Five Questions to ask before Plunging into an ETF

Exchange Traded Funds (ETFs) have been available on the ASX for over 2 decades, but in recent years, this category’s variety and representation within Australian portfolios have grown rapidly.

By offering exposure to different global markets, industry sectors and strategic themes, as well as non-equities asset classes like bonds and commodities, ETFs can provide relatively low-cost “building blocks” for a diversified portfolio.

However, as with any investment, it’s very important to understand what you are putting your money into, and to ensure that it suits your specific needs.  Here are five questions to ask yourself, or your financial adviser, before you purchase an ETF.

Question 1: Does it accurately capture the market exposure that I want?

You wouldn’t judge a book by its cover, so make sure to look beyond the ETF’s name to properly assess the underlying exposure of the product. Common misunderstandings include:

• Mistaking a “picks and shovels” exposure, through owning suppliers and supporters of a sector, for that sector’s output. For example, a portfolio of cryptocurrency miners and exchange operators is not the same as a direct investment into cryptocurrency;
• Confusion between ETFs linked to a commodity’s spot price, which is the price for immediate delivery, and those representing a futures curve, which will move with expectations for longer-term pricing; and
• Overlooking exchange rate movements, which can influence your returns from anything not priced in Australian dollars. This impact can be neutralised with a currency-hedged ETF.

Question 2: Is the exposure active, passive, or somewhere in between?

Early ETFs were purely passive, usually linked to an equities index like the S&P/ASX 200, but now, there are also actively managed portfolios within an ETF structure. “Smart beta” portfolios which apply rules-based investment strategies are becoming more common too, for example, one might invest in a basket of stocks which screen well on quality factors. The exposure type affects fee levels and return potential, with passive ETFs tending to be the cheapest, but lacking the potential to outperform an index benchmark.

Question 3: How liquid is this product?

It is possible for the price of an ETF to diverge from that of its underlying exposure, particularly in volatile market conditions such as the COVID-19 panic in early 2020. To ensure that investors can get in and out of a product when they want to, ETF providers often employ a Market Maker, an institution which quotes separate prices to buy and sell units.

Generally, ETFs with a smaller pool of units on issue are more likely to have poor liquidity, and this can show up in a wide spread between the buy and sell prices. Using “at-limit” orders when trading ETFs can help ensure that you receive the price you expect.

Question 4: How does the fee compare to alternatives, and what are the trade-offs?

Low cost is a major benefit of ETFs, but when you have several to choose from, it’s worth understanding why one’s management fee is cheaper. Active management usually costs more, and ETFs linked to a major market benchmark are sometimes priced higher because the index provider takes a cut of the total fee. Unusual products may carry a scarcity premium, while new or smaller-scale offerings may have lower fees, both to compensate for their initially poor liquidity, and also to entice more patronage over time.

Question 5: How does it fit with the rest of my portfolio?

Any new investment should be considered in the context of your existing portfolio. ETFs can provide valuable diversification, but they can also be a source of inadvertent overlap or concentrated exposure to certain sectors or factors. For example, ETFs linked to the S&P 500 index, the NASDAQ 100 and an actively-managed global growth strategy might overlap in high exposure to the Big Tech stocks, so this combination might not provide adequate diversification.

Source: Lonsec