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Six critical questions to ask about ETFs

Amanda Skelly

Amanda Skelly outlines some critical elements SMSF investors need to know when weighing up an allocation to these instruments.

With the use of exchange-traded funds (ETF) by SMSF trustees and their advisers continuing to gain momentum, it is important financial planners and accountants take the time to assist trustees in their understanding of this rapidly growing category. Presented here are the answers to six simple questions designed to help guide and deepen your SMSF clients’ understanding of ETFs.

What are the investment objectives

As with any financial product, SMSF trustees should carefully consider the objectives and risks associated with an ETF investment. This and other information is available in an ETF’s product disclosure statement (PDS) and on its website, and should be considered in light of the SMSF’s financial needs and objectives. Here are some things to consider:

Investment objectives

ETFs follow a wide range of investment strategies and objectives. In addition to the stated objective of an ETF, you should consider how the provider is attempting to achieve that objective.

You should understand the index the ETF seeks to track. While a number of ETFs might cover the same market segment, they may do so in different ways. For example, an index might have a few or a few thousand securities, and it may weight them equally, by market capitalisation, by dividends or by other mechanisms. You should also assess how the ETF tracks the index. It may invest in every security in the index, or it may invest in a representative sample of securities in the index. Some ETFs may also employ derivative instruments. The chosen approach may affect how well the ETF can track the index (tracking difference) and may pose other risks.

Risks

An SMSF investment strategy needs to take into account the risks associated with the investment. Like all pooled investment vehicles, ETFs are subject to risk.

These risks are explained in the PDS. The principal risks are typically those associated with the ETF’s investment objective, that is, adverse developments in the securities or market segments in which the ETF invests, or related developments such as interest rate or currency fluctuations.

How do SMSF trustees use ETFs?

Trustees use ETFs in a wide variety of ways, all of which can support building for and managing a comfortable retirement portfolio.

The most common use is to help meet the SMSF’s diversification requirements by providing a simple, low-cost way to invest across a number of asset classes. This may include using an ETF to provide access to a new asset class in a single trade, further diversify an existing asset allocation to minimise stock-specific risk, or tactically adjust a portfolio to take advantage of opportunities during different market cycles. ETFs can also help manage additional cash. This is because they provide a simple way to get instant market exposure, whether it’s for the short or long term.

ETFs can also be tax effective as they pass on all franking credits to SMSFs and are eligible for favourable capital gains treatment.

What are the costs associated with investing in an ETF?

There are several costs associated with investing in an ETF. These include:

Fund operating expenses

Like managed funds, ETFs charge fees to cover operating expenses, such as investment management and administration fees, among other things. These fees are detailed in the fund’s PDS, expressed as a percentage of fund assets paid annually. This percentage is commonly called a management expense ratio (MER). ETFs typically have lower MERs than comparable retail managed funds. However, investors must also consider the following costs associated with buying and selling ETFs that are not captured by the MER, and that may not apply to managed funds.

Brokerage commissions

Because ETFs are exchange-traded, investors must buy and sell them through a broker who is typically compensated for this service. Some brokers charge a flat fee for each transaction, while others may assess a fee based on the total assets in the investor’s account.

Bid/ask spread

When buying or selling an ETF on the secondary market, there is typically a difference between the highest price a buyer is willing to pay for the ETF (the bid), and the lowest price a seller will accept to sell the ETF (the ask). As a result, an investor will typically buy ETF units for slightly over ‘market’ price and sell for slightly less. Bid/ask spreads are typically lower for larger ETFs and those that are heavily traded and/or highly liquid. This cost is similar to the buy-sell spread of a managed fund.

Premium/discount volatility

Although ETFs are designed to trade on the secondary market at a price that approximates the market value of the underlying assets, at times the market price may be higher (a premium to) or lower than (a discount to) the estimated market value of the underlying assets. Premiums and discounts are not direct costs to an investor, but changes in premiums and discounts (that is, volatility) may affect the value of the investor’s ETF investment, for example, if an investor buys shares at a premium and sells at a discount.

How do SMSF trustees buy and sell ETFs?

Most investors, including SMSF trustees, buy and sell ETFs on the secondary market – such as the Australian Securities Exchange – at a market-determined price. This means they enter their trades through a brokerage account and typically pay a brokerage commission, just like trading a share.

For those ETFs that are less liquid, it is recommended investors refrain from trading before 10.15am or 10.30am. This gives the institutional liquidity providers additional time to ensure ETF prices more accurately reflect the true value of the ETF. Many SMSF investors also avoid trading at the market close, as the closing auction can result in additional price volatility.

When placing a trade order through a brokerage account, there are two basic options: market orders and limit orders. The selection will impact on how (and possibly whether) an investor’s order is executed.

Market order

A market order is an order to buy or sell a security at the best available price. Generally, this type of order will be executed immediately. Although placing a market order ensures a trade will be executed, the price at which the order will be executed is not guaranteed to be an optimal price. It is important for investors to remember that the last-traded price is not necessarily the price at which a market order will be executed. In fast-moving markets, the price at which a market order will execute often deviates from the last-traded price or ‘real-time’ quote.

Limit order

A limit order is an order to buy or sell a security at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. A limit order is not guaranteed to execute. A limit order can only be filled if the security’s market price reaches the limit price. While limit orders do not guarantee execution, they help ensure that an investor does not pay more (or receive less) than a predetermined price for a security.

How can an ETF be evaluated?

There are a number of metrics that can be used to evaluate an ETF. Because SMSFs use ETFs in a variety of ways, the relative importance of each of these metrics may vary.

Performance

While past performance is not an indication of how an ETF may perform in the future, an investor may wish to evaluate an ETF’s performance against its stated objective or benchmark. For an index-based ETF, this is measured by the ETF’s tracking difference.

Tracking difference

Tracking difference is the extent to which the ETF’s return deviates from the return of its benchmark index. Tracking difference can be influenced by a number of factors, such as how an ETF seeks to track the index (that is, whether it invests in every security in the index or in a representative sample of securities in the index), the ETF’s operating expenses, and how the manager handles index rebalancing and corporate actions.

Cost

As outlined above, there are a number of costs associated with investing in an ETF, including fees charged by the ETF provider and brokerage commissions.

An investor may also wish to consider indirect costs, including those stemming from the bid/ask spread and any premium/discount volatility.

Liquidity

Liquidity refers to how easily an ETF can be bought or sold. Securities with high trading volumes are generally considered more liquid. ETF liquidity should be considered with respect to both the ETF and the underlying securities the ETF holds. Highly liquid ETFs and ETFs that have highly liquid underlying securities (even if the ETF does not have high trading volumes) typically have narrower bid/ask spreads than ETFs that trade less or hold less liquid securities.

I read the following statements about ETFs. Are they accurate?

ETFs are tax efficient

ETFs are often described as more tax efficient than managed funds. While this is not a hard and fast rule, two tax-efficient mechanisms, available to all types of funds, are commonly employed by ETFs: low portfolio turnover strategies and in-kind redemptions. ETFs that do not use these mechanisms may not be more tax efficient than other funds, and in fact may be less tax efficient than managed funds that do use them.

It is important to note that while these strategies can reduce capital gains distributions to investors while they are holding the ETF, investors ultimately pay taxes on any capital gains when they sell their ETF holding. Thus, these strategies may enable tax efficiency, but not tax avoidance.

ETFs are less expensive than managed funds

As mentioned above, ETFs charge fees to cover operating expenses, such as investment management and administration fees, among other things.

While ETFs typically have lower MERs than comparable managed funds, SMSF trustees should also consider other costs associated with ETFs, which may not apply to managed funds, such as brokerage commissions. There are also indirect costs, including those stemming from the bid/ask spread and any premium/discount volatility.

Some ETFs are not suitable for buy-and-hold investors

ETFs are available in a wide range of strategies. Some ETFs are complex, may be more appropriate for sophisticated investment approaches, and may not be suitable for buy-and-hold investors, for example, those that are significant users of derivatives. As with any financial product, trustees should understand the objectives and risks associated with an ETF before investing.

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