Christine St Anne: A number of fixed income ETFs have already hit the market. Today I'm joined by iShares' Tom Keenan, and financial advisor, Russell Medcraft, who'll both give us an idea about these products and how to use them in a portfolio.

Gentlemen, welcome.

Russell Medcraft: Thank you.

St Anne: Tom, can you give us a rundown about the types of fixed income ETFs you've just launched?

Tom Keenan: Yes, we've launched three. iShares have launched three new fixed income exchange traded funds on to the ASX. There's three ETFs, and all track benchmarks of high quality bonds. By high quality bonds, we're meaning AAA rated Commonwealth of Australia Government Bonds, semi-government bonds, which are essentially state government bonds, and investment grade corporate bonds, so high quality corporate bonds.

St Anne: And with the yield generated from these products, how is that redistributed back to investors?

Keenan: So just like our equity ETFs, our domestic equity ETFs, the fixed income ETFs will pay a quarterly distribution, and that's the way the income is paid out to investors.

St Anne: So, what sort of benchmarks do they track?

Keenan: So as I said, there are three benchmarks associated with the three ETFs that we've launched. The first one to talk about is the UBS Treasury Index, so that is an ETF that is giving an investor pure exposure to AAA rated Commonwealth Government of Australia debt. Remember Australia is only one of a dozen countries left with a AAA credit rating, so the Australian government is viewed as one of highest quality lenders in the marketplace.

We also have an ETF tracking the UBS Government Inflation Linked Bond Index and this is state and Commonwealth Government Inflation Linked bonds, and inflation linked bonds provide investors with a very pure hedge against inflation or a very pure way to protect a portfolio against the long-term corrosive impact that inflation can have on purchasing power over the longer term.

And then there's is the UBS Composite Bond Index, now this is the broadest measure of fixed income in Australia and it's because it includes roughly a third Commonwealth Government debt, roughly a third semi-government debt, which essentially is state government debt, and roughly a third high credit quality corporate bonds. So, it's a much broader measure of the Australian bond market, has a slightly higher yield due to that corporate component and certainly one of the - certainly is the most widely used benchmark by the industry when measuring the performance of the Australian bond market.

St Anne: Russell, as a financial advisor, how do you use these fixed income ETFs in a portfolio?

Medcraft: Well, we develop model portfolios with predominantly these ETFs, term deposits and a bit of cash. We've been using hybrids for the last couple of years quite actively to give us that bit of extra spread, if you like, in a portfolio. But since these have come on to the marketplace, we've now altered our asset allocation, moving out of hybrids into these types of ETFs.

We've been waiting for a while for these to come on to the market, and for a retiree or a person with a self-managed superfund looking at a good income stream, this combined with a good spread of ASX200 or whatever is, I think, an ideal way to get for a lot of retirees; low cost, transparent, and you can pretty much trade these things in and out very, very frequently. But predominantly our clients are retirees that are looking for a high degree of security, so I feel that these give them that high degree of security, but also low cost and the ability to be able to get in and out of the market. So, we don't have those disasters like frozen funds that we had a few years ago.

St Anne: Tom had mentioned the different benchmarks tracked. Can investors use all these ETFs?

Medcraft: A combination of the ETFs and it really all comes back to the client profile; what asset allocation you put together in a model for a client. But I would recommend that you could probably use all of them or a combination of them.

St Anne: Russell, can you just drill down and give us a little bit more of an idea about how this portfolio is allocated?

Medcraft: Good question. A lot of investors over the last number of years have taken up these hybrids vigorously, and we’ve experience the over-subscription even over the last three to four, five months. We’ve found that traditionally they have been substituting fixed interest for hybrids, because they're wanting this extra yield. So, that's what they want. They needed a greater performance in their portfolio, but they're really unaware - they get their higher yield, but they are unaware of the security issues and the risks that they are running and this is what's coming through now. People we find are now substituting - not totally replacing, but substituting some of their hybrid exposure to these sorts of ETFs, these sort of assets to really protect their portfolio against possible downturns and giving them higher - they don't want the volatility, they want the security. So, these are an ideal solution for that.

St Anne: Term deposits continue to attract investor interest, Russell. So, can these fixed income ETFs be used in conjunction with term deposits?

Medcraft: Yeah, we're already finding now that we're - as their term deposits are maturing, we're contacting our clients to have a greater allocation of this sort of asset. We find that they're giving it a little bit extra yield, but also a greater degree of spread because retirees and investors these days really want a great deal of spread across the asset class and across manager and so on. So, I think this part of the market is going to really be a dominant player in the next three to five years to protect against the - as Tom said, the asset allocation in equities, it's like an direct inverse relationship to the equities market, and that's what we're very excited about.

St Anne: Gentlemen, thank you both for your time.

Medcraft: You're welcome.

Keenan: Thank you.

Christine St Anne: In this month's ETF wrap-up, I'm joined by Morningstar's Tim Murphy, who shares his insights into the latest trends in the market including the actively managed ETF.

Tim, welcome.

Tim Murphy: Thanks, Christine.

St Anne: Tim, firstly, can you give us an idea about who are the winners and laggards from last month?

Murphy: So, it was a big risk-on trade month in February, and so that meant some of the commodity ETFs topped the pile, specifically Silver in the BetaShares Oil ETF were at the top of the pops. With that risk-on trade, one of the common risk-on elements is the Aussie dollar, and so the flipside of that meant some of the worst ETFs during the month were some of the foreign currency exposures again, with a couple of BetaShares, currency, British pound, U.S. dollar, this sort of thing lagged and dropped during the month.

St Anne: In this month's report, Tim, you take a closer look at an actively managed ETF, can you give us an idea behind this product?

Murphy: Sure. So, there is currently no active ETFs in Australia. All the ETFs are purely passive, but there is a lot of interesting developments going on offshore in this space. Now there has been a few active ETFs in the last couple of years coming about in the U.S., but nothing has really gained a lot of traction to-date. However, on the 1st of March, PIMCO launched an ETF version of the world's largest mutual fund, the PIMCO Total Return Fund, which is a fixed interest fund run by Bill Gross, has well over $200 billion in assets in it. And so now there is an ETF version of the world's biggest fund, it’s really going to be a litmus test for where active management can work in the ETF structure.

Of course, one of the things with ETFs is the increased transparency, so publishing daily what the portfolio managers are up to, and certainly most active managers out there complain about having to provide that level of transparency to the market and fear about being front run, and there's certainly some asset classes, something - particularly like small caps, where that would be a valid concern. However, this - the world's largest mutual fund now available as an ETF is really going to be the litmus test for whether active management can play a role and can work inside the ETF structure.

St Anne: You mentioned that this product is not available in Australia, but do you expect it to be eventually offered to our investors?

Murphy: I think, at some point in the future, you're likely to see that, as the whole world is watching how this PIMCO ETF is going to track over the next year or so. It's going to be very interesting and really is going to help people make a firm decision about whether active management can or will work inside that. Because certainly then, if the world's largest fund run by probably one of the world's best known investors in Bill Gross can get away and run an ETF successfully while telling the world what he is doing on a daily basis, then it kind of dispels most fund manager concerns about being front run out there, if the world's biggest fund manager and most followed fixed interest manager certainly can get away and do it successfully.

St Anne: Is the actively managed ETF quite similar to a listed investment company or a LIC?

Murphy: They share some similar traits, however, there are certainly some important differences and it comes back to the structure, so yes, like most listed investment companies are actively managed, so an actively managed ETF you might ask, what's the difference? The important differences are the open end versus closed end structure of those, so listed investment company is closed ended, and by that I mean, does an initial capital raising, and then there is a fixed number of units on issue into perpetuity unless they do a buyback or do another capital raising.

An ETF is open ended, so that means authorized participants can create and redeem shares on a daily basis to meet the demand or supply on either side of the buy-sell trade to keep the ETF closer to the NAV, and so that's the important implication of that open ended structure for ETFs, as they’ll always trade in and around the NAV of the underlying constituents.

Whereas, anyone who has invested in LIC will know that over time given the closed end nature of it, that LIC can trade at either a premium or in some cases a significant discount to its underlying NAV, purely based on those mismatch of supply and demand dynamics in the market.

Certainly, at the moment, most of the LICs in Australia are trading at fairly steep discounts to their underlying NAV, which shows you there isn't a great demand buying for those at the moment. So, trading at 10%, 20% discounts in some cases to the underlying value, whereas, if that was an ETF structure, the market maker would quickly be able to bring that back to the close to the underlying NAV, by creating redeeming units to arbitrage that premium discount away.

St Anne: Tim, thanks so much for your insights today.

Murphy: Alright. Thanks, Christine.

Christine St Anne: Earlier this year, the ASX changed its operating rules to allow fixed income ETFs to list. Now, new products have finally entered the market. To give us an idea about what these fixed income ETFs mean, I am joined by Morningstar's Tim Murphy.

Tim, welcome.

Tim Murphy: Hi, Christine.

St Anne: Tim, so can you give us an idea about these new fixed income ETF products?

Murphy: Sure. So there's been lots of talk in the market about this for quite some time now, but you know, the ASX has had to change its rule. It's been a long drawn-out process, but finally got there at the start of this year, and so now you've just seen BetaShares come to market with a cash ETF and now Russell and iShares on the same day both launched fixed interest ETFs tracking a range of different domestic indices.

So, it's really adding an extra piece to the puzzle. We've had equities and commodities and property-based ETFs to-date, and now you've got the sort of fixed interest and cash options as well, which really fill out the multi-asset range of ETFs you can now trade on the ASX.

St Anne: Tim, you mentioned indexes, so do investors need to be mindful of the different indexes these ETFs track?

Murphy: Absolutely. Like any ETF investment, your investment is - you're party to whatever the underlying constituents of that index are, and so looking specifically at the fixed interest ETFs we've seen launched. There's a mix of treasury or government security-only. There is some corporate-only, and then there is some, what we might call aggregate or combination of those two.

So, for instance, for example, the well-used Australian Bond Index, the UBS Composite, iShares has an ETF tracking that index, which is a combination of government, semi-government, and corporate issuance.

Then on the other side of that, say like Russell has launched both government-only and corporate-only as well. So, you've got myriad different options that have been launched in a space of just this week.

St Anne: Tim, investors have traditionally had access to fixed income products via managed funds. How do fixed income ETFs differ from these managed funds?

Murphy: Yes, so structural differences of an ETF versus a managed fund are no different for fixed interest as they are to equities or any other asset class. So, the key difference has been the ETF is obviously listed, traded on the exchange as opposed to a managed fund, which has a buy and sell with the NAV struck once a day. So, you are open to the vagaries of the market, but then also those structure and tax benefits that are applicable to the ETF structure are equally applicable here as well, whereas the managed funds structure you are more attune to being, suffering or benefiting from the tax consequences of other investors in the pooled unit trust, ETF tends to be a cleaner tax structure for investors.

St Anne: Delving a little more into the structure, Tim, how are things like capital appreciation and income yield distributed in these ETFs to investors?

Murphy: Sure. So, as with ETFs and distributions, it's really just a pure function of the underlying constituents of that. So, the ETFs will typically - as coupons in the case of fixed interest ETFs are paid out, they will collect those and then periodically distribute those and typically you will find that quarterly pay those out straight through. And generally speaking, the yield on the ETF will match the, sort of, weighted average yield of the underlying portfolio.

That's slightly different to a managed fund distribution where the yield on the underlying constituents is one element of it, but certainly flows in and out of the managed fund. It can also have an effect, as can capital gains that are realized within the managed fund structure. So, distributions coming out of an ETF, the rest being equal will be a bit cleaner and bit closer to the underlying yield of the investments as opposed to the managed fund structure.

I should just add too that another advantage of the ETF thing that you can get, when you're looking at the yield is the transparency. So, often you look at a lot of fixed interest managed funds and you wouldn't have the faintest idea what they're actually investing in, whereas now with the transparency of the ETF you can see exactly what the underlying constituents of this - of each ETF are. So whether it's Commonwealth government securities, New South Wales Treasury Corp issues, Commonwealth Bank paper, whatever it is, actually being able to understand who the issuers are in your ETF is much more transparent than in most managed funds.

St Anne: So, how do these fixed income ETFs differ from other income yielding investments?

Murphy: Yes. So, at the current time, the obviously topical one out there is term deposits, whose rates continue to be quite elevated. So, the running yields on a lot of these ETFs at the moment aren't particularly standout relative to term deposits. That's just a function of where the market is at the moment. So, looking in on a pure yield basis, not necessarily relatively attractive versus term deposits, but that won't always be the case and equally too, fixed interest does play a different role to what pure cash does in the sense of the duration exposure that you get and insurance of your portfolio, if you like, that that provides during bad times is necessarily a cash alternative deposit holding, who doesn't provides two different sort of things there.

St Anne: Finally, Tim, what type of investors will these ETFs appeal to?

Murphy: Sure, so like any fixed interest investment, it's going to appeal to those that are most conservatively-minded, have more of a focus on some regular income generation and a high degree of capital preservation.

So, that's really we've being waiting for in the ETF space today. You've only had these growth asset classes, so the likes of equity and property to choose from. But now as with fixed interest ETFs now live up and running on the ASX, those with the real conservative investment mindset have the option within the ETF space of choosing between a range of fixed interest and cash conservative options now.

St Anne: Tim, thanks for your insights today.

Murphy: Thanks, Christine.

Christine St Anne: Today we speak with Morningstar's Tim Murphy about the latest changes to the ETF market, and what investors can expect for 2012.

Tim, welcome.

Tim Murphy: Thanks, Christine.

St Anne: Tim, so what were the top performing ETFs?

Murphy: So, top of the pops in December for ETFs was the agricultural side of things. So as tends to be the case, when you've a bit of volatility in markets, last month you saw, I mean, the beta shares - one of the beta shares hedged agricultural ETFs at the top of the market, so that was a strong performer for December.

St Anne: With agricultural ETFs, are they more susceptible to extreme price movements?

Murphy: Well, like any commodity, they're cyclical - highly cyclical, and often speculative sort of sectors. So as I said, they're sorts of niche exposures just tend to be at either the top or bottom of any performance list on a given short-term basis.

When you get concentrated niche ideas like that, that's the very nature of them. So, whereas the more probably broader diversified types of ETFs, which should form the core of most portfolios, all - most of the time tend to be in the middle of performance tables, the more volatile concentrated niche sectors, like single commodities will tend to be top or bottom on any short term basis.

St Anne: So, Tim, what were the ETFs that didn't perform as well as expected?

Murphy: On the flipside, so other commodity ETFs, some of the precious metals, things like silver and gold instead have been - particularly gold being very popular themes, but in that environment, in the back end of 2011, really suffered from sharp outflows and weakening sentiment driving prices down there. So as tends to be the case, at either end of the - both the top and the bottom on short term basis, you tend to see the more concentrated volatile sectors dominating those areas, and the end of 2011 was no exception to that.

St Anne: There's also been a lot of discussion about fixed income ETFs, do you expect any product launches shortly?

Murphy: Yes. It's certainly been a while coming, and ASIC and ASX have finally gotten their act together, and given the final regulatory tick of approval to allow fixed interest ETFs to now be listed and launched in Australia in 2012. And we certainly expect to see that being the big trend in 2012 ETF product launches. All of the key product providers that we talk to have got fixed interest ETFs in the pipeline. So, by the mid-year, expect to see all of the large ETF offerers: iShares, Russell, Vanguard, State Street, expect to see all of them having ETFs or fixed interest ETFs available in the market.

St Anne: Tim, so it's 2012, what are your thoughts of some of the major trends that will happen in the ETF market this year?

Murphy: It's interesting, I mean, 2011 turned out - had been sharp growth in the years leading up to that, tended to - it was a solid rise year. I think that was a function of market flows and sentiment more generally. Most investors were parking their money in the bank, flows into things like term deposits were very strong. Flows into any sort of risk assets, whether it was equity markets, funds, ETFs were stagnant and non-existent. So, you saw the market track sideways last year.

This year with the increase of product availability in ETFs with fixed interest, we certainly expect to see that drive an increase in investor interest, and subsequently assets. But also too we would expect to see the growth trend in ETFs pick up and become more in line with that sort of long-term growth trend we expect to see in the Australian ETF market, which continues to be a long way behind ETF developments in the rest of the world.

St Anne: Tim, thanks for sharing your insights with us today.

Murphy: Thanks, Christine.

Christine St Anne: With interest rates now falling on term deposits, investors are looking for new sources of income. Today, I am joined by iShares Tom Keenan to discuss the case for equity income. Tom welcome.

Tom Keenan: Morning, Christine.

St Anne: Tom, how does yield from shares compared with term deposit rates?

Keenan: Well, term deposit rates depend on the provider and also the term. So, it varies, but if you look at one-year term deposit rates at the moment, they're hovering just above the 5% mark depending on the provider. Now that's a significant change from only a few months ago, when these were close it to 6%. So, with bond markets pricing in further falls in interest rates over the coming months, there is the growing risk that these term deposit rates could fall further and this is something that investors should be very aware of.

If we compare term deposit rates with the yield that investors are getting for equities, equities can be returning or yielding significantly more than that. Certainly, the Dividend Opportunities Index, which is the index that Ivy Dividend ETF, the iShares High Dividend ETF tracks to the end of September, when you account for franking credits, has yielded over one-year 7.98%.

St Anne: Tom, you run a High Dividend ETF, what's in that portfolio?

Keenan: Yes. So, our High Dividend ETF, which is the iShares S&P/ASX High Dividend Fund or ETF attracts the Dividend Opportunities Index. That's an index that holds 50 companies. So, if the company is to be included in that index, they must meet firstly, minimum size and liquidity criteria, and then they must meet certain stability criteria around profitability and earnings growth. So, once they meet that criteria the stocks are then ranked according to their yield.

StAnne: So, how do you generate these high dividend distributions?

Keenan: So, the fund must payout all dividends that are paid by the individual companies in the fund. So, the companies will pay through time and then we will distribute those dividends each quarter. So, there is a quarterly distribution that the fund will pay.

St Anne: Tom, as you know the banks are very well known for delivering high dividends. How do you get the diversification in your portfolio?

Keenan: So, this fund is quite unique in terms of the universe of high dividend ETFs, in the sense that it's got in-built diversification rules. So, there are sector limits of 20%. So, no one sector in the fund can be more than makeup 20% of the total assets under management of the fund, and that's significant because if you think of the financial sector, and the financial sector waiting to the broader market, that's closer to 40%.

So, this fund is underweight the financial sector and that's mainly due to that sector limit. Then at the stock level, the diversification rule state that no one stock can be more than 4% at the time of rebalance. So, those diversification rules ensure that you get diversification beyond the big four banks.

Really, this fund can then work very well, potentially work very well with the existing investments that Australian's already hold. Most Australian's already have allocations to the big four banks for their source of equity income, this fund allows them to diversify their overall portfolio away from just the big four banks.

St Anne: Tom, investors like cash because it's a safe asset class. Doesn't this strategy make sense in times of volatility?

Keenan: So, investors are right to think about total return, and there is no doubt that the term deposits do shelter investors from markup volatility, but there is a couple of things that investors need to take in mind. Firstly, term deposits do not protect investors against inflation, and so those investors that are heavily invested in term deposits, could be eroding the purchasing power of their retirement income. Equity income does provide that hedge against inflation or can provide that hedge against inflation, due to the potential for capital growth, and certainly, that's something that we've seen over the longer term from equities.

The final point that I would make is that Australian corporates are in relatively good shape and there is a lot of bad news priced into equity markets at the moment. So, it could be a difficult decision for investors to reconsider their equity income as a source of their overall portfolio income, but often it's those in difficult decisions that are the most rewarding over the long-term. Now could be a good opportunity in light of those falling interest rates to reconsider their source of equity income.

St Anne: Tom thanks for your time today.

Keenan: Thanks, Christine.

Christine St Anne: In this month’s Monthly ETF wrap-up, I'm joined by Morningstar's Alison Stauss to look at any new products in the market and who were the best performers. Alison, welcome.

Alison Stauss: Hi.

St Anne: Alison, to start off with, who were the best performing ETFs?

Stauss: So, overall October, the best performing ETF was Aii's energy ETF. It had 12.24% return which is well and above the others. This was followed by the financial ETFs all had about 10% return.

St Anne: Which ETFs lagged the markets?

Stauss: Interestingly, the two bottom ETFs this month were the two best performing ETFs in September, and this was BetaShares’ USD product, and iShares Japan. These both lost about 8%, and this flip-flopping sort of highlights the volatility in the share markets that we've been seeing lately.

St Anne: Alison, this month you look at the breakdown in the market, what ETFs are investors now demanding compared to what they looked at the beginning of the year?

Stauss: So, we had a look at the number of assets in each different type, and so -- a broad-based international ETFs seem to have gained the most, and this has been at the expense of the broad-based Australian assets which, while they are still far and away the largest sector, largely due to STW’s half market share. They were the only sectors that lost money over the past year.

Another interesting change was  that the strategy-based ETFs, which we include the four income ETFs and Russell's Value ETF doubled their assets over the month, and I think this just shows that investors are looking not only for ETFs that they can understand and are transparent, but also that can provide a specific exposure for their portfolio.

St Anne: Alison, any new products to the market?

Stauss: Yeah, BetaShares actually just last week launched an oil ETF, which again just shows that investors are looking for specific exposures for their portfolio. So, we expect to see more of this kind of niche product come out into the market.

St Anne: Alison, you also looked at small cap ETFs and they seemed to perform differently from each other. What was this so?

Stauss: The performance of the small cap ETFs, so there is three in the market, is a good opportunity to look at the effect that the index can have on the performance of an ETF. So, Vanguard‘s VSO tracks the MSCI Australian Small Companies Index while State Street’s SSO and iShares' ISO track the S&P/ASX Small Ordinaries Index. So, there was about 1% difference in return between Vanguard's product and State Street and iShares product, and this is due to the underlying index. So, in order to understand it you need to look at the construction of the index. So, the MSCI index targets the bottom 14% of the share market, while the S&P/ASX Index excludes companies in the ASX 100 but goes down to including the 300, and they target a total 7% of the market cap, and so this results in sort of different holdings in the stock. So, the MSCI Index has about 70% mid-cap companies while the S&P only has about 55%. And there is similar difference when you look at the small and micro-cap as well. So, the different holdings will ultimately affect the performance of the ETF.

And to further break it down, ISO and SSO which both track the S&P Index also had different returns, and this is because they both use an optimized sampling method which means that each manager has a specific model that they are using to determine the optical weightings in which stocks are actually included in their ETF.

St Anne: Alison, so how should people use small cap ETFs in their portfolio?

Stauss: Well, because the small caps are historically more volatile and there is a lot of sector concentration, we suggest that the small cap holdings be used just as a part of a broader Australian equities exposure.

St Anne: Alison thanks for your views today.

Stauss: You're welcome.