Christine St Anne: The Exchange Traded Fund or the ETF market certainly had a number of changes last year. Today, I am joined by Morningstar's Tim Murphy to give us the latest insights into the ETF wrap-up for 2012. Tim, welcome.

Tim Murphy: Hi, Christine.

St. Anne: Tim, so who were the top performers for the last quarter of 2012?

Murphy: So last quarter was a – very much a risk gone quarter. Lots of equity markets fared quite well around the world and that was certainly reflected in the types of ETFs and their performance that it was achieved in the fourth quarter. So topping the pops was the iShares' China ETF and then you saw a range of other new, mostly equity-related ETFs topping the charts behind that as equity markets were right around the world rallied quite strongly.

St. Anne: What about the laggers?

Murphy: So the bottom of the list was you know a couple of the commodity ones seem to have stood out in particular. You know things like natural gas where there has been a big over supply, come on board in the US. It really took a breather in the last quarter, it's fair to say.

St. Anne: Tim, last year we had a number of fixed-income and commodity ETF products coming into the market. How did they go with investor support?

Murphy: So you know, varying levels of support. None of those new ETFs took huge amounts of assets. I think one of the fixed interest ETFs got up just up by the $50 million, but in the rest, somewhere beneath that. So we haven't seen huge investor take-up just yet. But that's also partly a cyclical as well, given there wasn't a lot of new assets flowing into many e-products of any description last year, whether there were ETFs funds are into the market. So, I think you certainly saw a lot of new products being launched last year which will lay the ground work for all sorts of future development, future demand in coming years.

St. Anne: How are the ETF market compared with managed funds?

Murphy: In terms of flows, ETFs did pretty well. So, total asset levels sort of increased about 25 per cent year-on-year. Now a good chunk of that was market movement in relation to particularly the second half of the year, equity markets in particular taking off and certainly at this stage, most of the larger ETFs in Australia are equity related. So that factored in. But you did see some nice inflows too into a handful of some of the specific equity ETFs, and then Alpha was a combination of the newer ones particularly in fixed interest as you mentioned before.

St. Anne: Tim, so does this mean that you see more investors focus on ETFs rather than managed funds?

Murphy: Well, you are not going to see a wholesale shift but certainly at the margin, you are seeing that. And that comes back to the cost factor, you know, FOFA (future of financial advice) comes informally on 1 July this year. This trend towards lower cost investing is a structural change. It's not going to go away. So in most cases, at the margin that's going to favor lower cost ETFs at the expense of higher cost managed funds. At the same time you are seeing more managed fund products come to market that are lower cost and are addressing that. So certainly those are the structural change taking place is a benefit of ETFs and should be a tailwind to it rolling forward. But you are not going to see a wholesale – everything out of managed funds into ETFs, no, at this point.

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

Murphy: Thanks Christine.

Christine St Anne: In this month's exchange traded fund or ETF wrap up. I'm joined by Alex Prineas, who talks to us about how the products have performed and the new product from UBS.

Alex welcome.

Alex Prineas: Thanks, Christine.

St Anne: Alex, so, what were the best performing ETFs in the month of September?

Prineas: The best performing ETFs were mostly commodity related. So, we saw an announcement of policy from the US Federal Reserve. It's been dubbed QE-Infinity. It's basically a commitment to continue the policy of quantitative easing indefinitely.

So, that has all sorts of repercussions some of which have do with possibly debasing the US dollar and so precious metal ETFs were popular in September. So, we saw things like ETFS Physical Silver was up more than 12 per cent and we also saw strong runs from the ETFS Physical Platinum and BetaShares gold bullion.

There were also some industrial and energy products that also did well. So, ETFS Natural Gas and ETFS Industrial Commodities ETF were both up more than 10 per cent each. The only non-commodity related ETF that performed strongly although it was in the top 10 over the month was iShares MSCI Hong Kong product, but we know that the Hong Kong dollar is pegged to the US dollar. So, when you get an announcement quantitative easing, you can't say a liquidity injection into Hong Kong, so that may have been related.

St Anne: The not so good performers?

Prineas: Well, funnily enough, the worst performing ETFs were also commodity related products and I think that highlights in the short run, the commodity complex doesn't necessarily move in unison, but the worst performing products were more agricultural or oil related. So, we saw ETFS Agriculture and BetaShares Crude Oil both down around 5 per cent. Oil prices were limited during the month by an oil production pledge from Saudi Arabia and then it wasn't surprising to see some weakness in agricultural commodity prices. They had a very strong run in the previous few months on the back of the U.S. drought.

I guess commodity prices can be volatile and they can also be un-correlated to other asset classes they can be affected by things like crop yields, the weather, political decisions. So we often see commodity related ETFs at the top or bottom of performance tables in the short run and this month they dominated both the top and the bottom of the tables.

St Anne: Alex, UBS has recently launched a new ETF product. Can you give us an insight into this product and how it differs from the existing ETFs out there in the market?

Prineas: Yeah, the UBS product is an interesting one and it's based on buy ratings from UBS's fundamental equity research team. They have some quality filters overlaid, so you end up with a 40 stock portfolio. But ultimately I guess you could say it is a rules based ETF, but those rules are based on an underlying group of equity investors looking for attractive stocks.

So, UBS can't market it as an active ETF, because the regulation in Australia doesn't allow that. But essentially it is an ETF with an active stock selection component to it or a listed fund, I guess you could call it. The pricing also suggests that that's where it's pitched with a fee of 0.7 per cent. Looks quite expensive if you compare it to passive or index based ETFs. But if you compare it to an actively managed fund, say your average Australian shares, unit trust or super fund, the pricing looks more competitive. So, UBS's product is an interesting development. It's an example of the lines being blurred between ETFs and actively managed unit trusts or funds.

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

Prineas: Thanks Christine.

Christine St Anne: UBS recently launched in Australian equities exchange-traded fund, or ETF, to the Australian market. To give us an insight into how this ETF works, I'm joined by Ben Heap. Ben welcome.

Ben Heap: Thanks, Christine.

St Anne: Ben, UBS has been offering ETFs globally since 2001, why have you decided to offer ETF now into the Australian market?

Heap: This is a market that's one of the larger investment markets in the world and it's a market where UBS has been committed for a long time. With respect to asset management, we've seen the success with our ETF offshore and we've seen the steady growth of the market here, and so we think that growth will continue. We think that’s one of the things investors are looking for and our mantra is always to give investors products that meet their needs.

St Anne: There are a number of established ETF providers already in Australia. Ben, how is UBS going to distinguish itself from those other providers?

Heap: It's a very good question. I think a number of competitors, as you rightly say, have been here for a while and offering traditional passive ETF products. We had sought to do something a little bit different. We've sought to develop a product in our initial ETF, which offers a solution for investors which is a little bit better than might be available through a traditional passive ETF.

And in doing that what we've done is taken traditional market cap-weighted index and instead developed an index which takes account of quality of underlying stocks. In other words, do I hold all the stocks ASX 200, if instead you can hold a subgroup of those stocks which are likely to be better performing.

St Anne: Ben, can you tell us a little bit about the UBS preferred research index, which is what your ETF tracks?

Heap: Sure. That's right. So that is an index that the UBS Investment Bank has created and we are managing against. That index, instead of simply holding stocks in accordance with market capitalization, uses a series of filters to identify what we hope and expect will be a better performing subgroup of the overall index.

Now those filters are in part quality based, so very simply the buy recommendations that come out number one rated investment bank research type, traditionally that research has only been available to institutions, so this makes that research available to retail SMSF (self-managed superannuation fund) investors and in a series of quantitative filters as well.

So rather than simply holding in accordance with market capitalization, we use what's called a modified market capitalization. So that allows us to hold some smaller stocks that we think will be significant outperformance in a higher percentage and it means we're not obligated to simply hold the banks and the resource companies in large part.

St Anne: So what sort of companies are in that index?

Heap: It is still all stocks from ASX 200, so it's by definition large Australian well-known brand name stocks. We will always hold at least one bank. We will likely always hold stocks from the resources sector and then we'll hold industrial stocks as well. But instead of simply holding 50 per cent of our overall index in the top 10 stocks, which is roughly their percentage of market capitalization, we're able to hold a broader group of those stocks. So it will be traditional brand names and every day you can go to the UBS website and see exactly what stocks were in the index.

St Anne: Ben, you mentioned that index is more customized and uses filters. Does this mean your ETF is a bit more active than some of the other passive ETFs out there?

Heap: Yeah, I think that’s a good question. We, obviously, also have actively managed funds, which are based on the fundamental research from our teams all around the world and this ETF is not designed to replace those actively managed funds at all. That is a solution that meets a lot of our investors' needs.

For some investors a pure passive solution at a very low cost is what meets their need. For institutional investors to look at something in between and that is a cost-effective solution, which is based on an index so it provides broad exposure to the Australian equities market, but with a better return than you would otherwise be able to earn from simply investing in the index itself.

St Anne: How is that research shaped with your ETF product team, are there any processes in place?

Heap: Yeah, absolutely and there's very clear Chinese roles around these types of things in practice, the investment bank has constructed an index and that index is made available every day through our website and on that index, you can see exactly what stocks make up the index. We are in managing to that index.

So investors have absolute transparency, which is one of the strong advantages of ETFs. They know they are, through this ETF, holding the underlying stocks. It’s what's called a physical replication ETF, which is a very important principle and they’re able to take advantage of that expertise and invest in those preferred stocks in a way that we think is very cost-effective versus the alternatives in the market.

St Anne: Ben, a lot of our investors love their dividends. Does your ETF give investors these dividends?

Heap: Absolutely. So this ETF will pay semi-annual dividend based on the dividends that come from the underlying companies and therefore, the sort of dividend return will be very similar to the overall market return in terms of income. However, Christine, this is a space we certainly see appetite from investors and one of the things we are looking at going forward is developing a dividend or income skewed version of our ETF as well and that's something we'd like to offer to investors in the near future.

Christine St Anne: Today I'm joined by Morningstar's Alex Prineas to give us the latest update on the ETF or Exchange Traded Fund industry.

Alex, welcome.

Alex Prineas: Thank you.

St Anne: Alex, so what were the best performing ETFs for August?

Prineas: Sure, the best performing exchange traded products were mostly specialized commodity products in August. So, you had things like ETFS, Brent, crude oil, that was up more than 12% on the back of political tensions in the Middle East and a hurricane in the U.S. You also had ETFS Physical Silver, that was up more than 10%. In fact the precious metals products did quite well over the months of the top five performers. Three of them were precious metals related, so you had the Silver ETF that I just mentioned and then ETFS Platinum and Palladium products were also up more than 7% each.

August highlighted that commodities don’t always move in unison especially in the short-term. A lot of the worst-performing ETFs were commodity related, but more so focused on industrial commodities. In any given month you'll often see commodity ETFs at the top or bottom of the performance tables because of their volatility. So that makes them quite popular with traders, but we tend to focus – well, Morningstar focuses its research more so on the diversified broad-based ETFs that are more likely to form the building blocks in an investors' portfolio. So, things like State Street's ASX 200 ETF, which is a diversified portfolio of Australian shares or Vanguard's world ex-U.S. ETF.

St Anne: Alex, high dividend ETFs did quite well? Was that a reflection of investors demand for yield?

Prineas: Yeah, high dividend ETFs did deliver solid returns in August. Most of them were up 2% or more after more than 5% rise in the month of July. They have flattened out in September though, but what you've got to remember with high dividend ETFs is, the name doesn't tell you everything.

So if you take, for example, the iShares high dividend ETF, that was actually much flatter over those three months of July, August and September. The iShares product has a bit more of mid-cap flavor to it. So the large cap high-yield stocks have actually been sort after recently because of investors want to put their money somewhere. They want to get a decent yield, but they're also concerned about the safety of that dividend.

So it's been the large-caps that have done well whereas the mid-caps, which are more volatile have been a little more stagnant. So, you've seen that differentiation between the different type of high dividend ETFs.

St Anne: ETFs have continued to grow. They grew 4% in July and then another 2% in August. Alex is this because of new product launches or investor demand?

Prineas: Yeah. We have seen a proliferation of exchange traded products this year. The volume of ETF assets is more often than not is driven by market movements rather than investors actually rushing into the ETF market.

However, if you look over multiple months, the new products have made an impact. It's not across the board, some of the new ETF products are still tiny, but some of them have been quite successful. So, if you look at say the BetaShares high interest cash ETF, that was I think launched in March 2012, but by the end of September, it already gathered $60 million in assets. So, still small, but it's growing at quite a quick rate.

St Anne: Alex, finally in 2012, we've seen 22 new products come into the market, do you expect more ETFs to come for the remaining year?

Prineas: Yeah. The number of launches has slowed down a bit in the last month or so and fixed income was a major gap in the ETF market earlier this year, but then when the ASX allowed fixed income ETFs, all the major providers wanted to be in that space. So, you saw a lot of launches from iShares, Vanguard, Russell, State Street and you also saw that BetaShares cash ETF that I mentioned before.

We also saw 10 new commodity exchange traded products from ETFS, so that added to the numbers. I wouldn't expect as many ETFs or exchange traded products going into the closing period of 2012. So we just aren't seeing the demand from investors and advisors. But even if there are a lot of launches, I don't think there is any reason for investors to rush in.

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

Prineas: Thank you, Christine.

Christine St. Anne: It's that time of the month again, the ETF or Exchange Traded Fund monthly wrap up. Today, I'm joined by Morningstar's Tim Murphy to give us the latest update to the market.

Tim, welcome.

Tim Murphy: Thanks, Christine.

St. Anne: Tim, the usual question; what were the good performing ETFs and the not so good performers?

Murphy: Sure. So, June was an interesting month, and certainly like most of the other months, it's those commodity ETFs dominating the top and both the bottom of the list. Dominant in the top was agricultural commodities in this sector. So, the BetaShares agricultural basket was the top performing ETF for the whole month. But alongside that in the early June, we saw ETF Securities launch a range of different commodity including soft commodity ETFs, and while they didn't perform for the whole month, since they weren't listed for that time they certainly offer a very strong start.

On the flipside of that, you saw weakness in precious metals. So, some of the ETF Securities are in the palladium, platinum, these sorts of things were at the bottom of the pile, and more domestically focused sectors. You saw some of the results of mining sector ETFs also show weakness during the June month.

St. Anne: Tim, BetaShares also launched a BEAR ETF. Can you give us a little insight into this new product?

Murphy: Sure. So, like the name, like the expression in the ‘bear market’, the BEAR ETF tries to profit from bear markets. So, it's promising to deliver inverse exposure of the broad market. So, while it's not perfectly going to track it from day-to-day, through time what you'd expect is if the market goes down, the BEAR product will make money, and I should highlight that the BEAR isn't strictly speaking an ETF.

But equally too, if the market goes up then that product will lose money. So, it's really trying to provide a tool for people who want to take a short-term view on the market may be going down, and that's one way to profit through an ASX listed security.

St. Anne: Tim, you mentioned that it wasn't a strictly an ETF. So, what exactly is the structure of this product?

Murphy: It's a listed fund. So, because it doesn't it purely track an index, the way they manage the inverse exposure, it can vary between sort of 90% and 110% of the actual index through time. And so because of that, it's not strictly speaking an ETF, but what you should expect through a cycle is it to broadly deliver the opposite performance of the market.

St. Anne: So Tim, is this product more of a short-term trading tool?

Murphy: Well, I guess it all depends on your outlook and your timeframe. So, most of us would think that over the long-term, markets tend to trend upwards, in which case, this product - the BEAR product, wouldn't be a particularly good long-term investment and so that's certainly I think going to make it more of a short-term tool. If you want to take a shorter-position with a view that the market may go down, then this is one way of being able to do that.

St. Anne: Tim, finally, global provider Van Eck entered the Australian market. Does this mean more product innovation in the ETF market?

Murphy: Yeah, it will be an interesting one. Time will tell. Certainly, Aii, they took over - hasn't been a strong player in the Australian ETF space. Their ETFs have been quite small, very limited assets. Van Eck is one of the larger players, particularly in the U.S. with their Market Vectors ETFs. So, it's going to be quite interesting to see how their Australian ETF products strategy develops.

We don't have any clear indications on what that may look like at this point, but I'll certainly watch this space, because most of the global providers are certainly looking at Australia as a big opportunity and somewhere where they can bring new more innovative products to market over time.

St. Anne: Tim, thanks again for your time.

Murphy: Thanks Christine.

Christine St Anne: A number of new products have come into the ETF market. To make sense of these products and what they mean for an investors' portfolio, I am joined by Morningstar's Tim Murphy. Tim welcome.

Tim Murphy: Thanks Christine.

St Anne: Tim, so ETF securities have launched a number of ETCs or Exchange Traded Commodities, can you give us an idea about what these products are?

Murphy: Sure, so there is lot more tools now available to construct commodity based portfolios for investors in Australia. ETF securities launched a range of commodity ETFs as you said across both soft commodities and metals. So things like natural gas, copper, corn, wheat, as well as baskets of combinations of all of those as well. So there certainly are lot more options now available to invest in a range of commodities, both metal based and soft commodity.

St Anne: How do these ETCs differ from ETFs or Exchange Traded Funds?

Murphy: So what you'll find is in most cases, most ETFs will be physically backed and by that I mean the ETF will hold the underlying securities that make up that index. With many commodities, in particular soft commodities, if you think about it, it's not practical to physically hold the underlying asset.

So when you buy the corn ETC, there isn’t a warehouse full of corn backing that, but rather these things tend to be based on futures curves or in the case of ETF securities, a differed purchase agreement, which is a derivative type agreement that introduces a different set of risks to deliver that exposure. So, rather than having the physical underlying asset you introduce derivative credit exposure risk to the counter party to that transaction.

St Anne: Tim, the derivatives element behind the ETCs - does this mean risk for investors?

Murphy: It just means a different risk that you need to be aware of. So when your derivatives aren't necessarily bad, but if you want to get say corn exposure that's the most efficient way of getting it. Because physically holding corn; the storage costs, the chance of it going off past its used by date, that sort of thing doesn’t make it practical, if that’s the financial exposure you want to achieve. So using a derivative based product to get that exposure is the most efficient way of doing it. It's just a different set of risks that you need to be aware of and understand before making such an investment.

St Anne: Finally Tim, how do these ETCs fit in an investment portfolio?

Murphy: Most of these should only be niche players in a portfolio. Some of these exposures are very particular and very specific and also potentially very volatile. So things like any of these individual commodity ETFs, if they’re used at all, should only form or a very small part of an investor's broader portfolio, which is diversified across a number of areas.

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

Murphy: Thanks, Christine.

Christine St. Anne: Russell Investments recently made changes to its high dividend ETF. Today, I'm joined by Scott Bennett to talk to us about who are the companies that are giving you, the investors the high dividends. Scott, welcome.

Scott Bennett: Hi Christine.

St. Anne: Scott, besides the major banks, who are the companies in your top 10 holdings?

Bennett: Yeah. We've got a really diverse set of holdings in the top 10 for our high dividend index especially. So when we look through the major holdings, in that we have allocations to things such as telecommunication, obviously through Telstra, which is a very high yielding stock. We also have allocations to areas such as media as well, so Seven West Media is a company that has come up and shown fairly good yield over the past 12 months and we expect that to continue, obviously. Then outside of that we've got exposures in gaming, through companies such as Tatts, and then also more the consumer staples through Wesfarmers and also Woolworths, which have very sustainable - what we think a very sustainable dividend yields. On top of that we also ensure that we do have exposure in the resource sector as well, and that exposure is primarily through BHP, which has a very strong history of paying growing dividend.

St. Anne: Scott, on the point of BHP, a number of investors have been a little bit cranky about the company not giving them the dividends they deserve. So where are they among your top holdings?

Bennett: Yeah. I mean that's quite interesting. I mean BHP generally, the yield on BHP stocks are round about 3% per annum, and that's before including for franking credits. So once you to include franking credits on top of that, you are looking at something around about a 4% yield, which is around about 2% below market, so not the best yielding stock. The reason for that is, I mean, BHP, while it's not necessarily a fantastic growth company, it is very capital intensive in terms of them seeking out acquisitions and the like. But what we’ve seen with BHP, and what might not actually show up on dividend yield. So they have actually been fairly good in terms of managing their capital structure.

Last year, we saw around a significant result of that being, their $2 billion buyback, which many investors were able to participate in and that resulted in substantial amount of yield pickup and income for investors, where that $2 billion effectively treated as a special dividend. BHP, while the yield might not look that attractive in terms of its dividend policy, we think it's been fairly conservative, but definitely progressive in terms of the way it manages dividends over time.

St. Anne: Scott, can you give us a little idea about the processes you have in identifying the sustainable dividends?

Bennett: In terms of the process of using for RDV, what we really want to focus on is not so much what the companies have paid out in the past, but what they are likely to pay out over the next three years. So the reason for that is that dividends, like earnings can be highly sporadic. Those companies are actually likely to pay dividends next year, and for several years after that. So that when we buy a stock, we have a very high likelihood, that it will actually pay dividends over the next three years. So that's where we put the greatest emphasis on the stocks that we are looking at. We obviously do make sure that those companies that we are holding have had a history of paying out a dividend over their history. So we look out over the last five years and look at what their dividend payments have been like over those five years.

The other criteria that we look at, this relates back to the BHP stories, it's really important for investors that their dividends are growing through time. So, if you just save the same amount of dividend each year, over a 10 period, inflation would have eaten away around about a third of the value of that dividend. So you need your dividends to be constantly growing to maintain the purchasing power. So, we explicitly look for dividend growth, and make sure that the companies we are buying have the history of increasing their dividend over time.

Then the final measure we look at is earnings variability. So we want to make sure that the companies that we are investing in are sound, and then they're not highly cyclical.

St. Anne: Investors love the banks when it comes to income stocks. What about the importance of diversification?

Bennett: In the Australian market, we think it's very important to think about diversifying, especially when you are looking at income investing. Because while income investing should be relatively safe way to invest, there are traps obviously associated with very high yield stocks; and while we have confidence in the ability of banks to meet their dividend payments, we think there are lot of a opportunities that investors could forego by just limiting themselves to the banks, and we think there is some very good solid defensive opportunities out there for investors.

ETF include things like SP AusNet, which is an electricity supplier in Victoria. Very stable growing dividend and on a yield of around about 10% fully franked, we think that that offers obviously an attractive opportunity to investors outside of what they might hold within the banks; and we think that level of diversification is important, just so that you’re not overwhelmingly reliant on one source of income.

St. Anne: Scott, banks are also facing a lot of pressures at the moment, so do you think that they are able to sustain the relatively high dividends?

Bennett: Yeah. We think from a capital perspective and from a balance sheet perspective there is not that much pressure to the banks being able to sustain their dividend payouts, and also kind of increase their dividend payouts. What we've seen is the banks have been fairly resilient through time, in terms of supporting their dividend, even though their earnings may have been at risk through some period.

So just as a general policy, the banks don't like to reduce their dividends as a whole. So we think structurally, there isn't really much of a threat to the bank dividend. However, we do kind of realize that from an earnings perspective, the banks can be somewhat at risk. But we think that that risk isn't enough to erode their ability to pay dividends.

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

Bennett: Great, thanks Christine.

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.