As published in The Australian on 10 October 2017
What is on your ‘to do’ list today? Some of the busiest people I know are ‘retired’ on the run to play golf or bridge, look after parents, children or grandchildren or jetting off on another well-deserved holiday.
We all lead busy lives, working, looking after family and visiting friends. No wonder investors are turning to exchange traded funds or ETFs in droves. Who has time to individually assess companies for investment anymore?
An ETF is an index based portfolio of underlying assets such as stocks, bonds, oil futures, gold bars or foreign currency that divides ownership of those underlying assets into shares. These assets are indirectly owned by ETF investors who are entitled to a proportion of profits, income or dividends and franking credits paid by investments contained within an ETF. Similar to shares, ownership of an ETF share can be bought, sold or transferred on an exchange, such as the ASX.
As ETFs track an index, it’s important to understand what constitutes the index. For example the ASX 200 has a heavy weighting to financials, with the four major banks making up a significant share. An ETF tracking that index will hold large allocations to the banks when investors may already hold individual bank shares, increasing concentration.
Other equity based ETFs will have greater allocations to larger companies, and if it’s a US based index, that would likely increase the allocation to tech giants such as Google, Apple, Facebook and Amazon, which may precisely suit your goals.
Bond ETFs work a bit differently. Indices are not necessarily made up of the biggest companies like equity indices rather the biggest bond issuers. So in some cases, as governments take on more and more debt by issuing bonds, they become bigger constituents of the index. More debt usually also means higher risk, not something investors would necessarily want.
If we consider the largest domestic bond issuer, the Australian Commonwealth government, it features in many of the indices. Outright investment in a ten year government bond might show very good income, especially if it was issued when interest rates were high, but a low overall return if held to maturity.
The bond ETFs that hold Commonwealth government bonds may do the same. Income may be great now but holding onto the ETF without understanding the potentially much lower returns as government bonds mature is bound to disappoint unsuspecting investors.
Direct bond investors can choose to hold Commonwealth government bonds or not. Or to invest for a while and sell before the bond approaches maturity and its value starts to decline. Unlike other asset classes, biggest is not necessarily best, particularly when it comes to the value of outstanding debt.
There are other disadvantages of being a passive index investor.
There isn’t going to be any management or analyst that suggests you sell the units in the ETF because market risk is rising. Passive investment is a great lure when the market is performing, but what happens when conditions change?
If some of the investments in your ETF start to falter how will you know? Some ETFs literally contain hundreds of individual investments. Losses across some of those investments are unlikely to materially change the unit price. It’s going to take big market moves to materially influence the price. If you decide to sell in a stressed market, it’s likely others will be heading for the exit, pushing down underlying asset values even further and reducing exit prices.
The diversification an ETF provides can be hugely beneficial, especially for those just starting out. However, you may not be achieving the diversification you think and could be highly exposed to low yield Government bonds. Those that want choice and control, especially longer term investors, would know the benefit of focussing on fewer, select investments.