Exchange traded funds—also known as ETFs—are managed funds or unit trusts quoted and traded on a stock exchange. Although they are built similar to managed funds, ETFs are traded like shares: making their pricing transparent and opening up selling and buying throughout the normal trading day.
In the past, ETFs were meant to track the performance of a given class of assets or indexes. Now, ETFs are more diverse and incorporate risk management into their design. This has helped drive an expansion in their popularity: in just Australia, there are over one hundred ETFs available on the ASX to invest in.
ETFs help investors circumvent company risk and instead focus on other risks, such as that coming from a given sector or the market in general. Even active managers can make use of this particular plus of ETFs. In fact, when it comes to generating alpha, investing in ETFs can be a more useful tactic than relying upon bottom-up strategies for picking stocks. ETFs make it easy for investors to reap the benefits of the 80/20 rule of investment (80% of outcomes can be attributed to just 20% of causes for an event).
Conventional wisdom in the stock market overwhelmingly focuses on specific companies and their issues, but their returns tend to be marginal. Sectors more often determine what returns an investor can expect. Getting the sector call right, then, pushes investors a long way towards beating the market. Utilizing ETFs to do this means investors have a bigger chance of profiting and can free themselves from the need to focus on company specifics.
Though they’re a brilliant option for investors today, ETFs were not always so plentiful, accessible, and diverse. The modern markets offer ETFs that cover large caps, small caps, domestic stocks, and international stocks—among almost countless others. ETFs can offer investors exposure to not just commodities, but also different strategies for investment—many of which will be outlined below.
Debunking ETF Myths
A great deal of misinformation surrounds ETFs, making them seem riskier and less useful than they are in reality. Here are five of the most common and the truths behind them:
Myth 1: Investing in ETFs is risky
Like with other securities, some ETFs will be risky and others will be less so. The liquidity of an ETF depends on the liquidity of its underlying assets, which means that its riskiness also depends on the assets that underlie it. For that reason, ETFs invested in cash will be less risky than those invested in a number of large stocks listed on an exchange. (The ETF invested in large stocks will be less risky, however, than one invested in small companies.)
The liquidity of underlying assets almost entirely determines its level of risk: the structure of an investment does not typically have an impact on its level of risk.
Myth 2: ETFs can’t beat the market
Whether an investor is active or passive, ETFs should hold a place in their portfolio—some classes of assets may not be available elsewhere. With ETFs, investors can over- or underweight a specific sector and in turn beat the market on sector over/under performance. So if an investor combines different ETFs (or an ETF with managed funds or direct equities), then an alpha-generating complete portfolio can be pieced together.
Myth 3: If ETFs track the same index, then they’re the same
As the market for ETFs changes and expands, more and more ETFs will track the same index. But that doesn’t mean that each ETF is the same. Fees charged by the ETF manager, their unique buy-sell spreads and particular tax advantages can all vary from ETF to ETF, making it worthwhile for an investor to choose carefully.
Myth 4: ETFs are not a liquid asset
Like ordinary shares, ETFs are listed on exchanges and traded. But ETFs are not like plain old stocks: the volume of an ETF does not serve as an actual indicator of its liquidity. Instead, the liquidity of an ETF’s underlying assets is the only appropriate indicator. The liquidity of an ETF must be supported by at least one market maker. With stocks, support by market makers is unusual (except with the largest and most actively traded stocks); the onscreen volume acts as a reliable indicator of its liquidity.
Myth 5: ETFs own no assets
In Australia, an overwhelming majority of ETFs are backed by assets and own the investments that underlie them. Even ETFs that track physical assets whose size or number would make them impossible to directly hold—things like grains or crude oil—are backed by cash, making them as good as owned.
The Convenience of ETFs
Thanks to their unique features, ETFs offer a relative edge that no other investment structure can. Investors need not worry about finding sellers because an ETF’s liquidity is ensured. The cost to trade an ETF is nominal, too, thanks to the competition existing between different market makers who serve to narrow the buy-sell spread and keep it near to the net asset value (NAV) per unit.
Trading tips for ETF investors
Investors are open to purchasing and selling ETFs in the same way as other listed shares. To assure that an investor strikes the best deal in trading ETFs, a few tips can be followed.
First, pay attention to intraday net asset values when placing an ETF trade.
When it comes to determining a fair value, ETFs make it easy: an estimate of the fair value of NAV can be determined at any time in the trading day. Orders to buy, then, can be set at a level close to the fair value. This calculation changes in real time, meaning that the value assigned by an exchange or a fund manager is indicative only of an intraday net asset value (iNAV).
Second, always use limit orders.
When placing an order to sell or buy an ETF, investors are wise to set a price limit, rather than allow the order to be fulfilled at market price. Specifying price limits ensure that purchases take place at the correct price, chosen after the ETF’s iNAV has been determined.
If the market is volatile, an ETF’s iNAV can easily change throughout the day. If a broker is simply instructed to fulfill an order at market price, then there is a risk that the order will be filled not at the optimal price, but at the price which the buy-sell spread has moved to. If the buy-sell spread is very tight, this is no problem. In a volatile market, though, that spread can widen greatly. An order placed at market price, then, could be filled at an unusually wide spread—wasting money.
Third, be aware of the hours of trading in an ETF’s underlying market.
When the trading day is through, the market makers will widen their buy-sell spreads to account for the close of the asset markets underlying the ETF. To take advantage of narrow buy-sell spreads, it is best to place orders when underlying markets are open.
Fourth, know that onscreen volumes do not indicate actual liquidity.
With ETFs, investors enjoy the benefit of trading with market makers as counterparty. If then, an investor wishes to make a large sale or purchase of ETF units, they need not take heed of any onscreen data. The ETF investor can contact a fund manager and then the market maker will increase onscreen volumes so as to fulfill the investor’s trade.
Fifth, try not to trade at the very beginning or very end of the day.
During the first ten and last ten minutes of the market day, it is not uncommon for the market to experience increased volatility. Market makers increase their spreads during such times, and the prices on which the iNAV will be based can move in only minutes.
Sixth, know the differences between management fees and “all-in costs.”
It’s not unheard of for investors to look only at management fees when determining the price of an investment. To do so, however, is a mistake. Management fees go towards the compensation of fund managers and are correlated with the level of complexity (as determined by the manager themselves) of operating the ETF. But there are more costs involved in the purchase of ETFs. All-in costs include not just the management fee, but also the ETF’s buy-sell spread and brokerage fees. To maximize the return on an ETF, all of these expenses should be kept in mind while purchasing.
Tactical strategies
Many of finance’s greatest macro economists have learned to love exchange-traded funds (ETFs) because of their ability to aid investors in allocating assets as widely as possible and their ability to play off of the far-reaching macroeconomic forces which control the markets.
Valuation-based tactical asset allocation
Investors need not simply guess where the market is heading in the next few months. Different valuation models can be applied to the market to try to predict if securities will bring good returns. One method of doing so is to examine share prices going back into time and see whether the security has tracked the movement and growth of the economy. If it has, and its current price is above the GDP’s growth trend, then it is safe to assume the security is overvalued. Typically, this leads to an above-average growth rate for years to come—making the security a great medium-term investment and rendering medium-term valuation-based tactical asset allocation a useful strategy to employ.
Rotation strategies: maximizing money
Just as it is possible to utilize a variety of valuation models, different rotation strategies can be used to increase the chance of outperforming the market.
Traditionally, an investor may divide his or her money into, say, three funds promising to beat the market. If they had a 60% allocation to equities, then 20% would go into each one. An investor can, however, take a chunk of that initial amount of money and place it in an ETF that tracks the market, leaving the rest of the money to be dispersed as per the first example. This is called the “core-satellite approach,” and it makes it easier to separate the alpha from the beta—and is cheaper than being heavily invested in both. Returns from the funds could be volatile on a year-to-year basis due to their occupying a smaller share of the portfolio. Still, simply getting the sectors calls right—as stated before—can take investors a long way towards outperforming the market.
Small caps: market beaters when timed right
Though they can suffer through periods of underperformance, small caps have their time of glory—usually at the start of economic upturns, like those seen in 2003 and 2009. ETFs including small caps may not be as wise an investment in the middle or end of economic cycles, however. Still, small-cap fund managers enjoy a better chance of outperforming their index compared to large-caps.
Income strategies—not just for the elderly
It isn’t just older, more conservative investors who seek income returns in the stock market. Younger investors may choose income over capital growth, too, if the market seems to be heading sideways—that is, not growing and offering adequate capital appreciation. Instead of investing in other places, people can look towards high-yielding ETFs offering dividend yields in place of stock appreciation or towards “buy-write option strategies” that let investors sell call options and collect a premium. This isn’t without its risks: if a market rises strongly after a call is sold, then the investor misses out on a potential capital gain.
Going global with ETFs
Investment performance can dip, as Australia’s has in recent years. ETFs that give heed to our global marketplace, though, can help ensure that returns continue to flow in for wise investors.
In the time between the mid-1990s and the global financial crisis, Australia tended to outperform markets worldwide in both hedged and unhedged terms. But since 2009, Australia has mostly underperformed when compared to the global market—possibly because of the country’s low exposure to the technology sector, which remained robust around the globe. Investors can—and have—responded to this by investing in two very different ETFs: one with a currency hedge, giving exposure to the global marketplace; or an unhedged ETF that bets on the continued fall of the Australian dollar.
Investing in commodities through ETFs
Investors today have access to a wide variety of commodity ETFs. Some even incorporate a broad index of commodities, including the energy, agriculture, livestock, and precious metal sectors—all combined into one ETF. From the point of view of strategic asset allocation, commodities are wonderful diversifiers.
During times of slow economic growth, commodities may not shoot up as fast as in times of plenty. But the demand for one commodity never fails: agriculture. As the climate changes and Asian countries grow and increase their food demand, agriculture is likely to become an excellent sector to consider for investors seeking tactical exposure.
Tactical switching strategies using bonds
Commodities aren’t the only option for ETFs—there is a variety of bond ETFs for investors to choose from, as well. By looking at bond indices—specifically the composite bond index relative to the Treasury index—investors can determine whether taking on additional risk is likely to result in extra returns.
If the potential for returns is not outweighed by the risk of taking on bonds, then investors who become overweight in corporate bonds run the risk of blowing out if the Federal Reserve raises interest rates. By switching between ETFs which focus on indexed bonds or nominal bonds, investors can navigate through market upheavals and blowouts in implied risk spreads.
Riding the wave: momentum investing
Momentum investing is another way for courageous investors to beat the market by carefully monitoring moving averages of markets. Momentum investing, like most other forms of investing, can be combined with an array of different strategies—no single one of which will be right for all investors.
Some momentum investors will aim to be long in the market when prices are higher than their moving averages and then short the market when prices dip below their mean—resulting in their switching out of the market and into cash during market downturns and buying back into the market when prices rise again above average. During the global financial crisis, an approach like this would have served well—if an investor did not miss the market upturn. In times such as ours, however, where economies are rebounding, arrangements like this tend to underperform.
Investors can also utilize momentum strategies to craft a kind of “hedge fund” with different ETFs. Such an arrangement would differ from a normal hedge fund which may tend towards simply following trends rather than acting as quantitative managers.
Another option is to simply invest in a couple high-performing ETFs for three, six, or twelve months—and reap their continued benefits when it comes time to sell.
Take your pick of ETF options
While utilizing ETFs, there are a large variety of tactical strategies that can be relied upon. It is up to the individual investor to figure out which way suits their needs and best helps them reach their financial goals. Though they do not offer cut-and-dry approaches to beating the market, ETFs are a wonderful way for investors to diversify their portfolio—and develop the tactical strategies they trust for investing.
Conclusion
ETFs are rising in popularity—and for good reason. Their simplicity, guaranteed liquidity, transparency, flexibility, and low costs make them desirable investments. Cheaper, faster, better—ETFs are a wonderful alternative to standard securities.