There are new ETFs listing almost every day. They tempt investors with niche market offerings, cheaper fees or offering exposure to the new flavour of the month. Even if this is not the case and you are making a considered decision to add exposure to your portfolio through an ETF, it’s important to run through the process to determine whether it is actually necessary.

In this week’s episode of Investing Compass, we leaned on the insights of Shamir Popat from our Manager Research team. We asked him about the key insights from his report, 5 tips for evaluating investment funds. You’re able to find a breakdown of the report here.

Here’s some of our best resources on choosing ETF investments, which we believe is more important than the final investment selection itself.

3 things to check before adding another ETF: Portfolio overlap, cost and whether the new potential piece moves you closer to your goals.

Unconventional wisdom: Three tips for ETF investors overwhelmed by the abundance of choice. More isn’t always better and having too many options is challenging for investors.

Future Focus: Red flags for ETFs. What should investors avoid?

4 steps to build an ETF portfolio. How to create an ETF portfolio to achieve your goals.

Mark to market: Going all in on ETFs. Mark answers a reader question about asset allocation in retirement and the risk of ETFs.

Young & Invested: Is your ETF at risk of failure? Examining the forces behind fund closure.

Why ETFs may not be the best choice for investors. As their popularity increases it is important to consider the downsides to ETFs.

Young & Invested: The illusion of ETF returns. Finding false comfort in recent winners overlooks an important signal of fund quality.

Young & Invested: Are thematic ETFs worth it? Walking the line between strategy and speculation.

Young & Invested: Why these ETFs are likely to disappoint investors. A resurgence in thematic ETF inflow suggest that investors are ready to repeat the same old mistakes.

What if you’ve already made a mistake?

Have you invested in an ETF that you no longer believe in? Shani has created a decision tree on what to do with your holding if you’ve realised it does not deserve a place in your portfolio.

You can find the transcript for the episode below:

Shani Jayamanne: Invest Your Way is a different kind of book about money. We want it to be a trusted resource for investors who have graduated from Investing 101. For investors who know what a share is and an ETF is, but are struggling to put it all together to get onto the pathway to financial independence.

Mark LaMonica: Too much financial commentary focuses on investments rather than on the people investing. We believe investors are hungry for a new perspective. The investors we talk to tell us that they are tired of aspirational messages that lack the practical steps to put a plan into action. They don’t want bewildering and unrelatable jargon and complexity. They want the focus to be on the only thing that truly matters, creating a better life for themselves and their loved ones.

Jayamanne: Invest Your Way is a guide to successful investing with actionable insights and practical applications. You’re able to purchase the book through the links in the episode notes and at major bookstores or request a copy through your local library.

Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

LaMonica: We have a guest episode today, Shani, and it’s with Shamir Popat. Shamir is a Senior Manager Research Analyst at Morningstar who has been with us for almost four years. Prior to this, Shamir was a fund manager with a deep understanding of investment analysis, which is good for us and good for the topic today.

Jayamanne: So, there was really no better person to pen the inaugural report, Five Tips for Evaluating New Investment Funds, and we thought this was a great report because there are tons of insights in there for investors.

LaMonica: And his insights come at an important time for individual investors. The market is becoming saturated with new funds. We’ve seen 7,000 funds launch since the year 2000, and we’ve seen more than 3,000 closures. There are risks with picking investment funds, and it’s important to know what to look out for.

Jayamanne: That’s right, Mark. And the report goes through five tips for investors to get to the heart of this and to have the best chance of picking a good fund that helps you to achieve your financial goals over the long term. And the tips are – is assessing the edge of a product, which we’ll ask Shamir about; look for substance over hype; assess the investment team’s expertise; assess how the portfolio will be built; and that low costs lead to a greater likelihood of long-term success.

LaMonica: And the report concludes with five useful questions that investors can ask themselves every time they’re assessing a new fund or ETF.

Jayamanne: But we’re going to ask Shamir about the top insights from the report and the practical insights that individual investors can take and apply to their own investment strategy when looking for opportunities.

LaMonica: So, Shamir, thank you for joining us. We ask the same question to every guest we have on here. And I think a lot of listeners don’t know what professional researchers or investors do on a day-to-day basis. So, what fills your days?

Shamir Popat: Sure. So, I’m a Senior Manager Research Analyst focusing on evaluating investment strategies across Australasia. Most of my coverage is actually being global equities this year. My day-to-day involves like a deep dive analysis into fund managers’ processes, portfolios and performance, essentially helping investors separate the signals from the noise. We’re also very fortunate in our role where we interact with really smart fund managers and their teams, and it brings a wealth of perspectives on markets, but it also allows us to cross-examine fund offerings to see where those gaps are in expectations versus reality. Before Morningstar, I was an investment consultant, so I’ve been privileged to gain experience in a practitioner’s lens as well as the research mindset in this role.

LaMonica: And we’ll get back into that and meeting with fund managers, but we did want to concentrate on a report that you wrote. And you looked at what I guess we’re going to call an explosion of fund launches in Australia and New Zealand. And before we get into some of those details, why does that matter for an everyday investor?

Popat: I think when you see over 7,000 fund launches since 2000 and 3,000 closures, that’s a lot of noise. I mean, for investors, the challenge isn’t access. It’s discernment – the risk that many new funds don’t survive or fail to deliver on their promises. So, understanding what to look for now is more important than ever. And we were – it was a great opportunity. We did this as a cross-border paper with different regions all contributing research towards this sort of paper and its views. And we’ve seen the threads of the same across the world.

LaMonica: Now, we get a lot of questions from individual investors. And one concern is that what happens if somebody “steals” my money and we talk about the custodian model and everything else. But what happens if a fund closes? You said there’s been 3,000 closures since the year 2000. If you are an investor in a fund or an ETF that closes, what happens?

Popat: It’s a common fear, but you don’t lose your money. Typically, the fund winds down. It returns capital to investors. The bigger risk is actually the opportunity cost, where you either stuck in a fund that underperforms and doesn’t align with your goals. I think you both alluded to investor behaviors in prior podcasts, where we see inflows into new products based on the hype. But if you look at that investor’s money-weighted return, it’s compromised because by the time they’re getting into these products, the theme is already underway. And if the product doesn’t reach viability, then we see it close, which is almost like a negative investment decision for the investor.

You look at the performance of some of these crypto, climate change, cloud computing ETFs. They look like heroes in the last two years. But if you go back since their launches a few years prior, investors actually haven’t made good returns. So, then it’s the risk on the timing. When to pick the fund? How does the average investor makes that decision of when to go into the fund? We know investing is simple, but it’s not actually that easy.

So, yeah. I think you both did a great podcast episode a few weeks ago on the red flags on ETFs. Similar findings, the threads we’re seeing from both our perspectives are continuously confirmed. And it applies across the industry, whether it’s an active or a passive ETF structure. The momentum and the hype in the market since 2022, it’s been nothing short of fascinating. And we’ve seen short-term decisions that really show this FOMO desperation amongst investors. I mean, the lines at ABC Bullion over the last couple of weeks, that’s a great example of this all playing out.

LaMonica: So, let’s get back a little bit into your job. And you were talking about how you meet with fund managers a lot. And you’ve talked in some of your reports how you’re trying to assess a fund’s edge. What should people do? You obviously get to spend your days doing this. You get to actually spend time with the fund managers. You have all the reports and data that Morningstar has. What about just an everyday investor who’s maybe going out there and trying to find an active fund to invest in? What can they do to find something that will do well?

Popat: It all starts with the basics. What’s the fund doing that others aren’t? There’s a lot of marketing hype contained in these materials. You see it on flashy websites. But let’s take a category like global equities. There’s 300 funds to choose from. What is that new fund bringing that others don’t do already? When an investor sees the messaging, just simply look at the portfolio. If you see the top ranked stocks are very similar to what you’re already exposed to or what you’re already holding in other funds, you already know there’s quite a big overlap. So, you’ve got to ask, well, what are they actually going to do? Then you look at the fact sheet, the PDS. Is there something differentiated in the strategy or the philosophy? If it sounds more of the same, it probably is. And because that category is so crowded, that bar for differentiation becomes super high. Marketing terms that sound vague, presentations full of cyber techno terms that don’t simply explain how a manager’s process aims to generate outperformance is a key flag.

LaMonica: And we do talk a lot on this podcast about the pretty poor track record that active funds have had in beating their benchmarks. So, Morningstar puts out the Active/Passive Barometer report that measures this. Do you think individual investors are better off just going to index funds instead of trying to go through this process of finding the few funds that actually beat the index?

Popat: That’s a very interesting question.

LaMonica: A loaded question. I know.

Popat: It’s loaded but there’s also paradoxes because if you look at whether it’s Australian equities or global developed equities, those are very efficient markets that are pricing in new information very quickly. And index funds make sense in those areas. In less efficient markets like small caps or emerging markets, skilled active managers can add value because those markets are so inefficient. So, the key is, I guess, knowing where active management has a fighting chance, where you can spend your fee budget and get bang for buck in terms of active management value add.

But if you think in terms of a global equities portfolio, the rise of this active ETF concept is sort of a paradox in itself because fund managers have launched a vehicle for investors to make their own asset allocation decisions instead of staying invested for the longer terms to actually capture what the manager is trying to deliver, the alpha which only materializes over longer periods. So that in itself is an interesting thing to watch. But yeah, overall, we’ve seen enough studies that go to show 80% or so of fund managers over time have just struggled to beat the benchmark, especially in the recent few years.

LaMonica: So, a follow-up question is, I think investors get confused. You mentioned active ETFs, but then there’s kind of the middle ground, right? So, these are what we generally call thematic ETFs. So, it is technically tracking an index but that index has been designed in an active way to capture a certain theme. This could also extend into a factor ETF, something with high dividends. I mean, what do you think about those? Where does that fall in that spectrum between active and passive in terms of a broad index like the S&P 500?

Popat: Sure. I guess from a manager research perspective, we see those sort of products that are trying to capture distinct factor as something like a smart beta type of approach where an investor wants a dedicated factor exposure and the fund can reasonably capture or has enough empirical evidence that it can display that it can capture that factor. That gives a sort of sense of reliability to how it’s going to do it. But in the end, it’s very hard to rate because your first issue is if I’m buying a factor with thematic-driven ETF, how do I know how long that cycle is? Am I late in the cycle? Am I getting in too late? Has the cycle begun? Is it going to be prolonged? We don’t know. Look at the concept of thematic. Structural drivers, demographics, regulation – they sound perfectly long term, almost like secular trends that are going to keep going. But thematic funds that are launched to play on those types of trends can easily change their spots in between. Check if your existing portfolio already gives you exposure to those kinds of themes.

We’ve seen ESG funds riding the wave of tracking an environmental index. The top exposure in one of the benchmarks is Tesla at 20%. You’ve got an overlap with some of the other funds in your portfolio already playing at Tesla. So, there’s active fund managers that have taken high conviction in Tesla. So, you’ve got to make sure that you’re not doubling up on your positioning because ultimately the whole of portfolio construction is going to define where your portfolio is going to go. So yeah, I think the main thing is just making sure that there’s no overlap in the themes that you’re playing.

LaMonica: Yeah, and I’m a pretty skeptical person. So, I tend to think that, okay, why would somebody launch this thematic ETF, for example? Well, because they back-tested something and it has performed well. And everybody already believes in it, which might mean it’s too late. But yeah, that’s challenging for investors. And you mentioned a couple of these. The marketing obviously generally cites that strong performance which has happened in the past. And we’ve seen this with AI, certainly. You mentioned climate change, these other big themes. Is there anything an investor can do to say, is this a genuine long-term opportunity? Or is this just hype?

Popat: I think the biggest thing you have to watch out for is what are these products holding in terms of that overlap? Because those concentrations can be pretty big. As an example, if you bought the MSCI Taiwan Index, what are you actually buying? It’s 60% of TSMC. There is massive, massive exposures when you’re buying a thematic-based ETF, because they will be very concentrated, playing some of the top performers. And often, if you cross-check it with active managers, they would say, actually, we’d never touched these stocks for these specific reasons. Not to say that the index won’t outperform the active manager or anything. But in the end, the investor playing that exposure for that hype of a thematic or a theme, often it’s coming in too late. By the time that thematic fund is launched the theme is underway, and often they’re the last to basically get in. So that’s also a big danger.

LaMonica: Yeah, and I think it’s a really good lesson, because I think a lot of people read the marketing material. AI – AI will change the world, and you think, great. But people don’t actually look what’s in the portfolio. And yeah, I think AI is also a good example. All the giant AI companies are also the ones that are making up a lot of the S&P 500, and a lot of the MSCI Global Index. And yeah, that’s a really good advice.

So, another thing that you guys talk about a lot on our Manager Research team is that fees are a key predictor of long-term success. I do feel like after a very long time, starting with Bogle whenever he started in the 70s talking about this, most investors know this and look at fees. But how should you compare fees? Because fees are different. If something’s a broad-based index product, if something is thematic, if something’s actively managed, what should investors think about with fees when they’re looking at those different levels?

Popat: Your first perspective on fees was absolutely crucial. It’s one of the most reliable predictors of long-term success. We’ve seen it with the Active/Passive Barometer that these lower-cost index funds in efficient markets tend to outperform over time, or at least not outperform but deliver the index exactly as what they intend to. But it’s not just about being cheap. It’s actually about the value you’re getting. If a fund charges more, whether it’s a thematic fund or whether it’s an active fund, it clearly needs to justify why. What are they doing to actually generate outperformance over and above the opportunity cost of an investor simply buying an index fund? That is ultimately your benchmark.

If I’m an investor in a global equities index product paying 15 bps per annum, that is my defined benchmark. Anything I do from there has to be measured against that opportunity cost. If I’m buying a thematic fund, am I sure that I’m going to be allocating into this at the right time? Am I sure I can time this entry? Am I sure I can time the exit? Whatever tax implications of it for getting in and out? But also, the cost. The cost might be marginally higher, whether it’s 40 bps per annum. That doesn’t sound like a big deal. It’s not much of a big difference in fees. But is that product risk able to deliver what it intends on the label? And how much worse off am I going to be if it doesn’t? And that’s ultimately what you’re paying for. It’s not just the cost of entry. It’s the cost of that decision over time. Same with active management. You are paying them to actually deliver outperformance over and above an index. And that’s ultimately the opportunity cost.

LaMonica: Yeah. And it’s probably something – you talked about this a little bit before – but it’s probably something if you cannot go up to a mate and articulate why this fund is going to, whether it’s active or thematic, why this is going to give you the outcome you want, you probably shouldn’t invest in it. So at least research something enough until you can explain it.

So, with your report showing 7,000 new funds have been launched since the year 2000, if an investor is considering a brand-new fund, what is the first question they should ask themselves?

Popat: Why does this fund exist? What makes this fund worthy of my attention? If you can’t answer that clearly, whether it’s the strategy, the team, the cost, it’s probably not worth your money. There’s enough options out there to choose from already that are doing things that have high overlaps to each other. We rate the very differentiated strategies. We’ve seen whether it’s an index, smart beta or active offering. We know which are the ones that are truly differentiated and deliver to expectations over time. But for the plethora of products that are out there and the average investor, they really need to take a deep look into, at a simple level of saying, why would this fund add value to my portfolio? Is it going to cross over with anything in my portfolio already? And am I paying too much for something that’s over-promising? So, yeah.

LaMonica: Yeah, a lot of questions. But I think that’s good to have a high hurdle rate to actually invest in a new fund. Because as you said, there’s a lot already out there that kind of covers most things. But let’s finish up with if there’s one thing from your report that people should walk away from this episode remembering, what is that one thing?

Popat: Don’t get distracted by shiny new things. Focus on what matters, the strategy, the team, the cost and the alignment with your goals. A little bit of healthy skepticism goes a long way.

LaMonica: All right. That’s a great place to end this. Good advice for every investor out there. So, thank you very much for joining us.

Popat: Thank you for having me.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

Invest Your Way

A message from Mark and Shani

For the past five years, we’ve released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.

We’ve shared our journeys with you, and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey – Invest Your Way. Invest Your Way is a book that focuses on the investor, instead of the investments. It is a guide to successful investing, with actionable insights and practical applications.

If anyone would like to support this project you can buy the book now. Thanks in advance!

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