seller) to another (the buyer) and go through a securities exchange two-day settlement process.

However, a scenario may arise where there is no ready seller in the secondary market, and demand exceeds what is currently available to trade. In this situation, market makers will request the issuance of units (i.e creation of new units) by authorised participants. To create new units, an AP enters the market and buys the securities in the creation basket at the percentages according to the underlying benchmark. The AP then delivers this basket of securities to the ETF issuer in exchange for an equal value of units in the ETF. The market maker then acquires these ETF units from the AP, and then proceeds to offer them on the market.

The process also works in reverse for redemptions. That is, if the AP has a block of ETF shares to sell, they will receive a basket of underlying securities, from the ETF issuer to sell, and the funds raised are used to redeem the ETF.

ETF pricing

Several factors influence an ETF’s price, including the movements of the underlying securities, exchange-rate movements (for international investments) and investors’ demand for the ETF. The ETF issuer calculates and publishes the ETF’s net asset value (NAV) daily. The published NAV is based on the underlying securities’ closing market prices, minus the ETF’s fees.

From time to time, mis-pricing in the market may occur. For example, if there are many more buyers than sellers, the price of the ETF can go up by more than the true value of the underlying securities. This could be an opportunity for arbitrage by market makers and APs, knowing they can buy the underlying securities and create new shares of the ETF at fair value while selling them to investors at a price above this. 

Australian investors have been enthusiastic adopters of ETFs, with a number of benefits:

1. Lower cost: ETFs are typically able to achieve lower operating costs and the management fees (commonly referred to as management expense ratios, MER) can be significantly lower than other forms of professionally managed investments.
2. Liquidity: Most ETFs offer good liquidity, allowing investors to trade an ETF just like any other stock on the Australian share market. Two common sources of liquidity help to improve the buying and selling of an ETF. The first is liquidity created through trading ETFs between buyers and sellers on exchanges. The second is through market makers and authorised participants, who ensure there are enough ETF units supplied for the demand and that the ETF's price closely matches to its NAV.
3. Diversification: ETFs can allow investors to diversify their portfolio into markets that maybe difficult to access, including international stocks, bonds, currencies and commodities.
4. Flexibility: Like shares,ETFs trade on the ASX, which means they can be bought and sold during the ASX's trading hours.
5. Transparency: Information regarding the fees, holdings, and returns can be accessed anytime via the fund manager’s website.
6. Tax: ETFs are relatively more tax-effective than actively managed funds as they tend to have lower portfolio turnover.

Despite the strong growth in the ETF market, some care is still required in trading ETFs. It’s important to understand that ETFs, just like stocks or bonds, do not provide guaranteed returns. Investors should always read the associated product disclosure statement carefully to ensure they understand how the relevant product operates. Investors need to be aware of certain ETF risks and characteristics:

1. Tracking error: Several factors such as fees, taxes, and transaction costs can cause a divergence between the ETF’s unit price or NAV and the price of the underlying index they are designed to track.
2. Liquidity: As mentioned above, most ETFs offer good liquidity, but liquidity in the broader ETF market could decrease in times of market stress, and make the buying or selling of ETFs difficult.
3. Counterparty risk: This comes into play when dealing with synthetic replication (synthetic ETFs involve the use swaps or options). To obtain the swap, the synthetic ETF issuer enters a swap agreement with a counterparty, which is often an investment bank. Risks arise should the counterparty be unable to meet their obligations under the arrangement. Investors in synthetic ETFs, for example, should determine if the counterparty is strong enough to withstand a downturn in markets.
4. Complexity: Some investors might not fully appreciatethe risks associated with complex ETF structures such as Leveraged, Inverse, and Fixed income ETFs, which involve the use of derivatives to achieve their investment objective.  
5. Tax: ETFs are widely considered to be tax efficient, but this doesn’t apply to all of them. It’s important for investors to understand a fund’s tax treatment, especially if it’s exposed to commodity and currency markets. These funds are usually taxed differently than others.
6. Timing: Investors need to exercise caution when placing trades - to receive an ETF price that is closer to the value of the underlying assets, it is recommended investors place orders to buy or sell around 30 minutes after the markets open to 30 minutes before they close.
7. International ETFs: ETFs that are listed overseas and made available for trading in Australia, may require a W-8BEN form to be completed.

For a detailed discussion about ETFs, contact an Ord Minnett Adviser.