Plain Talk Guides

Exchange Traded Funds (ETFs)

A new and exciting way to index from the indexing specialists What is indexing? ETFs - Another way to index How do ETFs work? ETFs - Fees and Costs How can you invest in ETFs? Participants in the ETF market What are the benefits of ETFs? Risk and return How do you choose between ETFs and managed index funds? How can you use ETFs in your investment portfolio?

 

A new and exciting way to index from the indexing specialists

Since Vanguard first introduced indexing to retail investors in the United States in the 1970s, it has become a popular investment strategy with institutional and individual investors and advisers alike. In Australia index funds under management climbed to their highest ever level of $184 billion in June 2008 (Rainmaker Roundup March 2009).

Vanguard pioneered the concept of indexing, introducing the first retail index fund in the US in 1976. Vanguard has since become one of the world’s most experienced and successful indexing specialists. In fact, the Vanguard Group manages more than US$1 trillion worldwide (as at 31 March 2009). Vanguard is now the largest index manager in Australia managing over 33 per cent* of index funds under management, which equates to almost $60 billion dollars.

Now there is a new way to access Vanguard’s proven index management approach – through exchange traded funds.

Exchange traded funds (ETFs) were first introduced in the US in 1989. They have since become one of the fastest growing investment products in the world. In 2008 ETFs were one of the most traded investment instruments in the US and by 2012 assets under management worldwide are expected to exceed US$2 trillion.

This Plain Talk guide introduces indexing with ETFs and explains how they work, the benefits and risks associated with them and how you can use them in your investment portfolio.

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What is indexing?

Indexing is a way of gaining exposure to an investment market. Most investment markets have indexes that measure their value over time. For example, a share index measures the change in the value of shares of the companies included in the index. There are a variety of indexes that cover various industry sectors and asset classes, including Australian and international securities, property, bonds and cash.

Indexes provide a way for fund managers to measure their performance. Usually, active fund managers will try to outperform the index, (also called a benchmark), by picking the securities they believe will outperform in the future.

Indexing is different to active management. As an index manager Vanguard believes that over the long term it is difficult to consistently beat market indexes by trying to pick winners. Our aim is to deliver the index return before fees by constructing diversified investment products that track the same or similar assets and weightings as the benchmark.

Index managers don’t try to outperform the market. Instead they invest in all or a representative sample of the securities in the index – such as the S&P/ASX 300 which tracks the Australian sharemarket – and let the fund grow with the market over the long term. Because index funds invest in all or most of the securities in an index they provide diversification, which means lower risk.

Quite often the best performing asset class in one year can appear at the bottom of the ladder the next. The same can be true for investments within each asset class. The graph below shows the value of $1000 invested in different asset sectors over a five year period.

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ETFs - Another way to index

An ETF is a sharemarket quoted fund which is constructed as a broadly diversified investment portfolio of either shares, bonds or real estate securities.

Most ETFs use an indexing approach that seeks to track specific market or sector indexes. Consequently, index based ETFs carry all the benefits of traditional index funds, such as low operating costs, diversification, potential for tax efficiency and simplicity while also offering the liquidity and transparency of securities listed on an exchange.

Australian investors currently have access to both domestic and crosslisted ETFs.

Domestic ETFs are ETFs that are listed only on their own domestic stock exchange, for example the Vanguard Australian Shares ETF which is listed on the ASX.

Cross-listed ETFs are ETFs that have their primary listing on an overseas exchange, for example the New York Stock Exchange (NYSE), and cross-listed on the ASX. Vanguard’s cross-listed ETFs are managed by our parent company The Vanguard Group, Inc. in the US.

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How do ETFs work?

Vanguard ETFs are index funds and they aim to deliver the index return, before fees, by building investment portfolios using similar assets and weightings as the benchmark index. This means an ETF’s return, before costs, should closely match the index it tracks, just like a traditional index managed fund.

Through purchasing a single Vanguard ETF unit (or security), investors gain access to a diversified index fund. You
can buy or sell ETFs at any time throughout the ASX trading day.

Vanguard ETFs are constructed using an indexing approach, so their value generally moves in line with the index they
track. For example, a 2% rise or fall in the index would result in approximately a 2% rise or fall for an ETF which tracked that index (all other things being equal).

From Issuer to Investor
The creation of domestic ETF securities

EXCHANGE TRADED FACT - ASX AQUA Market The ASX AQUA market is a new service for managed funds, ETFs and structured products. It is aimed at domestic and international product issuers that provide investment products for both retail and institutional investors who have not traditionally been provided with a dedicated operating framework within the exchange-traded environment. Investors purchase ETF securities on the AQUA market in exactly the same way they would any other security for example BHP or ANZ.

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ETFs - Fees and Costs

Index based ETFs are generally a low cost investment option, and substantially lower cost than investing in the same exposure of individually purchased shares. Because the funds are usually managed using an index approach the cost to manage is generally less than actively managed funds.

Management fees
A management fee applies as with any other managed fund. This is a fee charged by the fund issuer and covers all relevant fees and other costs involved in managing the ETF and deriving investment returns. These fees and costs include things like custodian fees, accounting and audit fees and index licence fees.

Brokerage fees
Brokerage fees are fees charged by the broker each time you purchase (or trade) an ETF. These fees vary, starting from around $20 per transaction.

EXCHANGE TRADED FACT - Bid/Ask Spread The amount by which the ask price exceeds the bid price. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.

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How can you invest in ETFs?

ETFs can be bought or sold on the ASX through a broker. The services of brokers range from full service brokers or financial planners through to non-advisory brokers. Non-advisory brokers enable transactions via the telephone or internet – for example CommSec or Etrade. Investors need to open an account with a non-advisory broker in order to purchase ETF securities, or contact their full service broker or adviser.

After trade execution the investor will receive confirmation of the trade settlement. On a regular basis the investor will also receive distribution statements, tax statements and other relevant information to their investments.

There are different ways to trade ETF securities:

Market Orders
A market order is a buy or sell order in which the investor instructs the broker to execute their order at the best price currently available.

For example an investor wants to buy 100 Vanguard Australian Shares ETF securities. You put in a market order for 100 securities and hit the execute button. The security order will automatically be matched up with the current market price and executed.

The downside of a market order is that you could end up paying a higher price for a security than you intended. Market orders can be used in both the buying and selling of securities.

Limit Orders
A limit order is an order to a broker to buy a specified quantity of a security at or below a specified price, or to sell it at or above a specified price (called the limit price).

If you want to buy 100 Vanguard ETF securities at 50 dollars per security, then your order will be automatically executed when the ETF price hits 50 dollars. Limit orders can be used in both the buying and selling of securities. For most investors this method ensures you only pay a price that you are comfortable paying for a security or sell at a price you wish to sell at.

With the limit order you are certain of the limit at which your securities will be bought or sold so there are no surprises. Another aspect of the limit order is the fact that your orders can be placed and executed while you are busy at work or enjoying a game of golf. On the downside it may take a long time for the price of the security to get to the same place as your limit order.

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Participants in the ETF market

Issuer
The issuer of an ETF provides investors access to the underlying assets of the ETF, such as the index funds which
underlie Vanguard’s ETFs, by issuing ETF units.

Market maker
The market maker’s role is to satisfy supply and demand for ETF units, seeking to provide continuous liquidity to the market. Market makers have two roles in the ETF process:

• They provide liquidity to the market by acting as the buyer and seller of ETF securities throughout the trading day, and
• They create and redeem ETF securities off-market to ensure that there are enough ETF securities on issue to meet the supply and demand in the market.

Authorised participants
Authorised participants (APs) also create and redeem ETF securities offmarket to meet supply and demand. APs are typically large institutional broking organisations.

They play a critical role in the construction of an ETF’s creation unit (large blocks of the ETF’s underlying securities). After acquiring all the underlying securities (in the basket) that will form the ETF, the AP will often need to transfer the securities to a custodian bank.

A firm may act as an AP or as both a market maker and an AP.

The process begins with the issuer distributing the basket composition to the market each trading day, allowing APs/market makers to price the basket of securities underlying the ETF.

Market makers place a bid/ask spread around the net asset value of the ETF and send these prices to the ASX as quotes. Market maker quotes are updated continuously throughout the day to reflect price changes in the underlying securities.

Share registry
The issuer of an ETF appoints a share registry to manage the administration for ETF investors such as confirming settlement, paying distributions and providing tax information.

EXCHANGE TRADED FACT - Basket of securities A basket of securities is a list of securities which the issuer of an ETF prepares each day which closely tracks the underlying index. The issuer sends this ‘basket’ out to the market makers who in turn trade the basket of securities in exchange for ETF securities.

 

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What are the benefits of ETFs?

Low costs
The management fees for index-based ETFs are usually significantly less than actively managed funds. ETFs are also more cost efficient than investing in the same exposure of individually purchased securities.

Diversification
Index funds invest in all or a representative sample of securities in an index and this provides you with a highly diversified investment.

As Vanguard ETFs are indexed managed funds, your investment is pooled with other investors’ money. This offers investors access to a wider range of investments which may not be accessible otherwise as an individual investor.

Potential for tax efficiency
Tax can potentially take a large chunk out of your investment returns so it pays to invest in funds that are tax efficient. The low turnover of indexed investments associated with an indexing approach minimises the capital gains distribution impact. This improves performance and tax efficiency over the longer term.

Liquidity
The authorised participant’s creation and redemption of ETF securities on a regular basis ensures an underlying
depth of liquidity. Unlike unlisted managed funds, investors are able to trade ETFs during ASX trading hours and at a price quoted on the ASX.

Transparency
The issuer of the ETF provides daily information to the market including the ETF basket, and daily calculated Net Asset Value of the ETF, making ETFs a highly transparent investment option.

EXCHANGE TRADED FACT - Net Asset Value (NAV) The process for creating or redeeming ETF securities ensures an ETF generally trades close to its Net Asset Value (NAV). The NAV is the underlying total value of net assets divided by the number of securities on issue. NAV = (Total Assets of ETF - Liabilities) / Number of ETF shares outstanding

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Risk and return

As with any investment, investing in ETFs is not risk free. Investors in ETFs should bear in mind one of the main principles of investing which is the higher the potential reward, the higher the risk of losing money. That said, the reverse is also generally true – the lower the risk the lower the potential reward.

Returns
The expected returns of Vanguard ETFs should generally be aligned with the index returns (before fees) that the ETFs track. Returns generally come in the form of income and growth.

Investors in ETFs can become entitled to income in the form of distributions from their holdings in two ways – either when they redeem (or sell) their securities or by receiving a distribution at the end of each distributable period (which is generally quarterly but can vary between ETFs). The amount received is based on the amount of ETF securities the investor holds.

Growth comes from any increase in the value of the portfolio’s assets and will be reflected in the NAV of the ETF. This return is only realised on the sale of ETF securities.

Risk
As a general rule, asset classes range from low to high risk in the following order; cash followed by fixed interest, property and then shares – as depicted in the risk spectrum below.

The price of an ETF can fluctuate within a wide range just like the overall stockmarket, which means investors should consider their own personal tolerance for fluctuating market values.

Currency risk
International ETFs are subject to fluctuations in the value of the Australian dollar against other currencies. Currency movements can impact the returns on your investment because losses or gains must be converted back into Australian dollars.

For example if the value of the Australian dollar rises, the value of investments held in non-Australian assets (e.g. US$) will fall. Conversely, a weaker Australian dollar increases the value of investments held in non-Australian assets. Hedging is not currently available with Vanguard ETFs.

ETFs are also subject to market, credit and manager risks associated with any managed fund investment.

Tax on Distributions
Any income in the form of distributions which an ETF investor receives during the year will be counted as part of their assessable income. The tax impact of this depends on the components of the distributions.

If an investor sells their ETF securities they may be liable for paying tax on any gains they make in this transaction.

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How do you choose between ETFs and managed index funds?

Vanguard ETFs and their equivalent managed index funds own the same underlying assets. So for investors the decision of which is better comes down to which investment best suits your particular circumstances.

When deciding between an ETF or a managed fund, you should consider:

If you have, or are prepared to open, an account with a stock broker or online broker
You will need a brokerage account to buy and sell ETFs. If you invest using a financial planner, they can access either index managed funds or ETFs via administration platforms such as master trusts and wrap access or via online broking facilities.

How often you invest
Brokerage fees apply when buying and selling ETFs on the sharemarket, however contributions to a traditional (managed) index fund do not attract any fees (other than the applicable buy and sell spreads). So ETFs may not suit investors who make ongoing, small contributions.

The importance of trading to you
An ETF can be bought or sold throughout the trading hours of the ASX providing investors with the option to enter or redeem their investment at any time.

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How can you use ETFs in your investment portfolio?

ETFs offer many opportunities to meet your investing needs. The ease, flexibility, diversification and low cost of ETFs make them an innovative and effective investment solution to:

Construct an investment portfolio
A combination of ETFs covering different asset types and markets can be used to build a robust investment portfolio that operates at low cost.

Build the foundations of a portfolio
Use ETFs to create a solid, diversified foundation or ‘core’ of an investment portfolio, complemented by other investments like direct shares or actively managed funds to potentially seek extra returns.

Rebalance a portfolio
Over time portfolios can move away from their initial asset allocations as the value of different assets change. ETFs can be used to quickly, easily and cost effectively correct these imbalances in a portfolio by purchasing the exact asset exposure required.

Trade in the market
ETFs offer investors the ability to rapidly deploy cash into the market, trade frequently at market prices and use ETF securities as collateral for margin lending (where approved to do so).

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