Just the beginning for ETFs and SMSFs

Like it or not – and ready or not – we live in a disruptive world.

It is uncommon for a week, even a day, to pass without reading about some new technology or research breakthrough that will disrupt – hopefully positively – the way we do things and challenge the established order of things.

There are plenty of dramatic case studies of established business positions being overwhelmed by disruptive start-ups or technology developments – think Amazon, Netflix, Uber, Airbnb and Google. The list continues to grow, but what is fascinating is the pace with which these businesses have evolved to quickly become the new established way of doing things.

The investing world has also had its share of disruption – albeit the pace seems a little more measured. Think online banking, the emergence and growth of online brokers and the increasing use of digital technology to help investors be more informed, view portfolios in real-time and have the ability to change as they see fit.

In the superannuation world there has not been a Google or Uber-type disruptor. Rather the disruption has come from the growth in Australians taking a hands-on approach to managing their superannuation by setting up an SMSF.

SMSFs are now the largest segment of the super industry, with 577,236 funds including 1.88 million members and $621.7 billion in assets, as at 30 June 2016.

Mum and dad super funds have gone mainstream.

That has happened without a technology ‘big bang’ game changer. But there is no doubt that technology has been and continues to be a major enabler of SMSF growth.

Online administration and reporting platforms that give SMSF trustees more control, timely reporting and tax management flexibility continue to develop apace thanks to technology developments such as cloud computing.

The relentless development of technology has translated into more competition and lower costs for SMSFs as administrators have embraced technology that automates previously manual accounting and audit processes, and delivers flexibility and transactional power to the SMSF trustee’s lounge room.

A second disruptive technology that is gaining more recognition is the growth and use of exchange-traded funds (ETF) and the indexing approach to investing more generally.

SMSFs are a good proxy for engaged retail investors. Their love affair with dividend-paying Australian shares has been well documented and is well known. What ETFs have added to the toolkit is the ability to diversify across the broader market or, importantly, provide an affordable access point to other markets – United States shares and emerging markets, for example – as well as different asset classes such as fixed income.

SMSF trustees have been early adopters of ETFs with a significant proportion of investors using the listed index funds investing via their SMSF – and the indications are that it looks like increasing.

Looking through the “2016 Vanguard/Investment Trends SMSF Report”, it is clear ETFs are coming of age as a portfolio construction tool for do-it-yourself super investors.

The number of SMSFs using ETFs has risen significantly, from 38,000 in 2013 to 90,000 in 2016. Although that remains a modest share of the overall SMSF market when you look at the dollars invested, given the total ETF market is now just over $24 billion compared with the $600 billion-plus invested through SMSFs.

The power of ETFs is they bring institutional-type portfolio tools to the desktop of an SMSF trustee or individual investor.

That is the disruptive power ETFs increasingly offer SMSF trustees.

Recently, various media opinion pieces have been critical of the growth of ETFs – or more accurately, critical of indexing as an investment approach. Some even went so far as to describe index investing as “dumb”.

Criticism of indexing is nothing new, but critics of late seem to be missing three fundamental points:

– When the majority of active investment managers underperform their target index, it should not be a surprise that investors look elsewhere.

– In a low-return environment, fees matter more than ever and SMSF trustees are alive to the impact of fees because they are much closer to the costs of running the fund.

– Although ETFs are largely based on indexes, that does not mean SMSF investors are passive. Investors using ETFs are often taking active views of markets and simply using ETFs as the implementation tool to gain portfolio exposure. (Not unlike large sophisticated institutional investors).

Alongside low costs, diversification is the other main driver of ETF use among SMSFs, particularly when it comes to tapping into global exposure. Access to overseas markets is now the strongest motivation for SMSFs using ETFs, with 53 per cent saying they used ETFs to gain exposure to index-tracking global equities funds. This compares to just 25 per cent of SMSFs using Australian equity index ETFs.

For example, some ETFs may track an index, but that index may not be a broadly diversified, market cap-weighted benchmark that many investors typically associate with traditional index investing.

When it comes to ETFs like this, investors should absolutely consider them an active decision to tilt at a certain factor (like yield) or specific sectors and regions, rather than broad asset allocation via index exposure.

As the number of products in the local ETF market grows, trustees will ultimately have greater choice in how they construct portfolios using ETFs. However, this will mean trustees will also need to exercise greater diligence to be sure they understand the underlying investment approach and whether it fits within an investor’s risk appetite.

This is where trustees may want to consider getting independent financial advice in helping them build balanced, diversified portfolios.

While the ETF sector will no doubt grow in complexity, it will also continue to give SMSFs greater possibilities when it comes to building portfolios using listed funds – and that means the potential for more diverse and flexible investing for retirement.

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