The exchange-traded funds (ETF) market in Australia has taken off as financial planners seek a new, simple and cost-effective way to channel clients' money into equity markets. InvestorDaily speaks to ETF developers and advisers at the forefront of the local ETF boom about their thoughts on the industry's progress and how the products are being incorporated into the financial planning process.
ID: What are your thoughts on the development of the ETF industry in Australia?
RG: Look, we started in 2001; it was reasonably slow going. In the last two, three years, however, as we have seen some obvious changes in the industry with greater understanding of the benefits of ETFs, which we will talk about no doubt, but also some moves towards fee-based planner arrangements, the funds under management have grown fairly dramatically.
We have the single largest strategies both in the United States and Australia. So the SPDR 500 is the single largest strategy in the ETF space in the world. The SPDR 200 is the single largest strategy in Australia and it has grown fairly dramatically as people have understood the benefits of these concepts.
ID: I think to add to that the important point is that what's driving growth in ETFs globally is exactly what is driving growth in Australia. Investors are looking for a new way to invest and ETFs provide very transparent, very liquid and very cost-effective ways to get specific market exposure, and those same principles that are driving growth in the US and other markets are the key things that are driving growth here.
RM: I can't speak for the US, but obviously in Australia we have started to capture ETFs as part of our core-satellite approach. I think financial planners around the country have been sort of forced into rethinking how they conduct their business, moving to fee-for-service, particularly in the superannuation space.
We like [ETFs] because they are transparent, they are tradable and obviously the funds management industry underwent a massive shock in regards to funds freeze and disclosure.
And with the various reviews that are going on now I think we are in a position from a financial planning perspective to really have to rethink how our business is valued, what position we occupy in the market space and more importantly consumers now are voting with their feet.
They are becoming more self-directed and they are doing it themselves. They are taking certain sectors off the shelf. So they are not necessarily going to an adviser and expecting that they will get slammed into a platform one way or another.
The growth of self-managed superannuation funds (SMSF) is evidence.
The tools that are coming onto the market to help financial planners manage their business and their models and their portfolios is sort of stripping away, if you like, the need to run on a platform.
The fact is that you generally valued your business based on the assets that you had under management rather than fee income and the whole thing is now turning around.
So the concentration for financial planning businesses is on profitability, not necessarily assets.
So that is why we are using ETFs because they are nice, transparent and we can strip out all the costs and add on our own costs of either distribution, advice or administration. So it is a great thing for the future of this industry.
JK: My main interest is in the international ETFs. We have seen a number of these be listed on the local market and I do use the local ETFs, but the international ones are my real interest.
I have found the international ETFs very valuable for my clients.
In terms of development of those international ETFs on this market, I would say the two biggest obstacles have been number one the currency, which as we all know has been appreciating over the last few years and that has been a big drag on the performance for international funds.
And the second one I would say is the lack of information. There is plenty of transparency, liquidity and tax efficiency as Tom mentioned, but I think the information that is available on international ETFs, none of the local brokers are really covering.
So you really are looking at external providers to provide this information to this local market about the international ETFs.
Now, the third thing that I think has been an obstacle up until now, Russell mentioned . platforms. My experience is that many people don't like to use international ETFs unless they can see it on their screen.
That is unless they can see it on Iress or on a local platform or somewhere where they can readily access the information. Advisers only have so much time during the day to look at these things.
So if they have to turn on another system, look at an international market, it is a real barrier in terms of the use of these ETFs.
Now I think that is changing, but nevertheless I think the Australian Securities Exchange (ASX) has done a very good job in supporting these ETFs and I think there needs to be more education done in terms of familiarising both the client base and advisers with what these international ETFs are all about.
RL: Just going back to the point on progress or the development of the industry in Australia. I think we would definitely still see it in an awareness phase. We are in the early stages and whilst Rob mentioned that we have seen very strong growth in the last couple of years and now with the entry of iShares and Vanguard to the market the awareness has started to increase quite rapidly.
There is still as John mentioned a point in the education, you know, how do the products work? And I think post-GFC advisers are quite rightly very cautious over new products of which they are unfamiliar. So we see a lot of work on the education front to really help advisers understand what the products are, how they work and importantly how you can use them within portfolios.
RG: Can I just add one more point? I think what has been front of mind with institutions as well is you realise that the institutional pick-up is definitely there in the ETF space.
I think as liquidity has picked up we have seen more and more institutions coming into the space.
It has been a nice, easy, fully administered strategy and when I say that I mean if they had gone and wanted to take a position in an index benchmark somewhere they would . have had to appoint a custodian.
This is a fully administered one-stop package that even institutions now are actively using.
Liquidity of the ETFs has improved quite dramatically in the last couple of years as well. ETFs are generally designed as an institutional-type solution that retail investors can access, but it's all a bit topsy-turvy how the end product works. Retail start coming in seeing the benefits of it, liquidity picks up and suddenly institutions start using it. So we have had deals now that are as much as $100 million intraday that's traded on the stock exchange.
There is no question when you look at the developments of the ETFs though over the last couple of years and you know I started this conversation by saying it was a mediocre performer for six or seven years and then it's just gone bang as shifts have happened in the industry. A lot of that has been the power of the press.
We have grown and we have grown dramatically and it's no coincidence that a lot of good journalism has happened in the last two years.
JK: I noticed in IFA that Barclays Capital was reported as [creating] this multi-ETF fund. That is going to be a big source of growth for these ETFs I think. I mean, they have taken three of the local international ETFs and they're putting a structure around it.
RL: I guess the other thing we have not touched on is the role of the exchange because they also along with the issuers are playing a part here in generally spreading the message about this as a new and growing product category and opportunity for investors and advisers.
ID: For financial planners, what are the advantages and disadvantages of using ETFs?
RG: Certainly transparency. You know exactly what you are getting, so there are no surprises. You are matching a benchmark return. You are holding every stock that makes up that index. It is not a derivative, so you are definitely getting the compensation of the income streams of the assets that sit behind it.
They are flexible so you can get in and out quite quickly, intraday as well because they are listed on the stock exchange.
You can buy amounts that are as low as $2000 if you want and buy every stock that makes up say the SPDR 200 series.
They are low cost, they are very low cost compared to other strategies available through a platform or mutual funds that might happen to be listed on the exchange.
The disadvantages are that if you wanted to buy $50 worth, the brokerage would kill you.
[Brokerage is] now essentially all online through all aligned brokerage services, so you have got to deal an amount where it makes sense to pay brokerage that you are paying. Another downside would be if you can continuously pick a persistently strong active manager, then you are better off with an active manager. But if you can't, you are better off with a core approach in indexing and we're agnostic on that, so we believe there are benefits for both.
RL: I think that's a very good point because the benefits that you outline are essentially the benefits of indexing. I think the trend in the market as advisers move to fee-for-service benefit indexing, but in particular ETFs.
And I think ETFs because they do have that added feature of being priced intraday is perhaps convenient for a lot of advisers and investors because of the transaction mechanism via the exchange.
And that is really the key difference between buying an index managed fund directly, but a lot of those benefits are very aligned. So it is a convenience factor and I would guess and I think that in itself is an opportunity for advisers as we see it because there is a new type of investor potentially for some practices, and that is the investor who prefers to see those investments transacted on the exchange and they are more comfortable with shares within their portfolios.
TK: There is no doubt that there are active fund managers that have proven they can outperform consistently. I think the key point is that finding those managers is what proves to be difficult for the financial adviser and so I think that's led to an increase in index funds or ETFs.
I think an easy way to explain it is that ETFs deliver the best of index funds management and combine that with the benefits that investors get from owning individual stocks. So really they're the best of both worlds.
They are the best of index funds management, diversification, transparency, low cost and you combine that with the trading flexibility and liquidity investors get from owning individual stocks.
And I think to Robyn's point that is exactly why these give advisers such a wonderful opportunity to take a different message to clients because due to the global financial crisis in particular, investors are looking for a new way to invest, perhaps a better way to invest and that has seen the growth in ETFs.
And I think that is why the SMSF market is often talked about within the context of ETFs because it does not matter what research you read about the SMSF market, but the primary driver of investing for SMSF investors is control.
And ETFs deliver that element of control that investors get from buying individual stocks, but it also gives some of the other traditional benefits of funds management, being diversification and investment management.
RL: Can I just add to Russell's earlier point as advisers really look at their business models post the global financial crisis they see, you know, what is their value proposition essentially? And if it's in working with clients to set strategy, here is a low-cost convenient tool to implement that strategy for clients.
RM: I mean it is all about control of the client and control of the business now. If you have been wedded to a platform in the past, you really have not had that control.
You have been subject to whatever the recommended list has been on that platform and we all know about the conflicts of interest that have helped developed those lists over the years.
So if you like it is a 'daunt' for advisers and I believe the market is now starting to open up and advisers are now winning back control of the whole client equation and ETFs give us that control.
The issue is we have never had consistency in this industry. We have either had product inconsistency, so products have come and gone, fund managers have come and gone and legislation has forced us to rethink our strategies almost every second or third year.
So invariably we'll go back to the client with a different strategy which could involve very much either a different platform, a different product or a different set of rules.
The thing I like about where we are going now, and I am speaking purely from a self-managed super perspective, and I see the market breaking into two distinct pools here.
The self-managed super market is really now controlling anyone with a reasonable amount of money who wants to become involved in the investing of their wealth and the low end of the market where this MySuper scenario will fit, it's for a person who can't be bothered with their super.
They have got multiple accounts and they just need somewhere to put it and they have been forced, super funds have been forced now to create low-cost product that takes all the choice out of the consumer but it protects the consumer . no advice, no trail commission and really for the adviser, no value.
So it's now forcing the adviser out of that market and into the advice fee-for-service market predominantly in the self-managed super space.
Now ETFs I expect will explode because in the SMSF space, they give the adviser a real low-cost, transparent, fluid, readily available product that suits the long-term goals of their clients.
Remember a financial planner is really about setting goals and objectives for clients and just reviewing and updating them every year. We are not necessarily a trader and we are not an active investor.
People really like to sit and just monitor their progress along their lifelong ambition.
I think we have really just overestimated what clients want over the last couple of years. You will get your client in and all of a sudden, particularly by using a platform, you would get them in and reallocate them, sell them out of this product and put them into that product and transaction costs [occur] all over the place.
Really what the client basically wants to know is are they on track for what their long-term objectives are? And ETFs are fantastic for that because you can set and forget.
You can build a core and satellite approach. You can then run your little satellites around it to achieve a little bit of alpha over and above that and more importantly give you and your practice some flavour of individuality.
Because at the end of the day when your client comes in you are charging them a fee, you have got to work out 'what am I actually doing for that fee'?
RL: And potentially bringing us back to the disadvantages at the moment - the products are unhedged. Currency hedging is a very important aspect of Australian investors' exposure to offshore assets, and also perhaps the more limited product range which I am sure we will see broaden over time. But at the moment advisers cannot implement a full portfolio solution across all asset classes using ETFs; it is an equity-based solution at the moment.
RG: It's not easy to build a hedge in an ETF. It is not an easy concept. And you have got to be careful as well that you are not just doing it because the Aussie dollar is at 93.5 cents and in six months time we are back to 85 cents and nothing happens.
ID: How are advisers using ETFs to build client portfolios?
TK: From the iShares perspective there is no doubt that the early adopters of ETFs in Australia for us have been the independent financial adviser market and, getting back to what we were talking about before, building core, in our case global equity portfolios using a combination of two or three of our ETFs that are listed on the ASX and that is what we are seeing.
We are seeing advisers build portfolios using various ETFs and allocating quite actively. They will move away from traditional global equity benchmarks, a common one being the MSCI World Index, and overweighting emerging markets or overweighting China and different parts of the world, and I think that is the flexibility and control that ETFs can bring to advisers' existing portfolio management or portfolio construction process.
RM: IShares are helping us out quite a bit. We have only got three model portfolios: conservative, balanced and growth; nice and easy. It is all just centered around asset allocation and iShares are helping us with the assistance of Morningstar and a whole range of tools, but it drills into the geographical spread, the asset allocation, the sector spread and all that sort of stuff so we are sort of half way through that. If we get that right . that's really backing up if you like the recommendation to the client.
So if we get this right then this is the sort of tool that the whole industry can adopt and I can see that organisations like iShares, Vanguard or State Street or whatever, that's what you should be concentrating on - is delivering those value-added tools to get you closer to the adviser.
We have to justify and back up our recommendation and we have to have tools to be able to do it. That is really going to separate you from the rest, if you can deliver those value-added tools and it's all about the education, asset allocation and drilling right down into what do those ETFs provide.
Clients love them and they understand them. As I mentioned before, we don't use a platform. They go into our website and we can tell who has looked at their portfolio every day on a client-by-client basis. And 80 per cent of our clients look at it every day. They understand it, it's very clear and transparent and they know that if they ever need to cash in or get out they know exactly the price they are going to get and just love it. They do not necessarily do that but they like to see things moving.
RG: We have seen some of the planners and clients in the retail space that we talk directly to fill their portfolios up with anything up to 80 per cent of core approaches in indexing. What would be your response to that [Russell]?
RM: That's a sensible strategy if the client's risk profile dictates that. I mean that's at the end of the day the 'know your client, know your product rule'. If a client is a conservative investor . I am quite comfortable with using an ETF or an index for a large chunk of their portfolio. If that is really what they want, they want passive long-term investing, that's it. It is what you do around the edge to add real value.
ID: How are research houses and platforms responding to ETFs?
TK: The research community is now starting to research ETFs more. Platforms I think are going to be a huge source of growth for ETFs. Up until now most of the money invested with iShares has been typically off platform.
But I think that in time we are going to see more money invested through the platforms. You have seen platforms invest in technology that makes trading in direct equities easier.
BT Wrap just launched their bulk trading functionality. They have recently enhanced some reporting functionality so the global ETFs actually come up in the asset allocation reports as global equities or international equities, not Australian-listed equities. That is a significant step forward because I think they see what is going on in the industry and they all want to tap into this SMSF market too.
RG: Absolutely, we thought the same thing four or five years ago that the platforms would not support the ETFs, that they were conflicted. Well that has definitely changed, definitely changed. The SPDR strategies now are on half a dozen of the major platforms.
TK: Most of our iShares listed on the ASX are available through both super and ordinary investment menus on most of the major platforms now. We do have research from the local brokers creating model portfolios for ETFs. So they will take three or four of our global ETFs and allocate a global equity portfolio. So you know a certain amount is invested in the US as opposed to Europe, as opposed to Japan as opposed to emerging markets, for example.
RG: With some of these research houses, they are saying 'well what's to research, it's just indexing?', which kind of misses the point. I mean the whole point of it is that I think we are going into a day and age now where there are so many freely available benchmarks around the world that you can trade . 90 per cent of the source of returns are dictated by getting your strategic asset allocation right.
It is all about benchmarks; it's not about picking stocks. Now when you look at the availability of benchmarks that you can get here and around the world, you can buy ETFs on any exchange around the world, they are now trading this. So individuals and institutions are now trading benchmarks as they would have stocks say 10 years ago and it's working.
But research houses are still saying 'well, there is not much science to it'.
TK: I think the more providers listing will increase the need for research because investors are going to have to become a lot more discerning about what ETF provider they choose. Because the more providers there are the more differences there will be between providers and basically the industry is dominated by three major players and they are all here today. So as other ETF providers come on I think investors need to seriously consider who they are investing in and that's the job of the researcher to perhaps guide people in that way.
RM: And I think it is your job purely for the three providers if you like to help the market understand that we are getting these little boutique ETF providers coming in. There's a real risk that the industry does not really understand [them].
RG: That's right and it concerns me. I was chatting with someone about these leveraged strategies coming through. You know that's interesting . that's very interesting. I mean, international strategies - I am fine with that in the Australian market. This is all about knowing the product and you want to make damn sure they know the currency risks that are associated with that.
ID: How should advisers view the currency aspects of ETFs?
TK: Currency can be viewed as a risk or it can also be viewed as an opportunity and currency can provide nice diversification to a portfolio at the right time. Everyone focuses on periods where the Australian dollar has been rising and therefore having a negative impact on returns, but if you were invested in an unhedged global equities fund or in the S&P 500 in June 2008, when the Australian dollar fell 30 to 40 per cent during that time, and so your investment in the S&P 500 was a lot smoother . the performance was a lot smoother and at some stages positive throughout that period.
So currency can have a beneficial impact on a portfolio and I think it is very important to remember that, because I think most people remember the negatives rather than the positives.
But that said, it is definitely a major consideration in using ETFs and I think again this is why the independent financial advisory market has been a major user because typically they will have a hedging policy.
A lot of our clients might have a 50/50 hedged/unhedged position in their portfolios if nothing else to smooth volatility that the currency can cause. So they will use the ETF for the unhedged and they will use a traditional managed fund for the hedged exposure. So it really comes down to the risk profile of the client and the way that the adviser is constructing portfolios.
RL: I absolutely agree with Tom's point that it is a risk which is dependent on the investor or adviser and whether they are open to that sort of volatility in their return.
RG: Can I just make an observation as well, and you know this is by no means suggesting that people should look at stand-alone international equity or fixed income solutions, but a significant part of the total return of say the Australian share market has come from yield. Thirty-five per cent of the yield in Australia is made up of foreign investment earnings. So let's not forget also that the Australian share market in itself also generates a lot from foreign earnings.
TK: There is no doubt that we are seeing people buying the iShares S&P 500 on the ASX at the moment and they are saying that the long-term average of the Australian dollar is far below where it is at its present level and so they may have a threshold where they might moved to an unhedged position, and then if the dollar drops like we saw it drop very dramatically a couple of years ago, they might move to a more hedged position.
So advisers are implementing positions based on where the dollar is versus long-term averages and again that's another core benefit of ETFs because that's a very simple thing to implement.
I think there will be demand for traditional index funds just as there will be always demand for ETFs. It just comes down to a business model issue. If an adviser is using a platform and it's all set up to trade direct equities, then they will potentially always use index funds.
ID: Is there any danger that investors can get overlapping international shares exposure by using ETFs?
RG: Yes, potentially. If you are buying BHP in Australia you are naturally buying a fairly heavy exposure to the resource industry. It is one of the largest weighted stocks in our index and, of course, if you go and buy an international equity capability or resources bent on the international market, then sure you are potentially getting a greater exposure than you may have thought. So again it comes back to knowing your product and making sure you fully understand the make-up of the benchmark that you're buying.
TK: And that is what ETFs deliver. Because an adviser can look at exactly what is in that ETF that they are investing in from two days ago, so they can pinpoint exactly where the overlap is. So yes there can be overlap but that's far easier to manage than say if you are using managed funds where you might be blending some active managers that invest in Australian equities and you don't know what that overweight position is.
RG: Or perversely you know one's long and one's short and one's long and one short and you have got a zero exposure, which is an index strategy anyway.
TK: So again it comes back to this element of control because the adviser can control that overlap.
RM: If you go to a boutique manager like, let's say, an Ausbil for instance, now they have or did have a very big weighting a few years ago in Rio Tinto.
But it was a point of difference and they got up and said 'well this is why we like Rio'. Now if I have a Colonial First State fund manager who I have found out just by accident has a fairly heavy weighting in Rio and I then blend it in with Ausbil, all of a sudden, but not that I want to, but I have got a client heavily exposed to Rio, which is totally out of kilter with the index.
And then all of a sudden what happens? The old [Alcan] takeover does not work, Rio's share price drops by 50-60 per cent. I am caught out.
If I had an ETF and I could actually drill down and say 'well, that's really what I want', at least I know what [the overlap] is.
TK: The ability to manage unintended risk in portfolios is [an aspect] of using an ETF because of that transparency.
ID: What advantages do ETFs provide in terms of tax? Are there any complications with US estate tax laws?
RG: When you are with an active manager, and again I highlight that I am agnostic here, but when you are with an active manager, you are turning over stocks and when you turnover stocks you are crystallising positions, crystallising capital gains, which means you are being taxed.
With indexing you have a sizeable core position and generally speaking, bar an applications and redemptions process, you are only tinkering with positions when benchmarks change so when you get price fluctuations in stocks. So you are not getting the turnover in indexing. The quantum, the tax benefit associated with that is actually quite sizeable.
RM: In fact, if you like a large reason why ETFs have all of a sudden come into favour is because financial advisers have lived through the 2006/07 time frame where our clients, because we do their tax as well, were just getting hammered with tax liabilities by the reweighting of portfolios and buying and selling. They did very well, but the fact is a lot of it was taken away just by the inefficiencies of managed funds and their tax structure.
So what we have done then, we've gone through that, clients have done well, paid a heap of tax then all of a sudden the market's savaged you and you don't have any tax liabilities on the way down, but you are now sitting on capital losses that you will only be able to offset by capital gains. So the poor old client's in a quandary. So when we sit down and talk to them about ETFs and say 'okay so you have been through that in the last couple of years, now let me tell you that an ETF is so much more tax efficient than a managed fund because you will only ever pay tax when you actually cash it in'.
TK: The tax efficiency is another reason, and I keep going back to the SMSF market, but this is a big reason why SMSFs are more and more embracing ETFs because of that inherent tax efficiency of an ETF.
So I mean whilst there is inherent tax efficiency that we have just discussed, there can be exposure to US estate tax. That really depends on how you invest and how much you invest.
ID: Could we see a proliferation of ETFs developed by active fund managers over the next couple of years?
RL: I think it really comes back to a point that Tom touched on earlier about if we look at developed ETF markets and, of course, the US is the most developed and between iShares, State Street and Vanguard I think that is 70 per cent or just over 70 per cent of all the US assets and in fact if we look at the top 10 products there, that accounts for 40 per cent of the assets.
So it is predominantly about buying, as Rob said, index exposure and the largest and most well traded, the most enduring ETFs are index exposure. You could come to Vanguard and buy a managed fund or you could buy a
