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How to make ETFs a legitimate
part of a portfolio
While it’s safe to say that most advisers know what exchange-traded funds (ETFs) are now, how to actually
incorporate them into a portfolio is not yet fully understood. Krystine Lumanta reports.
E
xchange-traded funds (ETFs) have now
been around for more than a decade ample time for financial planners to have worked
out what they are.
But now, planners are grappling with the
how question: How to use ETFs constructively
in developing investment portfolios.
Robyn Laidlaw, head of product development and management at Vanguard, says that
if planners already understand the benefits of
ETFs, they will quickly grasp the “context of
where they might play a role in portfolios”.
“Being low-cost, they offer diversification,
there’s a liquidity of the ASX trading - they have
that secondary market trading to them - and
they give advisers access to overseas markets,”
Laidlaw says.
She says they can be used as “building blocks”
to implement strategic decisions, both for longterm and short-term uses, such as “equitising”
cash.
“If somebody has a cashflow that’s going to
be invested in Australian equities…an ETF can
be a great solution because they’re simply bought
in one trade on the ASX, giving you market
exposure from the day you’ve acquired the ETF
and [avoiding the] drag of holding that money in
cash,” Laidlaw says.
Vanguard recently launched three new
ETFs, expected to be available from May 26: the
Vanguard Australian Shares High Yield ETF,
Vanguard MSCI Australian Large Companies
Index ETF and Vanguard MSCI Australian
Small Companies Index ETF.
The diversity of ETFs across the broad
market now means that planners not only have
more products to consider, but they can plan for
different results in return, according to the type
of portfolio that will be generated.
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Laidlaw says that if ETFs are thought of as
being the index funds in the portfolio construction process, they can really play a role in
forming the core ingredient. Having a main core
component will allow returns to be delivered in
line with the market’s performance.
“Therefore advisers can get a core exposure
- for example, an Australian shares ETF - that
gives them a diversified core [exposure] to the
Australian equity market,” she says.
Michael Molloy, certified financial planner
at Charter Financial Planning, has had more
than five years’ experience in applying ETFs to
portfolios.
He says that from a financial planning perspective, he can see that the majority of Australian portfolios will have ETFs incorporated into
them in the coming years.
“It’s fair to say you’d have a proportion in
there, whether it ends up being five per cent, or
25 or 30 per cent.
“If I look at my portfolios, most of my clients
do have an exposure to an ETF at some level, but
the extent to which that occurs is the variable.
“Certainly, I can see that there’s a role to play
to have these types of funds in there.
“Our practice has about 35 advisers and at
a practice level, they’re starting to look at it as a
legitimate part of the portfolio.”
Molloy says there are a number of ways to
use ETFs to achieve low-cost beta exposure to
the market.
“One way to look at it is as a core exposure,”
he says.
“Up [until] recently, it’s predominantly been
the Australian exposure where you may use an
ETF to represent a core component of your
portfolio and that may represent 50 per cent or
40 per cent.
“You have that as a core, low-cost exposure
where basically, you get the broader market.
Given the fact that the majority of fund managers often struggle to outperform, that’s sort of a
decent way to get your overall exposure.”
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This traditional strategy uses index-based
ETFs as the core component of a portfolio, but
also includes actively managed funds or assets
around that. The aim is to potentially increase
the overall portfolio return, without deviating
too far from the benchmark. The actively managed component will have a higher risk profile
than the core component, but will generally be
much smaller in size.
Laidlaw says that the core-satellite approach
is a strategy that Vanguard has been talking
about with financial planners for the past few
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ETFs provide opportunities beyond just passive
years.
“It’s not a question of, ‘Do I use index funds
or do I use active funds?’ But it’s really a question
of how do both play a role in my portfolio?” she
says.
Molloy says that planners can “put in some
direct stocks where you’ve got a higher alpha
or more risk on the table” but potentially, you
can “outperform comfortably with your stockpicking skills”.
“Or you may decide to choose a couple of
active fund managers, which historically have
added value, so you may put [in] one or two
direct active managers to complement the index
style from an ETF,” he says.
“You may also add a small cap manager - so
again, there’s potentially more risk, potentially
more alpha…to complement the broader return
from an ETF.”
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As more ETF products evolve due to the
availability of sector-type funds, they can be used
to tilt a portfolio into specific sectors, such as
gold or commodities.
If planners can get their heads around what’s
3
available and the differences
between each prodV810
uct, Molloy says they will be able to use ETFs
in a more sophisticated way when constructing
portfolios.
A lot of client portfolios now have a tilt towards gold through an ETF; and high-dividend
ETFs are another growing area for clients in the
retirement phase.
“You can have a tilt for a client in the
income phase and if they want more exposure
to dividends or a higher level of dividends than
the average market, then that’s a way of actually
getting exposure to that sort of area,” he says.
“If you drill down looking into the comparisons of StreetTracks, Russell and iShares, they
all actually operate quite differently. StreetTracks
has quite a high financials component, Russell is
midstream and
iShares
a lowyour
financials
world.
Easily
trackhas
andquite
attribute
“added risk”the
and
alpha above and beyond anchor exposure
exposure. So you may have a client that’s got a
“Traditionally, if they were using stocks to
Full transparency of holdings to more effectively blend with other investments
lot of bank shares specifically,
so the iShares may reflect an exposure, if you looked last year at the
simple
with one
complement them as far as having lowerRebalancing
finanASX 200,
[outtrade
of ] the top 25 performing stocks,
cials but has exposure to other areas.
21 of them were resources stocks.
“Or you can start to drill down into various
“Of the 21, none of them were BHP or Rio,
sectors depending on what kind of portfolio
which are the two biggest resources stocks, and
you’re looking to generate. So certainly there
probably the most widely held in Australian
[are] more options occurring there.”
portfolios.
Drew Corbett, head of investment strategy
“So therefore, advisers using ETFs in their
and distribution at BetaShares, says the greater
portfolios reflect an overweight to resources; or
choice in ETFs means that advisers can utilise
if they were more focused on dividends and they
them as key tools to tilt portfolios to the parwanted to reflect an overweight to the financial
ticular sectors they believe are generating higher
sector, they get the benefit of the ETF owning,
returns.
based on their cap weightings, all the stocks in
“The beauty of it is ETFs deliver virtually the that sector.
main sectors of the market,” he says.
“ETFs have seen terrific growth - over $5
“They can reflect a tilt towards, or an overbillion in assets, and we’re now up to 51 products
weight in, that sector through the ETF, rather
and I expect a few more products this year,”
than just through one or two stocks in their
Corbett says.
portfolio, which obviously doesn’t give them the
“One of the conclusions that the market has
diversity across all the companies benefiting from come to is that about 90 per cent of a stock’s perthe export boom of [raw] materials to the rest of formance is usually related to the performance of
It’s time to reDefine Dividends.
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reDefines the way investors access Australian blue chip
shares and franked dividends.
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the overall market and the sector that the stock
is in.
“Just getting the sector right generates the
bulk of your return, as opposed to determining whether BHP is going to outperform other
stocks.”
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Planners can use an ETF as a low-cost
anchor in portfolios, replacing more expensive
managed funds, or a number of individual equity
holdings.
Bronwyn Yates, product specialist exchange
traded funds at Russell Investments, says an
anchoring approach allows for additional equities
or managed funds to be blended with the ETF,
and can provide other opportunistic returns.
In this situation, ETFs should be recognised
beyond their traditional passive abilities.
“By having this core, it allows investors and
advisers to measure the progress of the portfolio
- of what’s happening to the core and also what’s
happening to the additional investments,” she
says.
Where clients are more focused on a higher
level of dollar income as an outcome, planners
can use an income ETF to achieve that certain
level.
“There’s a transparency so they can know
what’s actually in their portfolio and what they
might want to blend with that portfolio,” Yates
says.
“But because it comes through as a single
holding, they can demonstrate a clearer picture
of the level of income they’re receiving and how
it is achieving their stated goal of a certain level
of income.”
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In addition to using an ETF in the anchor
approach, clients are combining this with strong
growth individual securities and then applying a
margin loan over the whole exposure.
Yates refers to this as the “bucket approach”.
“The ETF is acting almost like a defensive
exposure that generates income to offset some
of the margin expenses, and the opportunistic
securities [component] is delivering more aggressive exposures.
“We’re seeing growth in using ETFs in
geared exposures in a portfolio,” she says.
“So whether it be margin lending, we’re also
seeing self-funding instalment warrants using
ETFs as part of their underlying exposure or
engine.
“What’s great for investors is that, sure,
they’re getting a diversified exposure, but still getting a geared exposure into the marketplace.
“And by using income ETFs, the income
that is generated from the underlying portfolio
goes part of the way to paying off the lending
expenses.
“So again these ETFs, and the single security
holding of them, makes them a very easy way to
implement a geared exposure into your portfolio.”
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Understanding how indexes are built plays a
crucial role in determining where ETFs belong,
as they essentially track an index.
Index provider MSCI has been building
indices for the investment market since 1969,
holding the longest history in index building for
global markets and constituent countries.
Michael Anderson, executive director MSCI,
says they build indices that represent the market
as best as possible in regards to their liquidity.
“We look at the equity market within any
particular market so they’re built up from country…into regional indices,” he says.
“In Australia’s case we look at all the stocks
listed in the Australian market.
“Predominantly, we screen the stocks for
liquidity - that’s the major thing we look for.
Are we building an investible-type index that
managers can purchase securities in and actually
replicate or at least get exposure to the securities
that are in the index?
“There’s nothing worse than a manager having a stock in an index that it can’t buy because
there’s no liquidity in that particular stock.
“If you’re looking at an ETF, you’re effectively
looking for a product [where] the index underneath the ETF needs to be very transparent in its
methodology, so that’s a huge thing.
“We also build benchmark indices that are
looking to offer all the opportunities there are
in the market, but also balance that out with the
turnover that’s possible of stocks going in and
out of an index and trying to manage that as
well.
“We build indices that are global and built
from the bottom up, style and thematic indices,
[and] a lot of market capitalisation indices as
well.”
Susan Darroch, head of global equity beta
solutions (GEBS) Asia Pacific ex Japan at State
Street Global Advisors (SSgA), says when they
decided they would offer a new ETF in the marketplace, they also decided it would need to track
a custom index that targeted higher than average
dividend yield.
“[MSCI] looked at the consistency and
persistence of high dividend yield stocks and a
few other things that made it the index we ended
up choosing,” she says.
“With all of our ETFs, we fully replicate
those indexes so we hold it at approximately the
same weight as it is in the index except for the
small caps one. [With] small caps, we take into
account that some of the stocks are less liquid
than others so we don’t necessarily hold all of the
stocks in that.
“We do a little bit of an optimisation so that
we still emulate the characteristics of the underlying index,” Darroch says.
“But we do that with probably about 90 per
cent of the stocks held in the index.”
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Anderson says the methodology used for the
resulting SPDR MSCI Australia Select High
Dividend Yield ETF was a global one, “effectively
customised for Australia, [taking] into account
the Australian marketplace and the influences
there”.
Guy Maguire, director and head of index
services at Standard & Poor’s, says: “S&P Indices
locally and globally is committed to the provision
of custom indices and we consider this a core
competency supporting ETFs and other product
structures.
“The Australian ETF market is still in early
stages of development and the extent to which
the ETF market will grow, particularly over the
next two to three years, will leverage recognised
index brands,” he says.
“S&P Indices, including the S&P/ASX
index suite denoting the underlying index, clearly
support the value proposition of ETF offerings,
rather than the absence of a recognised index
brand.”
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When the Financial Stability Board, an
international regulatory body overseeing the
global financial system, released a report raising
concerns about counterparty risks brought on by
synthetic ETFs, it sparked a frenzy of negativity
around ETFs.
In Australia, the reason for the success of
ETFs can be narrowed down to their simple and
transparent structure - and, in most cases, no
exposure to derivatives.
However, as the industry started to grow,
“people started tinkering with the original structure”, says Tom Keenan, director of Blackrock’s
iShares.
“And that’s what gave birth to the rise of
synthetic ETFs.”
The increasing popularity of synthetic
structures is evident overseas, mainly Europe, as
demonstrated by their high frequency trading.
Synthetic ETFs have a market share of about 45
per cent in Europe, compared to 14 per cent of
the ETF industry on a global scale.
The synthetic model uses derivatives in order
to deliver investment market exposure to investors.
Keenan says the most common way to do
this is to use swaps.
“Within that swap structure, there is an ETF
provider that uses a swap counterparty, who is in
some instances the parent company of the investment bank. So you’ve got these related parties
as the counterparty of the swap, and at times,
there is no transparency around collateral that’s
pledged in that swap,” Keenan says.
He says this in turn begins to compromise
the principles at the core of ETFs - namely
transparency and simplicity.
However, the majority of ETFs listed on the
Australian Securities Exchange (ASX) have no
derivative exposure at all - they are simply “plain
vanilla” structures.
“We don’t think all synthetic ETFs are bad,
but we think there are ways that you can mitigate
the inherent risks associated with running swapbased ETFs.
“Out of 51 Australian ETFs, there’s only two
that have any sort of swap-based arrangement,”
Keenan says.
“I would argue that it’s the best regulated
ETF market in the world because…the regulator
can look at what’s been generated offshore and
recognise some mistakes that have been made
[to] make sure those same mistakes don’t get
made.
“The regulator must have the ability to
look inside those synthetic ETFs and work out
what they believe is the best way to deliver [it];
that might be ETFs that have multiple swap
counterparties that offer full transparency of the
collateral pledged in the swap arrangement.
“You will definitely see synthetic ETFs
listed here and in some cases that will be entirely
appropriate. There’s got to be some types of
exposure that will be in demand from investors
that can only be delivered via derivatives,” he says.
Whether Australia will adopt the synthetic
replication to the same extent that Europe has
appears to be a question of how strict the regulator decides to be.
In the meantime, investors should take comfort in knowing the Australian market is tightly
regulated.
ASX-quoted ETFs were first offered for
trading over certain S&P/ASX indices in
August 2001. ASIC restricted counterparty
exposure to no more than 10 per cent when
BetaShares listed two synthetically-enhanced
ETFs.
Richard Murphy, ASX general manager
equity markets, says that ETF products must
“meet ASX rules and policy position on ETFs,
including ASX’s and ASIC’s positions on synthetic and inverse ETFs, which is to say, we allow
them with a range of limitations and additional
requirements”.
Accordingly, synthetic ETFs that use derivatives are allowed on the Australian exchange,
subject to ASX rules.
“ASX is progressing rules with ASIC aimed
at formalising these arrangements, which have
been imposed on a contractual basis for the first
ETFs in this space,” Murphy says.
Blackrock’s Keenan says it’s vital to ensure
that the industry exercises due diligence when it
comes to ETFs, just like any other product, and
that it’s important for investors to understand
that not all ETFs are created equal.
“There are big differences in the way they can
be brought to market,” he says.
“Don’t read the word ‘ETF’ and think they’re
all the same, because they simply are not.”
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Visit www.russell.com.au/etfs
D
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RDV. A smart
choice for SMSFs.
The Russell High Dividend Australian Shares ETF (RDV)
reDefines the way investors access Australian blue chip shares
and franked dividends.
RDV =
diversification across 50 blue chip stocks
the liquidity and transparency of an ETF
access to income and growth
a tax efficient investment
a new index tailor made to meet the needs of Australian investors.
It’s time to ReDefine Dividends. Learn more about RDV,
visit www.russell.com.au/etfs or email [email protected]
The Russell High Dividend Australian Shares ETF tracks an index that is weighted towards companies that are expected to deliver dividends higher than the market
average, however high dividends cannot be guaranteed. Issued by Russell Investment Management Ltd ABN 53 068 338 974, AFS License 247185 (RIM). This communication
provides general information only and has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to
consider whether this information is appropriate to your objectives, financial situation and needs. Any potential investor should consider the latest Product Disclosure Statement
(PDS) for the Russell High Dividend Australian Shares ETF (RDV) in deciding whether to acquire, or to continue to hold, units in RDV. Only persons who have been authorised
as trading participants under the Australian Securities Exchange (ASX) Market Rules can apply for units in RDV through the latest PDS. Investors who are not Authorised
Participants looking to acquire units in RDV cannot invest through the PDS but may purchase units on the ASX. Please consult your stockbroker or financial adviser.